Risk and Return

Fundamentals

Risk and Return I

Outline
Basic Concepts of Return
Basic Concepts of Risk
Sources of Risk
Measuring Risk of a Single Asset

Basics of Return
The investors invest in any asset in
anticipation of return on the same.
In case of financial assets, this can
also be termed as the financial results
of the investment or financial asset.
As one of the foremost criteria, an
investor can distinguish different
financial assets based on return on
such financial assets.

Basics of Return Contd.

Returns can be classified as historical or expected
i.e. prospective.
Returns can be in absolute value i.e. in terms of
currency and in relative terms i.e. in terms of %.
For example, if an investment purchased one year
back at Rs.120 is sold for Rs.132, the absolute
return is Rs.12 and the relative return is 10% (i.e.12
/ 120). Return in a way represents total gain or loss
on investment. The total gain/ loss can comprise of
periodic return and change in the value of
investment at the end of the holding period.

Elements In Return
Returns on a typical investment consists of
two components
1. Periodic Cash (Interest /dividend / income)
on the investment.
2. Change in Price of the asset (Capital gain
or loss) (Difference between the purchase
price and current market price or the price
at which can be asset sold)
Total Return == Income + Price Change (+/-)

Return Measurement

Risk In a Traditional Sense

Possibility that realized returns will be less
than the returns that were expected.
Forces that contribute to variations in return in
price / dividend / interest constitute elements
of risk
Influences of risk can be internal or external
External Uncontrollable-Systematic risk
Internal- Controllable Unsystematic risk

Systematic / Unsystematic
Risk
Systematic risks
Market risk
Interest rate risk
Purchasing Power risk
Unsystematic risks
Business risk
Financial risk

Systematic risk
Systematic risk refers to that portion of
total variability in return caused by
factors affecting prices of all securities.
Systematic risks Uncontrollable to a larger
degree & External
Sources of systematic risk - Economic,
political, and sociological changes.
Example : Impact due to fall in crude oil
prices, resulting in decrease in prices of
shares of few oil companies.

Unsystematic risk
Unsystematic risk refers to that portion of total
risk that is unique to a firm or industry.
Unsystematic risks Controllable & Internal
Sources of Unsystematic risk Management
capability, consumer preferences and labor strikes.
Unsystematic factors are largely independent of
factors affecting securities markets in general and
these factors affect one firm and hence they must be
examined for one firm.
Example : Maggie noodles issue drastic drop in
sales resulting in loss and decline in prices of shares
of Nestle.

Sources of Risk

Business Risk
Financial Risk
Interest rate risk
Liquidity risk
Market risk
Event Risk
Exchange Rate Risk
Purchasing-power risk
Tax risk

Market risk
Market Risk : Variability in return on
most common stocks that is due to
basic sweeping changes in investor
expectations.
Investor reaction - tangible as well as
intangible events.
Other factors Interest rates and
inflation are integral factors behind
market risk.

Interest rate risk

Interest rate risk refers to the
uncertainty of future market values
and of the size of future income
caused by fluctuations in the general
level of interest rates.
Interest rate riskisriskto the
earnings ormarket valueof a
portfolio due to uncertain future
interest rates.

Purchasing Power risk

Purchasing power risk can be defined in terms of
uncertainty of purchasing power of the amounts
to be received by the investor.
Purchasing power risk refers to the impact of
inflation or deflation on investment.
The chances of an adverse effect on the value of
money as a result of inflationary pressures within
an economy. The purchasing power risk of
holding Cash rather than a physical asset like
gold or real estate tends to increase when
inflation is high.

Business Risk
Business Risks can be classified as
internal / external
Internal : relate to Operational
efficiency etc
External : External operating
environmental factors government
policies, business cycle changes etc

Financial Risk
Financial risk is associated with the
way in which a company finances its
activities .
Gauging financial risk - assessing
capital structure of a firm.
A firm with no debt financing has no
financial risk

Risk Fundamental
Facets of Fundamental Risk:
Risk is fundamentally inherent to investment. All
types of investments do not fit to the pattern of
no risk, hence risk free return.
Since the investors bear the risk i.e. the
uncertainty in future cash flows, they will be
demanding a premium for the risk borne.
Although, mathematically risk can involve upward
or downward swing in the return, practically it is
the downside that bothers the investor.

Assigning risk allowance

(Risk Premium)
Definition of Risk Premium:
The return in excess of the risk-free rate of return that an
investment is expected to yield.
An asset's risk premium is a form of compensation for
investors who tolerate the extra risk - compared to that of
a risk-free asset - in a given investment.
The formula for risk premium, sometimes referred to as
default risk premium, is the return on an investment minus
the return that would be earned on a risk free investment.
The risk premium is the amount that an investor would like
to earn for the risk involved with a particular investment.

Risk Premium
Risk Premium =
asset or investment return risk free return
Risk Premium of the Market
The risk premium of the market is the average
return on the market minus the risk free rate.
Risk Premium on a Stock Using CAPM
The risk premium of a particular investment
using the capital asset pricing model is beta
times the difference between the return on the
market and the return on a risk free investment.

Types of risk that drives risk

premium
The different types of risk that can
drive
the risk premium are:
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Relationship Between Risk and

Return
return over and above RFR is known as
risk premium

Risk Movements & Return

(SML)

Risk Premium formula

RPi = E(Ri) - NRFR

Where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
Risk premium:
f(Business Risk, Financial Risk, Liquidity Risk,
Exchange Rate Risk, Country Risk); or
f(Systematic Market Risk)

Rate of Return
Required rate of Return: The investors invest
in financial instruments expecting some rate of
return. This depends on the return from the next
best investment option known as opportunity
cost and is affected by:
Time value of money todays one rupee is
better than tomorrows.
Expected rate of inflation
Risk involved because of uncertainty in the
cash flows from the investment

Real Risk Free Rate (RFR)

The Real Risk Free Rate (RFR):
This is the return that has no risk the following
features:
Assumes no inflation.
Assumes no uncertainty about future cash
flows.
Influenced by time preference for
consumption of income and investment
opportunities
in the economy.

 Basic formula for calculation of return

Calculation of Return

Systematic and Unsystematic Risk

Total risk to a stock not only is a function of the

risk inherent within the stock itself, but is also a
function of the risk in the overall market.
Systematic risk is the risk associated with the
market.
When analyzing the risk of an investment, the
systematic risk is the risk that cannot be
diversified away.
Unsystematic riskis the risk inherent to a stock.
This risk is the aspect of total risk that can be
diversified away when building a portfolio.

 Total risk = Systematic risk +

Unsystematic risk