RISK

&
RETURN
Realized Return
Expected Return
That which you have already earned
That which you expect to earn
So its fixed.
So its probabilistic
So if
n
p p p ,........, ,
2 1
are the probabilities associated with returns
n
R R R ,......, ,
2 1
Then expected returns

=
=
n
i
i i
R p
1
Probability Return
0.2 10%
0.3 12%
0.1 15%
0.4 20%
For the following, compute the expected return
Expected return=0.2*10%+0.3*12%+0.1*15%+0.4*20% = 15.1%
EXAMPLE
For investment in shares, returns can be in the form of
Dividends &
Capital Gains
So if:
P
t-1
is the price at time (t-1)
P
t
is the Price at time t
D
t
is the dividend at time t
Then
1
1
Re

+
=
t
t t t
P
P P D
turn
) (
1

t t
P P
Is called capital gains/loss as the case may be
Probability Dividend Price
0.3 2 90
0.4 3 100
0.3 4 110
You purchased 100 shares of X ltd at Rs. 100 per share in year
2005. The following table shows the probability associated with the
payment of dividend as well as the future price a year after your
purchase
Compute the expected return.
Answer: 3%
EXAMPLE
For investment in debentures/bonds, returns can be in the form of
Interest &
Capital Gains
So if:
P
t-1
is the price at time (t-1)
P
t
is the Price at time t
I
t
is the interest earned from time (t-1) to time t
Then
1
1
Re

+
=
t
t t t
P
P P I
turn
) (
1

t t
P P
Is called capital gains/loss as the case may be
RISK
Variability in return
Measured by the standard deviation of returns
2
1
2
) ( *

=
=
n
i
i i
R R p o
n
p p p ,........, ,
2 1
are the probabilities associated with returns
Where
n
R R R ,......, ,
2 1
R
Is the expected return given by
=
=
n
i
i i
R p R
1
Probability Return
0.2 10%
0.3 12%
0.1 15%
0.4 20%
For the following, compute the expected return and risk as measured
by standard deviation
Risk=4.21%
Expected return=15.1%
Types of Risk
Interest Rate Risk
Market Risk
Business Risk
Financial Risk
Inflation Risk
Liquidity Risk
PORTFOLIO RETURN & RISK
Portfolio in finance refers to a collection of securities.
Prob Return (X) Return (Y)
0.2 10% 5%
0.3 12% 3%
0.5 15% -2%
The table below shows the probability associated with returns
for security X and security Y.
Given an amount Rs.100, if a person invest in equal proportion then compute
the return for the portfolio. Also compute the risk as measured by standard
deviation for each security
Answer: Return 7% , Risk 2.02% and 2.98%
2
12 2 1 2 1
2
2
2
2
2
1
2
1 12
2 o o o o o w w w w + + =
RISK OF PORTFOLIO
Where:
W
2
is the proportion of wealth invested in security 2
W
1
is the proportion of wealth invested in security 1
12

Is the correlation between return of security 1 and 2

Y X
Y X
R R Cov
o o

) , (
12
=

=
=
3
1
) )( ( ) , (
i
Y iY X iX i Y X
R R R R p R R Cov
Where
Risk of the portfolio 0.50%
Prob Return (X) Return (Y)
0.2 10% 5%
0.3 12% 3%
0.5 15% -2%
Expected Portfolio Return: 7% ,
Risk (X): 2.02%
Risk (Y): 2.98%
With this information compute the portfolio risk for the
previous question
What is happening here?
In the previous example expected return and risk of a
portfolio were computed for an equally weighted portfolio.
The weights could differ and so would the risk return profile
of the portfolio.
Risk
Return
Efficient Frontier
R
F

M
Capital Market
Line
S
m
F M
F S
R R
R R o
o
*
} {
+ =
Number of securities
Risk
Non-diversifiable risk
(Systematic)
.
.
Diversifiable risk (Non-
systematic risk)
Risk for a portfolio continues to decrease as the number of securities are
increased.
However after a point the risk can not be reduced any further by increasing
(diversifying) the number of securities.
Beta () is a measure of systematic risk, and shows the risk of portfolio in
relation to the market.
Sharpe showed that the security return are only related to its Beta and
derived the following relation between security returns and its beta.
) ( *
F M F S
R R R R + = |
Thus instead of plotting return against risk. We plot the relation between
return on a security and its beta. This line is termed as Security market line.
This is what is known as Capital Asset Pricing Model (CAPM)
ASSUMPTIONS OF CAPM
Absence of Transaction Costs
No Taxes
Investors have Homogeneous expectations
Investment decision based on single period horizon
Investors are risk-averse and use expected rate of return and standard deviation of
return as a measure of return and risk.
|
Return
R
F

A
B
Under priced
security
Over priced security
Security
Market Line
Given the following data
R
F
= 6% , = 1.2 , R
M
= 12%
Compute the expected return for the security.
If the above company declared a dividend of Rs.1.90 per
in the current year and the growth in dividends is expected
to be 5%, and its current price is Rs.10 then what is the
expected return.
Based on your computation, state whether the
security is over priced or under priced. Also
compute the equilibrium price of the security.
Beta of a security is measured by regressing security returns with the market
returns
c | o + + =
M s
R R *
This is called characteristic regression line.
) (
) , (
M
M S
R Var
R R Cov
= |
Measuring Beta