RISK AND RETURN

CONCEPT OF RETURN AND RISK

Investment return and risk are fundamental to understanding market behavior. The entire
scenario of security analysis is built on two concepts; Risk & return. The risk and return
constitute the framework for taking investment decision. There are different motives for
investment. The most prominent among all is to earn a return on investment. Risk can be viewed
as it is related either to a single asset or to a portfolio—a collection, or group, of assets but first it
is important to introduce some fundamental ideas about risk, return and the risk preferences.

RISK

Risk is the chance of financial loss. Assets having greater chances of loss are viewed as more
risky than those with lesser chances of loss. More formally, the term risk is used interchangeably
with uncertainty to refer to the variety of returns associated with a given asset.

For example: A Rs 5,000 government bond that guarantees its holder 5 interest after 30days has
no risk because there is no variability associated with the return. But on the other hand a 5,000
investment in a firms common stock, which over the same 30days earn anywhere from 0 to 10,is
very risky because of a high variability of it return.

RETURN
The return is the basic motivating force and the principal reward in the investment process. The
return may be defined in terms of (i) realized return, i.e., the return which has been earned, and
(ii) expected return, i.e., the return which the investor anticipates to earn over some future
investment period. The expected return is a predicted or estimated return and may or may not
occur. The realized returns in the past allow an investor to estimate cash inflows in terms of
dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return
can be measured as the total gain or loss to the holder over a given period of time and may be
defined as a percentage return on the initial amount invested.
Some risk directly affects both financial managers and shareholders.

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SOURCES OF RISK

1. Systematic / Shareholder-Specific Risks

 Market risk

The market risk refers to variability in return due to change in market price of investment. There
are different social, economic, political and firm specific events which affect the market price of
equity shares.
 Interest Rate Risk

The interest rate risk refers to the variability 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. 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.

 Liquidity Risk

The uncertainty associated with the ability to sell an asset on short notice without loss of
value.  A highly liquid asset can be sold for fair value on short notice.  This is because there are
many interested buyers and sellers in the market

 Purchasing-Power Risk/ Inflation Risk

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. It shows the impact of inflation or deflation on the investment.

2. Un-systematic / Firm-specific Risks

 Business Risk

The variation in actual earnings than the expected earnings refers to business risk. Or the
Business risk refers to the variability in incomes of the firms and expected dividend there from

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resulting from the operating condition in which the firms have to operate. For example, if the
earning or dividends from a company are expected to increase say, by 6%, however, the actual
increase is 10% or 12 %.
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 have lesser business risk.
 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. A firm having lesser or no risk financing has lesser or
no financial risk.

RISK PREFERENCES

Feelings about risk differ among managers and firms. Thus it is important to specify a generally
acceptable level of risk. The three basic risk preferences behaviors ---risk-averse, risk-indifferent
and risk-seeking as depicted graphically.

 For the risk-indifferent manager, the required return does not change as risk goes from x1
to x2. In essence, no change in return would be required for the increase in risk. Clearly this
attitude is nonsensical in almost any business context.
 For the risk-averse manager, the required return increases for an increase in risk. Because
they shy away from risk, These managers require higher expected returns to compensate
them for taking greater risk

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 For the risk-seeking manger, the required return decreases for an increase in risk.
Theoretically, because they enjoy risk, these managers are willing to give up some return to
take more risk. However, such behavior would not be likely to benefit the firm.More
mangers are risk averse for a given increase in risk, they require an increase in return, they
generally tend to be conservative rather than aggressive when accepting risk for their firm.

Accordingly, a risk averse financial manager requiring higher returns for greater risk.

Measurement of risk

 Measurement of Risk

Measurement of risk is associated with single asset from two ways:

 Risk Assessment / behavioral measure of risk

 Statistical measure of risk

1. Risk Assessment:

Behavioral view of risk and risk assessment includes:

 Sensitivity analysis

 Probability Distribution

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 2. Sensitivity Analysis:

The sensitivity analysis takes into account a number of possible outcomes/returns estimates
while evaluating an asset/assessing risk. In order to have a sense of variability among return
estimates, a possible approach is to estimate the worst (pessimistic), the expected (most likely)
and the best (optimistic) return associated with the asset. Alternatively, the level of outcomes
may be related to the state of the economy, namely, recession, normal and boom conditions. The
difference between the optimistic and the pessimistic outcomes is the range which, according tot
the sensitivity analysis, is the basic measure of risk. The greater the range, the more variability
(risk), the asset is said to have.

3. Probability Distribution:

The risk associated with an asset can be assessed more accurately by the use of probability
9distribution) than sensitivity analysis. The probability of an event represents the
likelihood/percentage chance of its occurrence. For instance, if the expectation is that a given
outcome (return) will occur seven out of ten times, it can be said to have a seventy percent (0.70)
chance of happening; if it is certain to happen, the probability of happening is 100 per cent. An
outcome which has a probability of zero will never occur.

n = number of outcomes considered

Based on the probabilities assigned (probability distribution of) to the rate of return, the expected
value of the return can be computed. The expected rate is the weighted average of all possible
returns multiplied by their respective probabilities.

Thus the expected return, K is 

                        ∑ni=1  KiPri

Where      K  = return for the ith possible outcome

                Pri = probability associated with its return

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 4. Statistical measure of Risk:

A statistical measure of risk includes three things:

   Variance

 Standard Deviation

 Coefficient of Variation

 Variance:

Variance is computed by summing squared deviations and dividing by the number of

observations minus one (n - 1). Squaring the differences ensures that both positive and negative
deviations are given equal consideration. The sum of the squared differences is then divided by
the number of observations minus one (n - 1).

 Standard Deviation:

Risk refers to the dispersion of returns around an expected value. The most common statistical
measure of risk of an asset is the standard deviation form the mean/expected value of return. It
represents the square root of the average squared deviations of the individual returns from the
expected returns. Symbolically, the standard deviation is

           √( ∑ni=1 (Ki - K- )^2 * Pri )  

The greater the standard deviation of returns, the greater would be the variability/dispersion of
returns and the greater the risk of the asset/investment. However, standard deviation is an
absolute measure of dispersion and does not consider the variability of returns in relation to the
expected value. It may be misleading in comparing the risk surrounding alternative assets if they
differ in size of expected returns.

 Coefficients of Variation:

Coefficient of Variation is a relative measure of risk per unit of expected return. It converts the
standard deviation of expected values into relative values to enable comparison of risks

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associated with assets having different expected values. The coefficient of variation (CV) is
computed by dividing the standard deviation for an asset by its expected value. Symbolically,

                       CV = σk / K-

The larger the CV, the larger the relative risk of the asset. As a rule, the use of coefficient of
variation for comparing asset risk is the best since it considers the relative size (expected value)
of assets.

 Risk of a Portfolio

A portfolio means a combination of two or more securities and an investment portfolio is any
collection or combination of financial assets. if we assume all investors are rational and therefore
risk averse that investor will always choose to invest in portfolios rather than in single assets this
extends the analysis of risk and returns associated with single investment to portfolio
investments. In real world situations, the risk of any single investment would not be viewed
independently of other assets. New investments must be considered in light of their impact on the
risk and return of the portfolio of assets. The financial manager’s goal is to create an efficient
portfolio, one that maximizes return for a given level of risk or minimizes risk for a given level
of return. We therefore need a way to measure the return and the standard deviation of a portfolio
of assets. Once we can do that, we will look at the statistical concept of correlation, which
underlines the process of diversification that is used to develop an efficient portfolio.

 Correlation:

Correlation is a statistical measure of the relationship between any two series of numbers. The
numbers may represent data of any kind, from returns to test scores. If two series move in the
same direction, they are positively correlated. If the series move in opposite directions, they are
negatively correlated

The Correlation between M and series N

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The degree of correlation is measured by the correlation coefficient, which ranges from +1 for
perfectly correlated series to -1 for perfectly negative correlated series. These two extremes are
depicted for series M and N in above figure .The perfectly positive correlated series move
exactly together; the perfectly negatively correlated series move in exactly opposite direction.

 Diversification:

The concept of correlation is essential to developing an efficient portfolio. To reduce overall risk,
it is best to diversify by combining or adding to the portfolio assets that have a negative
correlation. Combing negatively correlated assets can reduce the overall variability of returns.

Some assets are uncorrelated that is, there is no interaction between their returns. Combining
uncorrelated assets can reduce risk, not so effectively as combining negatively correlated assets
but more effectively than combining positively correlated assets. The correlation coefficient for
uncorrelated assets is close to zero and acts as the midpoint between perfect positive and perfect
negative correlation.

The creation of a portfolio that combines two assets with perfectly positive correlated return
result in overall portfolio risk that at minimum equals that of the least risky asset and at
maximum equals that of the most risky asset. However, o portfolio combining two assets with
less than perfectly positive correlation can reduce total risk to a level below that of either of that
component, which in certain situations may be zero. For example, assume that you manufacture
machine tools. The business is very cyclical, with high sales when the economy is expanding and
low sales during a recession. If you acquired another machine tool company with sales positively
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correlated with those of your firm, the combined sales would still be cyclical and risk would
remain the same. Alternatively, however you could acquire a sewing machine manufacturer,
whose sales are countercyclical. It typically has low sales during economic expansion and high
sales during recession. Combination with the sewing machine manufacturer, which has
negatively correlated sales, should reduce risk.

 International Diversification:

The ultimate example of portfolio diversifation involves including foreign assets in a portfolio.
The inclusion of assets from countries with business cycles that are not highly correlated with the
U.S. business cycle reduces the portfolios responsiveness to market movements and to foreign
currency fluctuations.

Returns from International Diversification:

Over long periods, returns from internationally diversified portfolios tend to be superior to those
of purely domestic ones. This is particularly so if the US economy is performing restively poor
and the dollar is depreciating in value against more foreign currencies. At such times, the dollar
returns to US investors on a portfolio of foreign assets can be very attractive. However over any
single short to intermediate period, international diversification can yield subpar returns,
particularly during periods when the dollar is appreciating in value relative to other currencies.
When the U.S currency gains in value, the dollar value of foreign currency denominated
portfolio of assets declines. Even this portfolio yields a satisfactory return in local currency, the
return to US investors will be reduced when translated into dollars. Subpar local currency
portfolio returns, coupled with appreciating dollar, can yield truly dismal dollar returns to US
investors.

Overall, though the logic of international portfolio diversification assumes that these fluctuations
in currency value and relative performance will average out over long periods. Compared to
similar, purely domestic portfolios an internationally diversified portfolio will tend to yield a
comparable return at a lower level of risk.

 Risk of International Diversification:

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U.S. investors should also be aware of the potential dangers of international investing. In
addition to the risk induced by currency fluctuations, several other financial risks are unique to
international investing. Most important is political risk, Which rises from the possibility that a
host government will take actions harmful to foreign investors or that political turmoil in a
country will endanger investment there. Political risks are particularly acute in developing
countries, where unstable or ideologically motivated governments may attempt to block return of
profits by foreign investors or even seize their assets in the host country. An example of political
risk was the heightened concern during 2003-2004 that operation enduring freedom would oil
production facilities in Iraq and cause a worldwide oil shortage and higher gas prices. This
concern was indeed validated by the rapid rise in fuel prices that began early in 2004 and
continued throughout the year.

Even where governments do not impose exchange controls of seize assets, international investors
may suffer if a shortage of hard currency prevents payment of dividends or interest to foreigners.
When governments are forced to allocate scare foreign exchange, they rarely give top priority to
the interest of foreign investors. Instead, hard currency reserves are typically used to pay for
necessary imports such as food, medicines and industrial materials and to pay interest on the
government debts. Because most of the debts of developing countries is held by banks rather
than individuals, foreign investors are often badly harmed when a country experiences political
or economic problems.

CAPM
Capital Asset Pricing Model
A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.

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The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure
(beta) that compares the returns of the asset to the market over a period of time and to the market
premium (rm-rf).
 Beta

Beta tells us how much the security’s rate of return changes when the return on the market
portfolio. Or measure of the volatility (tending to fluctuate sharply and regularly), or systematic
risk, of a security or a portfolio in comparison to the market as a whole.
Beta is calculated using regression analysis, and you can think of beta as the tendency of a
security's returns to respond to swings in the market. A beta of 1 indicates that the security's
price will move with the market. A beta of less than 1 means that the security will be less volatile
than the market. A beta of greater than 1 indicates that the security's price will be more volatile
than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the
market.
Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks
have a beta of greater than 1, offering the possibility of a higher rate of return, but also
posing more risk.

Example
As an example, let's assume that the risk free rate is 5%, and the overall stock market will
produce a rate of return of 12.5% next year. You see that XYZ Company has a beta of 1.7.

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What rate of return should you get from this company in order to be rewarded for the risk you
are taking? Remember investing in XYZ company (beta =1.7) is more risky than investing in the
overall stock market (beta = 1.0). So you want to get more than 12.5%, right?

 ra = rf + β( rm - rf)
 ra = 5% + 1.7 ( 12.5% - 5%)
 ra = 5% + 1.7 ( 7.5%)
 ra = 5% + 12.75%
 ra= 17.75%

So, if you invest in XYZ Company, you should get at least 17.75% return from your investment.
If you don't think that XYZ Company will produce those kinds of returns for you, then you
would probably consider investing in a different stock
 Security Market Line
The Security Market Line can be thought of as the graphical representation of the Capital Asset
Pricing Model. It illustrates the concept that it is possible to obtain any combination of risk and
expected return along the slope of the graph by investing some portion of your investment in the
market portfolio and borrowing the rest.

The Security Market Line is useful for determining whether an investment in an asset offers a
good expected return for the risk taken. By providing the Beta of the asset, the Risk free rate and
the Market Risk Premium, we will be able to plot the asset on the Security Market Line graph. If
the Expected return versus Beta of the asset is plotted above the Security Market Line, the asset

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can be thought of as being able to provide a greater return for the inherent risk. An asset with a
point below the Security Market Line can be thought of as getting less return for the amount of
risk taken.

 ASSUMPTIONS OF CAPM
All investors:

1. Aim to maximize economic utilities.

2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors

 FLAWS IN CAPM

1. If you go to a casino, you basically pay for risk. It's possible that the folks on Wall Street
sometimes have the same mindset as well. Now remember that CAPM assumes that given
"X%" expected return investors will prefer lower risk (in other words lower variance) to
higher risk. And the opposite would be true as well - given a certain level of risk investors
would prefer higher returns to lower ones. OK, but maybe the Wall Street people get a kick
out of "gambling" their investment. Not saying it's been proven to be the case, just saying it
could be. CAPM doesn't allow for investors who will accept lower returns for higher
risk.
2. CAPM assumes that asset returns are jointly normally distributed random variables.
But often returns are not normally distributed. So large swings, swings as big as 3 to 6
standard deviations from the mean, occur in the market more frequently than you would
expect in a normal distribution.

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3. CAPM assumes that the variance of returns adequately measures risk. This might be
true if returns were distributed normally. However other risk measurements are probably
better for showing investors' preferences. Coherent risk measures comes to mind.
4. With CAPM you assume that all investors have equal access to information and they all
agree about the risk and expected return of the assets. This idea, by the way is called
"homogeneous expectations assumption".
5. CAPM kind of skips over taxes and transaction costs. Some of the more complex
versions of CAPM try to take this into consideration.
6. CAPM assumes that all assets can be divided infinitely and that those small assets can be
held and transacted.

APPLYING THE CAPM

Despite limitations, the Capital Asset Pricing Model remains the best illustration of long-term
tradeoffs between risk and return in the financial markets. Although very few investors actually
use the CAPM without modification, its principles are very valuable, and may function as a
sufficient guide for the average long-term investor.

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