Risk & Return RSA

8/3/2019 Risk & Return RSA

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Dr. Rajinder S. Aurora


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Concept of Return

Reward expected by an investor from an investment

Rate of return helps make investment decisions

Analysis of Historical returns gives a feel of how the

investment is doing

Historical returns also help in estimating future returns


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Types of Returns

Realized Return:

Return that was or could have been earned

Also known as Ex-post

For Example: An investor takes a FD with HDFC Bankfor Rs.1,00,000/- with one year duration. On maturityhe gets back Rs.1,08,000/-. The realized return in thiscase is Rs.8,000/- or 8%


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Types of Returns

Expected Return:

Return anticipated from an investment over some

future period

May be earned or not due to risk or uncertaintyinvolved

Investor seeks compensation for the uncertainty byexpecting higher returns to off-set the risk

Difficulty to precisely determine the rate of return


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Components of Returns

Periodic cash receipts or income in the form ofinterest or dividends known as Yield

Appreciation / Depreciation in the value of the assetover a period of time known as Capital Gain / Loss

General expectation is latter should be greater thanthe former


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Measuring Rate of Return

Rate of Return represents the total return received by theinvestor during the holding period of the investment

Difference between the price of the security at thebeginning and end of the holding period

Expressed as a percentage of the purchase price of theinvestment at the beginning of the holding period


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Calculating Rate of Return

Rate of return is calculated as:Dt + PtPt-1

k = ------------------Pt-1

Where,k = Rate of ReturnPt = Price of the Security at time t at the end of the holding period or

purchase price

Pt-1 = Price of the security at time t-1at the beginning of theholding period or purchase price

Dt = Income or cash flows receivable from the security at time t


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Securitys Rate of Return

Return of Shares:

Income by way of dividend

Appreciation or Depreciation

Return on Bond/Debt Security:

Income by way of interest based on coupon rate

Appreciation or Depreciation


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Probabilities and Rates of Return

Can never be greater than 1

Sum of all probabilities should be equal to 1

Probability can never be negative

Possible outcomes are assigned probability of 1 andimpossible outcomes are assigned probability of 0

Possible outcomes must be mutually exclusive andcollectively exhaustive


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Risk and Expected Rate of Return

Chance that the actual outcome of the event shall differfrom the expected outcome

Wider the probability greater the risk or greater thevariability of returns


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Sources of Risk

Interest Rate Risk

Market Risk

Inflation Risk

Business Risk

Financial Risk

Liquidity Risk


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Types of RiskNon - Diversifiable Risk

or Market Risk Factors

Diversifiable Risk or

Specific Risk Factors

Major Changes in tax rates

War and other calamities

Changes in Inflation rates

Change in Economic Policy

Industrial Recession

Changes in Oil prices

Company Strike

Bankruptcy of Suppliers

Death of Key Company

Officer

Unexpected entry of a new

competitor


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Risk Reduction through Diversification

Number of Securities in the Portfolio

Risk

Non Diversifiable Risk

Diversifiable Risk

Total Risk of the Portfolio


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Beta

Measure of the non diversifiable risk of an asset relative

to that of the market portfolio

Beta 1 indicates an asset of average risk

Beta greater than 1 indicates above average risk

Beta lesser than 1 indicates below average risk

Beta of a portfolio is weighted average of the betas of

securities that constitute the portfolio


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Measurement of Risk

Relationship between return of a security and return on

the market described using Linear Regression

Slope of the Regression reflects responsiveness of the

security to the general market and indicates securitys

behavior vis--vis the market return

Beta Coefficient is the ratio of the securitys covariance

of return with the market to the variance of the market


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Capital Asset Pricing Model (CAPM)

Developed by William Sharpe, John Lintner and Jan

Mossin

Establishes a linear relationship between the required rate

of return of a security and it systematic or un -

diversifiable risk or beta


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Assumptions

Investors are risk averse and use expected rate of returnand standard deviation of return as appropriate measuresof risk and return for their portfolio

Greater the perceived risk the higher is the returnexpected by the investor

Decision based on single-period horizon i.e. immediatetime period

Transactions costs are low and hence ignored

Assets can be bought and sold in any unit desired

Taxes do not affect the choice of buying assets

Assets can be bought at the going market price


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Relevance of CAPM

Helps precisely define risk-return trade-offs

Expected rate can also be thought of as a required rate ofreturn because market is assumed to be in equilibrium

Expected rate is anticipated return and required rate israte expected to induce investors' to invest

Investors can invest in risk free securities like treasurybills

Risk averse nature makes them expect compensation forrisk taken

CAPM provides measure for risk premium


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Security Market Line

Developed by Modern Portfolio theory

SML provides framework for evaluating whether high-risk stocks are

offering returns more or less in proportion to their risk and vice

versa

Risk measured using beta values

Ex-post (after the fact) used to evaluate performance of Portfolio

Manager, Test theories such as CAPM and test market efficiency Ex ante SML used to identify undervalued security and price of risk

implicit in the current market prices.


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Contd.

Helps determine whether security is under priced or over

priced using the value of alpha

Alpha is the intercept of the fitted line and indicates what

the return of the security will be when the market return

is zero.

For Example if alpha of a security is + 5 %, it implies

that the security return would be 5% even when market

return is zero.

Risk & Return RSA

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