Risk & Return Analysis

Risk & ReturnBy:Aditya Menon J082Prabudh Bansal J080Divyani Sarjekar J074Overview Risk

Systematic risk & Non-systematic risk

Risk & Return analysis

Security Market Line

Risk and Return for single asset portfolio

Diversification of Risk

RISK

Risk is the probability that a loss will occur.

Loss can be Financial Or Non-financial.

Financial risk is the uncertainty associated with the changes in asset prices.Risks associated with investments

SYSTEMATIC RISK

The portion of the variability of return of a security that is caused by external factors, is called systematic risk.

It is also known as market risk or non-diversifiable risk.

Economic and political instability, economic recession, macro policy of the government, etc. affect the price of all shares systematically. Thus the variation of return in shares, which is caused by these factors, is called systematic risk. Systematic Risks

NON - SYSTEMATIC RISK:

Risk specific to firm.

Classified as Business risk and Financial risk.

These risks generally include credit risk, product risk, management inefficiency risk, operation risk, scandal, technological failures.

When variability of returns occurs because of such firm-specific factors, it is known as unsystematic risk.Non Systematic RisksRisk and Return AnalysisReturn is the total gain or loss experienced on an investment over a given period of time.Return = Cash Flows from the asset + Capital Appreciation/DepreciationR = {Dn + (Pn P0)/P0} * 100 WHERE R = Rate Of Return In Year n Dn = Dividend Per Share In Year n P0 = Price Of Share In The Beginning Pn = Price Of Share In The End Of The nth Year

Risk and Return AnalysisInvestors are risk averse; i.e., given the same expected return, they will choose the investment for which that return is more certain. Therefore, investors demand a higher expected return for riskier assets. Ex-post is the historical and ex- ante is the expected retun10Security Market LineIt represents the trade-offs between risk and return. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).Graphical representation of Capital Asset Pricing Model (CAPM)Mathematically, E(Ri)= Rf + (E(Rm) - Rf)where E(Rm)=Expected Return from the InvestmentRf=Risk-free Return= Beta

If > 1 then Aggressive StockIf < 1 then Defensive Stock

Assuming a linear relationship between risk and return, the assumption is that the y-intercept is the return on a risk-free investment (the risk free rate), and theslopeis thepremiumon risk in terms of expected returns

12Applications of SML

Identifying undervalued securities Determining the ideal market price of the securityTesting the market efficiencyRisk & Return for Single Asset (Ex-Post)Risk & Return for Single Asset (Ex-Ante)Expected Return= It is the weighted average of all possible returns multiplied by their respective probabilities.

E(R) = Ri Pi i=1Variance is the sum of squares of the deviations of actual returns from expected returns weighted by the associated probabilities.

Variance = (Ri E(R) )2* Pi i=1

DIVERSIFICATION OF RISK

Total risk of an individual security is measured by the standard deviation ( ), which can be divided into two parts i.e., systematic risk and unsystematic risk.

Total Risk () = Systematic Risk + Unsystematic riskReduction of Risk through Diversification

Only to increase the number of securities in the portfolio will not diversity the risk. Securities are to be selected carefully. If two security returns are less than perfectly correlated, an investor gains through diversification.If two securities M and N are perfectly negatively correlated, total risk will reduce to zero.

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