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RISK AND

RETURN

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W H AT IS INVESTMENT RISK ?

Typically, investment returns are not known with

certainty.

Investment risk pertains to the probability of earning areturn less than that expected.

Risk reflects the chance that the actual return on an

investment may be different than the expected return.Greater rewards are accompanied by greater risks.

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W H AT ARE INVESTMENT

RETURNS ?

Investment returns measure thefinancial results of an investment.

Returns can be expressed :

In terms of Money

In terms of Percentage

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W H AT IS T H E RETURN AN INVESTMENT

T H AT COSTS $1,000 AND IS SOLDAFTER 1 YEAR FOR $1,100 ?

In terms of Money$ Received - $ Invested

$1 ,100 - $1 ,000 = $100 .

In terms of Percentage$ Return/ $ Invested

$100 /$1 ,000 = 10% .

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R ISK AND R ETURN OF A SINGLE ASSET

The Rate of Return on asset =

Annual income + Ending price Beginning price

Beginning price

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EXPEC TED R AT E OF R ETURN

M easuring likely future return

Based on probability distribution

E[R] = 7 (p iR i)i=1

W here:E[ R] = the expected return on the stock

N = the number of states p i = the probability of state iR i = the return on the stock in state i.

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EXPEC TED R ETURN

Th e table below provides aprobability distribution for t h e

returns on stocks A and BState Probability Return On Return

OnStock A Stock B

1 20% 5% 50%2 30% 10% 30%3 30% 15% 10%4 20% 20% -10%

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EXPEC TED R ETURN

I n t h is example, t h e expected return for stock A would be calculated as follows:

E[R] A = .2(5%) + .3(10%) + .3(15%) + .2(20%) =12.5%

Now you try calculating t h e expected return for

stock B!

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EXPEC TED R ETURN

D id you get 20%? I f so, you are correct.

I f not, h ere is h ow to get t h e correct answer:

E[R] B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) =20%

S o we see t h at Stock B offers a h ig h er expectedreturn t h an Stock A.H owever, t h at is only part of t h e story; weh aven't considered risk.

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PORT FOL IO R ISK AN D R ETURN

The Expected Return on a Portfolio is computed as theweighted average of the expected returns on the stocks whichcomprise the portfolio.The weights reflect the proportion of the portfolio invested in

the stocks.This can be expressed as follows:

NE[R p ] = 7 w iE[R i]i=1

W here:y E[ R p] = the expected return on the portfolioy N = the number of stocks in the portfolioy w i = the proportion of the portfolio invested in stock iy E[ R

i] = the expected return on stock i

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P O RTF OLIO R ISK AN D RE TU RN

F or a portfolio consisting of two assets, t h e aboveequation can be expressed as:

E[R p] = w 1E[R 1] + w 2E[R 2]

I f we h ave an equally weig h ted portfolio of stock A and stock B (50% in eac h stock), t h en t h e

expected return of t h e portfolio is:

E[R p] = .50(.125) + .50(.20) = 16.25%

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MARK ET R ISK VS U NIQU E R ISK

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MARK ET R ISK VS U NIQU E R ISK

Market Risk ( systematic risk)y C annot be eliminated t h roug h diversification

y D ue to factors affecting all assets

Unique Risk ( unsystematic risk)y S

pecific to a firm

y C an be eliminated t h roug h diversification

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F INANCIAL L EVERAGE

The financial leverage occurs when a firms CapitalStructure contain obligation of fixed financial charges.For instance, interest on debentures, dividend on

preference share etcHigh financial leverage means high fixed financial

cost and high financial risk i.e., as the debt content inCapital Structure increases, the financial leverageincreases and at the same time the financial risk alsoincreasesit can increase the shareholders' return on their investment and often there are tax advantages

associated with borrowing.

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R EL ATI O NSHIP OF R ISK AN D R ETURN

Securities are risky because their returns arevariable.

The risk of a securities can be split into two parts: Unique and Market risk

Portfolio diversification washes away uniquerisk bur not market risk. Hence, the risk of afully diversified portfolio is its market risk.