NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-2
Session-3
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.
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.
Hence a basic formula used for calculation of return can be as below:

rt

Pt Pt 1 Ct
Pt 1

Where rt is the actual, required or expected return during period t, Pt is the current price, Pt-1 is the
price during the previous time period, and Ct is any cash flow accruing from the investment.
Suppose one has bought a share of ABC Limited at Rs.300 one year back. Over the last year ABC has
distributed dividend of Rs.5 per share. If the share of ABC sells at Rs.340 today, what is the return?
The total return is Rs.45 that comprises of Rs.5 of dividend and Rs.40 (Rs.340 Rs.300) in terms of
appreciation in the market price of the share. Hence the % return is Rs.45/Rs.300 i.e. 15%.
In case the share of ABC sells at Rs.280 today what is the return?
The absolute return (-ve)Rs.15 (i.e. Rs.5 dividend and loss of Rs.20 in terms of fall in price), which is
-5% on origninal ivestment of Rs.300.
Holding Period Returns
The holding period return is the return that an investor would get when holding an investment over a
period of n years, when the return during year i is given as ri:

holding period return

(1 r1 ) (1 r2 ) (1 rn ) 1
Suppose an investment provides the following periodic return over last five years:
Year

Return (%)

12

15

-8

14

16

The holding period return on the investment is computed as below:

(1 r1 ) (1 r2 ) (1 r3 ) (1 r4 ) (1 r5 ) 1
(1.12) (1.15) (0.92) (1.14) (1.16) 1
.5670 56.70%
This can be interpreted as 56.70% return over five year holding period. In case an asset does not
provide any periodic return like annual return in the previous example the holding period return
(HPR)can be calculated as below:

HPR

Ending Value of Investment

1
Beginning Value of Investment

Example: A financial asset was purchased at Rs.300 and it grew to Rs.370 over five year period. The
HPR over three year period is

400
1 0.3333 33.33%
300
This return can be converted to effective annual return which can also be termed as annual holding
period return or yield as below:
Annual HPR = (1+HPR)1/n 1
Where, n is the number of years the investment is held. In the previous example, the annual HPR is:
(1.3333)1/3 1 = 0.1006 = 10.06%
Expected Return
Unlike historical return, in case of expected returns are predicted for the future with relevant values
being predicted. The prediction can be for different expected outcomes. In such case probability is
associated with possible outcomes and expected return from an investment is estimated.
n

E (r ) piri
i 1

Suppose there are two shares A and B and rate of returns in different conditions are expected to be as
below:
State of the
Economy

Probability of
occurrence

Rate of Return (%)

A

Boom

0.50

22

24

Normal

0.30

18

18

Recession

0.20

14

12

The expected return on Share A = 0.50 x 22 + 0.30 x 18 + 0.20 x 14 = 19.2%.

Similarly return from Share B = 0.50 x 24 + 0.30 x 18 + 0.20 x 12 = 19.8%.
Risk:
Usually, investment returns are not known with certainty. In the context of investment, risk is defined
as the chance of suffering a loss. Assets (real or financial) which have a greater chance of loss are
considered more risky than those with a lower chance of loss. Risk may be used interchangeably with
the term uncertainty to refer to the variability of returns associated with a given asset. The common
sources of risk are as below:

Firm Specific Risks

o Business Risk: Investors can be subject to bad performance of business or the firm
due to several reasons like weak demand for the products/ services, technological
changes, supply related problems, mismanagement.
o Financial Risk: This emanates from the fact that the particular firm has borrowings as
its source of finance. Higher the borrowing, higher is the interest outflow. In good
condition, borrowing helps better return on shareholders funds an implication of
financial leverage. However in bad condition, borrowing can harm the firm.
Borrowings also invite default risk.
Investor-Specific Risks
o Interest rate risk: Change in interest rates can affect the value of interest bearing
securities. There is an inverse relationship between interest rate and value of interest
bearing securities like bonds, debentures, etc. The equity shares are also affected
indirectly by the movement in interest rates.
o Liquidity risk: The investors can have problem in converting the securities into cash
because of inadequate market or for the fact that the securities are not listed.
Sometimes, irrespective of listing, the securities are not traded in the market.
o Market risk: This is not related to the particular firms performance, but depends
upon the overall market condition being pessimistic or optimistic because of several
underlying factors. During a bullish period, prices of most of the equity shares move
up and vice versa in bearish period. Market also moves in cycles.
Firm and Investor Risks
o Event Risk: These are the risks caused due to unforeseen events related to the
company or a sector like ad adverse court judgment, regulatory policy change, sudden
demise of key people of the organization.
o Exchange Rate Risk: This risk is caused due to change in currency rates. Companies
having exports as major source revenue or imports of supplies are vulnerable to this
risk. In the present era of globalization, it is difficult for any company to be immune
to this risk.
o Purchasing-power risk: These are caused by changes in price level in the country.
Inflationary conditions can affect the firms adversely because of decrease in demand.
o Tax risk: Change in tax rates for companies and/ or investors can have adverse
impact. Sudden change in tax rules may affect the companies favorably or
unfavorably. Tax being a major element of expense for any company, adverse

change in tax rates can be taxing for the company concerned. Investors residual
income can also be affected by change in personal income tax rules and rates.
Unsystematic vs. Systematic Risk
The risks that can be controlled by diversifying the portfolio of financial assets are known as
unsystematic or diversifiable risk. The risks that cannot be controlled by investors are known as
systematic risk. Market risks are essentially systematic risk where as investor or firm related risks can
be diversified. Systematic risks affect the companies across the system.
Risk Preferences: By default investors are risk averse, the difference among investors is only with
respect to the relative risk averseness. However, based on the preferences for risk, investors can be
classified into three categories as below:

Risk Neutral

Risk Averse

Risk Seeking

Risk of a Single Asset: Please refer Figure 1. Which stock A or B is more risky compared to the
other? Do note that both the stocks have same average rate of return of 15%. The return distribution of
Stock B is more flat than that of Stock A, i.e. the range of possibilities of returns is more compared to
Stock A. From this figure one can conclude that Stock B is more risky than Stock A.

ProbabilityDistribution
StockA

StockB
Rateof
Return(%)

20

15

50
Figure1

Consider the following Assets for which the returns under various conditions of economy are given.
Economy

Prob.

G-sec

Stock 1

Stock 2

Stock 3

Stock 4

Recession

0.10

8.0%

-22.0%

28.0%

10.0%

-13.0%

Below average

0.20

8.0

-2.0

14.7

-10.0

1.0

Average

0.40

8.0

20.0

0.0

7.0

15.0

Above average

0.20

8.0

35.0

-10.0

45.0

29.0

Boom

0.10

8.0

50.0

-20.0

30.0

43.0

8.0%

17.4%

1.7%

13.8%

15.0%

1.00
Expected Return

The G-sec has same return irrespective of the economic outcome. This appears to be risk free.
Stock 1 moves along with the economy (positively correlated) whereas Stock 2 moves in opposite
direction of the economy (negatively correlated).
Measuring Risk: the simplest measure of risk is range which is defined as the difference between the
highest possible return and lowest possible return. In the above table, the range for Stock 1 is 72.0%
whereas for Stock 2 it is 48%. However standard deviation is considered as one of the very well
accepted measure of risk. Standard deviation is the square root of variance.

Variance

ri r Pi .

i 1
n

For Stock 1:
= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10))1/2 =
20.0%.
Similarly for other investments, the standard deviation is given in the following table.
Investment

G-Sec

Stock 1

Stock 2

Stock 3

Stock 4

0%

20.0%

13.4%

18.8%

15.3%

Additional Readings:
Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment,
3rd Edition, Pearson Education.
Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6th Edition, Tata McGraw-Hill.
Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th Edition., PrenticeHall.
Jones, Charles, P., Investment Analysis and Management, 9th Edition, John Wiley and Sons.
Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata McGraw-Hill.
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition,
Thomson South-Western.

Additional Questions:

Q. 1: Suppose one has bought a share of PQR Limited at Rs.224 one year back. Over the last year
PQR has distributed dividend of Rs.8 per share. If the share of PQR sells at Rs.250 today, what is the
return? If the share is trading at Rs.220 today, what is the return earned?
Ans.: The total return is Rs.34 that comprises of Rs.8 of dividend and Rs.26 (Rs.250 Rs.224) in
terms of appreciation in the market price of the share. Hence the % return is Rs.34/Rs.224 i.e.
15.18%. if the share is trading at Rs.220, return earned is: 1.79%.
Q.2: Suppose an investment provides the following periodic return over last four years as below:
Year

Return (%)

10

12

-6

12

What is the holding period return?

Ans. Holding period return = (1.10 x 1.12 x 0.94 x 1.12)1/4 1 = 0.672 = 6.72%
Q.3: Consider the two assets A and B for which returns (%) under different conditions of economy are
given as below. Find the expected return and risk (as measured by standard deviation of return) of
each asset.
Returns
Condition of
Economy

Prob.

Stock A

Stock B

Recession

0.10

-18.0

-10.0

Below avg.

0.20

-4.0

2.0

Average

0.40

12.0

8.0

Above avg.

0.20

24.0

12.0

Boom

0.10

30.0

18.0

1.00

Ans.:
Condition of
Economy

Prob.

Return

Prob.*Return

Prob.*(Return Exp. Return)2

Stock A

Stock B

Stock A

Stock B

Stock A

Stock B

Recession

0.1

18.00

14.00

1.80

1.40

13.92

6.08

Below avg.

0.2

(4.00)

2.00

(0.80)

0.40

41.47

15.49

Average

0.4

12.00

8.00

4.80

3.20

30.98

14.40

Above avg.

0.2

24.00

12.00

4.80

2.40

15.49

9.25

Boom

0.1

30.00

18.00

3.00

1.80

11.24

5.48

13.6

9.2

Variance
(%Square):

113.10

50.70

Standard
Deviation
(%):

10.63

7.12

Exp.
Return
(%):

Q.4: What are the different sources of risk?

Ans.: The different types of risks are as below (not an exclusive list):

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