Financial Management

Risk and Return

Returns are the gains or losses from a security in a particular period and are usually quoted as a
percentage. What kind of returns can investors expect from the capital markets? A number of
factprs influence returns

Risk: In the investing world, the dictionary definition of risk is the chance that an investment's
actual return will be different than expected. Risk means you have the possibility of losing
some, or even all, of your original investment. Low levels of uncertainty (low risk) are
associated with low potential returns. High levels of uncertainty (high risk) are associated with
high potential returns.

Types of Risk
Systematic Risk:
It refers to that portion of variability in return which is caused by the factorsaffecting all the
firms. It refers to fluctuation in return due to general factors in the market suchas money
supply, inflation, economic recessions, interest rate policy of the government, politicalfactors,
credit policy, tax reforms, etc. these are the factors which affect almost all firms. Theeffect of
these factors is to cause the prices of all securities to move together. This part of risk arises
because every security has a built in tendency to move in line with fluctuations in themarket.
No investor can avoid or eliminate this risk, whatever precautions or diversification may be
resorted to. The systematic risk is also called the non-diversifiable risk or general risk.
Types of Systematic Risk:
1. Market Risk:
market prices of investments, particularly equity shares may fluctuatewidely within a short
span of time even though the earnings of the company are notchanging. The reasons for this
change in prices may be varied. Due to one factor or theother, investors’ attitude may change
towards equities resulting in the change in market price. Change in market price causes the
return from investment to very. This is known asmarket risk. The market risk refers to variability
in return due to change in market priceof investment. Market risk appears because of reaction
of investors to different events.There are different social, economic, political and firm specific
events which affect themarket price of equity shares. Market psychology is another factor
affecting market prices. In bull phases, market prices of all shares tend to increase while in bear
phases,
the prices tend to decline. In such situations, the market prices are pushed beyond far outof
line with the fundamental value.
2. Interest-rate Risk: interest rates on risk free securities and general interest rate level are
related to each other. If the risk free rate of interest rises or falls, the rate of interest on
the other bond securities also rises or falls. The interest rate risk refers to the variability
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in return caused by the change in level of interest rates. Such interest rate risk usually
appears through the change in market price of fixed income securities, i.e., bonds and
debentures. Security (bond and debentures) prices have an inverse relationship with the
level of interest rates. When the interest rate rises, the prices of existing securities fall
and vice-versa.
3. Purchasing power or Inflation Risk:
The inflation risk refers to the uncertainty of purchasing power of cash flows to be received out
of investment. It shows the impact of inflation or deflation on the investment. The inflation risk
is related to interest rate risk because as inflation increases, the interest rates also tend to
increase. The reason being that the investor wants an additional premium for inflation risk
(resulting from decrease in purchasing power). Thus, there is an increase in interest rate.
Investment involves a postponement in present consumption. If an investor makes an
investment, he forgoes the opportunity to buy some goods or services during the investment
period. If, during this period, the prices of goods and services go up, the investor losses in terms
of purchasing power. The inflation risk arises because of uncertainty of purchasing power of the
amount to be received from investment in future.
Unsystematic Risk:
The unsystematic risk represents the fluctuation in return from an investment due to factors
which are specific to the particular firm and not the market as a whole.These factors are largely
independent of the factors affecting market in general. Since thesefactors are unique to a
particular firm, these must be examined separately for each firm and for each industry. As the
unsystematic risk results from random events that tend to be unique to an industry or a firm,
this risk is random innature. Unsystematic risk is also called specific risk or diversifiable risk.

Types of Unsystematic Risk:

1. Business Risk:
Business risk refers to the variability in incomes of the firms andexpected dividend there from,
resulting from the operating condition in which thefirms have to operate. For example, if the
earning or dividends from a companyare expected to increase say, by 6%, however, the actual
increase is 10% or 12 %.The variation in actual earnings than the expected earnings refers to
business risk.Some industries have higher business risk than others. So, the securities of higher
business risk firms are more risky than the securities of other firms which havelesser business
risk.

2. Financial Risk:
It refers to the degree of leverage or degree of debt financing used by a firm in the capital
structure. Higher the degree of debt financing, the greater is the degree of financial risk. The
presence of interest payment brings more variability in the earning available for equity shares.
This is also known as financial leverage.

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Capital Asset Pricing Model (CAPM)

CAPM is an economic theory that describes the relationship between risk and expected return, and
serves as a model for the pricing of risky securities. The CAPM asserts that the only risk that is
priced by rational investors is systematic risk, because that risk cannot be eliminated by
diversification.
The model takes into account the asset's sensitivity to non-diversifiable risk (also known as
systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as
well as the expected return of the market and the expected return of a theoretical risk-free asset.
The formula for the CAPM, which is included in the Paper F9 formulae sheet, is as follows:

E(ri ) = Rf + βi(E(rm) – Rf)

E(ri) = return required on financial asset i

Rf = risk-free rate of return
βi = beta value for financial asset i
E(rm) = average return on the capital market

This formula expresses the required return on a financial asset as the sum of the risk-free rate
of return and a risk premium – βi (E(rm) - Rf) – which compensates the investor for the
systematic risk of the financial asset. If shares are being considered, E(rm) is the required return
of equity investors, usually referred to as the ‘cost of equity’.

Assumptions of CAPM
1. Market remains efficient as the securities are traded in an efficient market. The efficient
market has zero tax environment and zero transaction costs.
2. The market has at all times a risk free return benchmark. The risk free return Rf is the
return at which no risk is taken. Thus at zero risk, the market still pays to the investor
some amount which is the risk free return. The Rf is given by banks, government
securities etc. so that all investors can borrow or lend freely at this rate. Above this rate
, any return implies that there ought to be some risk for which extra return is being
given.
3. The risk of the securities as well as the portfolio is measured by standard deviation of
their return.
4. The choice of the portfolio and securities depends upon the investors choice and
preference for risk and return.
5. At any level of risk choice by investor, he desires for maximum expected return while at
any level of expected return choice by the investor, he desires minimum risk.
6. Risk free asset is available.