RISK & RETURN

BY:
S.S. R. KRISHNA,
FACULTY (FINANCE) ( ICFAI )
 RISK

The chance that the actual

outcome form an investment
will differ from the expected
outcome

( outcome mean here return)

TYPES OF RISKS:
 Interest rate risk : the risk that arises due to
changes in the interest rate and these changes
have an impact on the prices of the investments that
is, investment value will change due to changes in
interest rates. Other things being equal, security
prices move inversely to interest rates.
 market risk: The risk that the investment value of
the security will get reduced to change in the market
conditions is market risk . The market risk affects
almost all the industries and one such factor from
which market risk arises is war between two
countries
 inflation risk : with the rise in the inflation there is
reduction of purchasing power, hence this is also
referred to as purchasing power risk and affects all
securities and that is why it is known as systematic
risk
 business risk : it is the risk associated with the
company’s products and services. This risk arises
because of doing business in a particular industry gets
transferred to the investors who invest in the business.
Financial risk : the risk that the company will not
have sufficient funds to meet its financial needs is
termed as financial risk. The risk arises when
companies use debt securities for raising finance. The
companies, which issue more debt securities, will have
higher financial risk.
Liquidity risk:
it arises because one is not able to
sell the security that one is holding. The
security market has no buyer for a particular
security. Before investing, one looks at the
trading on a particular security. As we have
seen earlier, a well developed secondary
market is the base for a primary market
 The risk of a particular
investment can be measured by
means of

3) standard deviation
4) variance
5) BETA coefficient.
Portfolio and risks:
1) PORTFOLIO : an investment portfolio stands
for diversified investments to mean investments
in different securities of different sectors.
Diversifiable risks: these risks affect only a
particular firm/sector and are even known as
unsystematic risks. The risk arises mainly due
to factors that are company specific.
ex: company strikes, product failure etc
Sol: the risk can be eliminate by investing other
type of securities
BETA:
It is an indicator, which indicates
how returns on particular security would
change due to change in the market index

if BETA < 1 DEFENSIVE SECURITIES

if BETA >1 OFFENSIVE SECURITIES
if BETA = SECURITY MOVE IN THE SAME
DIRECTION
 BETA
A quantitative measure of the volatility of a
given stock, mutual fund, or portfolio, relative
to the overall market, usually the S&P 500.
Specifically, the performance the stock, fund
or portfolio has experienced in the last 5 years
as the S&P moved 1% up or down. A beta
above 1 is more volatile than the overall
market, while a beta below 1 is less volatile.
BETA:
KJ = α J + βJ K m + e J

KJ = Expected return on security “J”

αj = Is the intercept which indicates what

the rate of return of security
βj = it is the beta coefficient of security
km = Expected market return
e j = Is the error term (with a 0 mean and
Capital asset pricing model:
Non diversifiable risks: the risk that
remains after diversification is non
diversifiable risk.
It adds risk of portfolio and is also
known as market/systematic risk.
The risk has to borne by investor
 This will arise in situations like
ex: political events, natural
calamities, change in economic policies
RETURN:
income received on
an investment plus any change in
market price, usually expressed
as a percent of the beginning
market price of the investment.
Measuring rate of return:
rate of return is expressed as the
percentage(%) of the security value. (the value. Which is at
the beginning of the holding period.
 it is the total return earned by the investor, which takes
into account both current yield & capital gain/loss.
TOTAL RETURN = CURRENT YIELD + CAPITAL GAIN/
LOSS
 It is the income from the security between the beginning
and the end of the holding period expressed as a
percentage of the purchase price of the security at the
beginning of the holding period.
The return acts as a benchmark due
to the fallowing reasons:
An investor can compare the returns to
different investment schemes and risks
associated with them
 Historical (past) returns when
compared will through light on the
performance of the company
 Historical (past) returns can be used to
estimate the future returns
Probabilities and rates or
return:
probability is a numerical
number, which shows the
chances of a particular event
taking place.
Expected return:

The weighted average of

possible returns, with the
weights being the probabilities
of occurrence
 CAPITAL ASSET PRICING MODEL:
This model helps in
pricing the securities, which are RISKIER. The model
establishes relationship between NON-
DIVERSIFIABLE risk and expected return of the
security taking into account the RISK FREE RATE OF
RETURN.

---------- by. WILLIAM F SHARPE,

JAN MOSSIN