Investment Management

Module 3: Risk & Return

Module 3: Risk & Return

Risk and Return Concepts - Concept of Risk, Types of Risk : Systematic risk &
Unsystematic risk. Calculation of Risk and returns. Portfolio Riskand Return: Expected
returns of a portfolio - Calculation of Portfolio Risk and Return. (Problems on
Calculation of Risk and Returns on Portfolio)

Risk and Return Relationship

The relationship between risk and return is one of the fundamental concepts in
finance. It states that, generally, higher potential returns come with higher risk,
and vice versa. This principle guides investors in making informed decisions about
their portfolios and helps them balance their desire for growth with their tolerance
for risk.

Risk, in the context of investments, refers to the possibility of losing money and
Return refers to the profit or income generated from an investment.

The Risk-Return Trade-off

The risk-return trade-off is the fundamental principle that investors must
consider when making investment decisions. It states that:

● Higher potential return: Investments with higher potential return are

typically associated with higher risk.

● Lower potential return: Investments with lower potential return are

typically associated with lower risk.

Investors must carefully consider their risk tolerance and investment goals when
making investment decisions. Risk-averse investors may prefer to focus on
lower-risk investments with modest returns. Conversely, risk-tolerant investors
may be willing to accept higher risk in exchange for the potential for higher
returns.

Factors Influencing the Risk-Return Relationship

Several factors can influence the risk-return relationship, including:

● Investment horizon: The longer the investment horizon, the more time an
investor has to recover from market downturns and potentially achieve their
investment goals.
● Investment diversification: Diversifying a portfolio across different asset
classes and sectors can help to reduce overall risk.
● Market conditions: Economic and market conditions can impact the
risk-return profiles of different investments.

Return

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Return refers to the gain or loss on an investment over a specific period, typically
expressed as a percentage. It is a measure of the profitability or performance of an
investment and is a key factor in assessing its attractiveness.

● It helps potential investors in making comparison of returns expected from

alternative investment opportunities
● Measurement of historical (past) returns places the investors in a position to
take stock of better performance in the areas of investment
● Measurement of historical returns also facilitates the assessment of future
returns

The total return composed of

a) current return (income) and
It is also called Yield. It can be either positive or Zero

b) capital return (capital gain)

It is the result of a price change. It can be either positive , Negative or Zero

Total Return = Current return + Capital return

Types of Return

Based on Investment Performance Stage

1. Unrealised Return: This refers to the potential profit or loss on an

investment that you haven't sold yet. It's a paper gain or loss based on the
difference between the current market price and your original purchase
price.

2. Realised Return - Realised return refers to the actual return earned on an

investment when it is sold or liquidated. It reflects the gain or loss realised
by an investor from their investment over a specific period. There is an
element of certainty.

3. Expected Return - Expected return refers to the anticipated or predicted

return on an investment over a future period. It is a measure of the average
or likely outcome of an investment, taking into account the probabilities of
different potential returns. There is the element of uncertainty and risk. This
is ascertained using historical returns.

Based on Inflation adjustment

1. Nominal rate of return : Return not adjusted for inflation

2. Real rate of return : Return adjusted for inflation

Based on Time

1. Absolute Return: Total gain or loss on an investment, no matter the time

2. CAGR: Smoothed annual growth rate of an investment over a specific period.
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Risk

Risk refers to the uncertainty or potential for loss in an investment or decision. It is

an inherent part of any investment and represents the possibility that the actual
outcome may differ from the expected outcome. It represents the uncertainty.

Risk is classified into Systematic Risk and Unsystematic Risk

Systematic Risk

Systematic risk refers to the risk factors that affect the overall market or economy.
It is also known as market risk or undiversifible risk. It is inherent in the entire
market system and affects all investments to some degree. Systematic risk is
caused by factors that are external to specific companies or industries, and it is
beyond the control of individual investors. It is also called Uncontrollable risk.

Systematic risks are driven by factors outside the control of individual companies
or investors. These factors are often complex and interconnected, making it
difficult to predict their exact impact.

a) Economic Cycle Risk : Economic cycle risk stems from the inherent cyclical
nature of economies. Periods of expansion characterized by rising output,
employment, and asset prices are inevitably followed by contractions or
recessions. These downturns can cause widespread corporate profit declines
and stock market corrections.
The Global Financial Crisis of 2008. This global economic downturn triggered a
significant slowdown in the Indian economy and a sharp decline in the stock
market.

b) Interest Rate Risk: Interest rate changes impact various sectors and
industries differently. When interest rates rise, it can lead to higher
borrowing costs, reduced consumer spending, and decreased corporate
profitability. Conversely, declining interest rates can stimulate borrowing
and economic growth.
RBI's Rate Hikes in 2018. The Reserve Bank of India's decision to raise interest
rates to control inflation led to a correction in the Indian stock market, as higher
borrowing costs impacted corporate investment.

c) Currency Risk: Changes in exchange rates between different currencies can

affect the value of investments denominated in foreign currencies.
Fluctuations in currency exchange rates can impact international trade,
profits, and returns on investments.
Rupee Depreciation in 2013. The depreciation of the Indian Rupee against the US
Dollar in 2013 increased the cost of imports for Indian companies, putting
pressure on their profitability and impacting the stock market.

d) Inflation Risk / Purchasing power risk : Inflation risk refers to the loss of
purchasing power over time due to the rising cost of goods and services.
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Inflation erodes the real value of money and can negatively impact
investment returns.
High Inflation in the 1990s and Early 2010s. Periods of high inflation in India,
such as in the 1990s and early 2010s, eroded the purchasing power of
investments and significantly reduced stock market returns.

e) Geopolitical risk : Geopolitical risk stems from political instability,

international conflicts, and trade disputes between nations. These events
can disrupt global trade flows, investment patterns, and investor
confidence. Geopolitical risk is inherently difficult to predict, but investors
can stay informed about global developments.
Russia-Ukraine Conflict (2022 - Present). The ongoing conflict has caused a rise
in global oil prices, impacting inflation in India and potentially affecting the
stock market in the future.

Unsystematic Risk

Unsystematic risk refers to risks that are specific to a particular company, industry,
or sector. Unlike systematic risk, unsystematic risk can be reduced or eliminated
through diversification. By investing in a variety of assets across different
industries and sectors, investors can reduce their exposure to unsystematic risk.
Thus it is also called a diversifiable risk.

a) Business or Company-specific Risk: This risk is associated with factors

specific to a particular company, such as management issues, competitive
pressures, legal and regulatory challenges, technological changes, and
supply chain disruptions.
Yes Bank, a major private lender in India, faced a liquidity crisis due to
mismanagement of loans and poor corporate governance. This resulted in a
sharp decline in its share price and a government takeover, impacting investors
significantly.

b) Industry Risk: Certain industries may face unique risks that can impact their
performance, such as changes in consumer preferences, technological
advancements, government regulations, or shifts in market demand.
In 2016, the Indian government implemented demonetization, which involved
removing high-value currency notes from circulation. This move aimed to curb
black money (undeclared income) often used in real estate transactions. The
sudden cash shortage impacted the real estate industry significantly.
Transactions slowed down due to a lack of readily available cash, impacting
both developers and buyers.

c) Financial Risk: Financial risk relates to factors such as a company's debt

levels, liquidity position, creditworthiness, and financial management
practices. Financial difficulties of a specific company can negatively impact
its stock price or bond values.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Reliance Communications Debt Crisis (2017): Reliance Communications, a

telecom giant, faced a massive debt burden due to aggressive expansion plans.
This financial risk led to bankruptcy and impacted investors who held the
company's debt and equity.

d) Event Risk: Event risk refers to risks associated with specific events, such as
mergers and acquisitions, product recalls, litigation, natural disasters, or
political instability. These events can have a significant impact on the value
and performance of individual investments
In January 2023, Hindenburg Research, a short-selling firm, released a report
accusing Adani Group of stock manipulation and accounting fraud. The report
triggered a massive sell-off of Adani Group companies' shares, leading to
billions of dollars in losses. This case exemplifies the event risk associated with
negative publicity and accusations of financial wrongdoing.

e) Operational risk:This is the risk of losses due to failures in a company's

internal processes, such as production delays, IT outages, or fraud.
Operational risk can be caused by human error or technological problems.
Maggi Noodles Lead Contamination Scare (2015): Nestle India faced a major
operational risk when its Maggi noodles were found to contain excessive lead
levels. This led to a product recall, reputational damage, and a significant
impact on Nestle's sales and stock price.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Systematic risk vs Unsystematic risk

Systematic risk is non diversifiable whereas Unsystematic risk is diversifiable

Systematic risk is measurable through beta whereas Unstable risk can be

determined by subtracting systematic risk from total risk

Risk vs Uncertainty

Risk

Risk refers to a situation where the outcome or consequences of an event or

decision can be estimated or calculated with some degree of confidence. It involves
assessing the likelihood of different outcomes and their potential impact. In other
words, risk implies that you have some knowledge or understanding about the
possible outcomes, and you can assign probabilities to them. By analyzing risks,
you can make informed decisions by weighing the potential gains or losses.

Uncertainty

Uncertainty, on the other hand, refers to a situation where the outcome or

consequences of an event or decision are unknown or cannot be accurately
predicted. It arises when there is a lack of information, knowledge, or
understanding about the various outcomes and their probabilities. In uncertain
situations, the future is uncertain, and there may be multiple possibilities or
scenarios, making it difficult to assess the likelihood or potential impact of each.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Measurement of Expected Return

Expected return is an educated guess about the average return an investment will
generate over a specific period. It's based on historical data, analyst forecasts, and
market conditions, but it's not a guaranteed outcome.

There are several methods to calculate expected returns

1. Extrapolation of Historical Returns

This approach assumes past performance is indicative of future results. You
can use simple averages or Compound Annual Growth Rate (CAGR) of
historical returns to estimate future expectations. However, past
performance doesn't guarantee future results.

2. Probability Tables
This method assigns probabilities to different possible return scenarios and
weights the expected return based on those probabilities. It requires more
complex calculations and assumptions about future market conditions.

3. Capital Asset Pricing Model (CAPM)

This is a widely used model that estimates the expected return of an
investment based on its systematic risk (beta) and the market risk premium.
It's a helpful benchmark, but it relies on certain assumptions about market
efficiency.

4. Arbitrage Pricing Theory (APT)

This is a more complex model that considers multiple factors besides
systematic risk to explain expected returns. It requires a lot of data and
estimation techniques.

5. Market Multiples
This method uses valuation ratios like price-to-earnings (P/E) ratio to
compare an investment to similar companies and estimate its expected
return based on market averages.

Expected Return using Mean

E(R) = Σri / n

E(R) = Expected Return

ri = Return
n = number of timeperiod

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Expected Return using Probability table

E(R) = Σripi

E(R) = Expected Return

ri = Return
Pi = probability

Note: The probability is determined by taking into consideration the historical data of
stock prices. Analysing the data can ascertain the probability of different levels of
returns.

Expected Return of a portfolio

ERp = Σwiri

ERp = Expected return of the portfolio

ri = Return of individual stocks
Wi = Weights of individual stocks (Weights are assigned based on the
allocation of investment to a stock in the portfolio)

CAPM - Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a financial model that helps investors
understand and evaluate the expected return on an investment. It provides a way to
calculate the appropriate return an investor should expect based on the risk
associated with that investment.

In simple terms, the CAPM model suggests that the return on an investment
depends on two main factors: the risk-free rate and the risk premium.

Risk-Free Rate: The risk-free rate is the theoretical return an investor would
expect from an investment with zero risk. It is usually based on the return of a
government bond or a similar low-risk investment. The idea is that any investment
should provide a return that compensates for the risk taken compared to a
risk-free investment.

Risk Premium: The risk premium represents the additional return an investor
expects to earn for taking on the risk of a particular investment. It is determined by
the relationship between the investment's volatility (measured by its beta) and the
overall market's volatility.

Beta: Beta is a measure of how much an investment's price tends to move in

relation to the overall market. A beta of 1 means the investment moves in line with
the market, while a beta greater than 1 suggests the investment is more volatile,
and a beta less than 1 indicates it is less volatile.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Market Risk Premium: The market risk premium represents the additional return
an investor expects to earn for taking on the average level of risk in the market. It
reflects the overall risk and return characteristics of the market as a whole.

By combining the risk-free rate and the risk premium, the CAPM formula
estimates the expected return of an investment:

Expected Return = Risk-Free Rate + Beta x (Market Risk Premium)

In essence, the CAPM model helps investors determine whether the expected
return of an investment adequately compensates for the risk taken. If the expected
return is higher than what the CAPM model suggests, the investment may be
considered attractive. If it is lower, the investment may be seen as less desirable.

Assumptions of CAPM model

● Efficient Markets: CAPM assumes that markets are efficient, meaning that
all relevant information is readily available to investors and quickly
incorporated into stock prices. This assumption implies that investors
cannot consistently outperform the market through superior information or
analysis.

● Rational Investors: CAPM assumes that investors are rational and make
decisions based on maximizing their utility or wealth. They consider the
expected returns and risks associated with different investments and aim to
optimize their portfolios accordingly.

● Homogeneous Expectations: CAPM assumes that all investors have the same
expectations about future returns, risk, and correlations among assets. This
assumption allows for the calculation of a single market risk premium and a
single beta for each asset.

● Risk-Free Rate: CAPM assumes the existence of a risk-free rate, which

represents the return an investor can earn with certainty. It serves as a
benchmark for evaluating the risk and return of other investments.

● Linear Relationship between Returns: CAPM assumes that the relationship

between the expected return of an asset and its systematic risk (measured by
beta) is linear. It implies that the risk premium increases proportionally
with beta.

● No Transaction Costs or Taxes: CAPM assumes that there are no transaction

costs or taxes associated with buying or selling securities. This assumption
allows for frictionless trading and easy diversification.
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Limitations of CAPM Model

● Market Efficiency Assumption: CAPM assumes that markets are perfectly

efficient, meaning that all relevant information is immediately reflected in
stock prices. However, in reality, markets may not always be perfectly
efficient, and there can be time lags or inefficiencies in the incorporation of
new information.

● Simplified Risk Measurement: CAPM relies on beta as a measure of

systematic risk, assuming that the relationship between an asset's returns
and the market returns is linear. However, beta may not capture all the
relevant risk factors and can oversimplify the complexities of risk inherent
in an investment.

● Reliance on Historical Data: CAPM relies on historical data to estimate

expected returns and beta. This assumption assumes that the past
relationship between returns and risk will hold true in the future. However,
future market conditions may differ from historical patterns, rendering the
model less accurate in predicting future returns.

● Homogeneous Expectations: CAPM assumes that all investors have the same
expectations regarding future returns, risk, and correlations among assets.
In reality, different investors may have varying expectations and
perceptions of risk, leading to a divergence of opinions and potential
mispricing of assets.

● Ignores Non-Market Risk Factors: CAPM focuses solely on systematic or

market risk factors and does not explicitly account for non-market or
firm-specific risks. Factors such as management quality, industry
dynamics, competitive position, and company-specific events can
significantly impact the performance of an investment but are not explicitly
captured in the CAPM model.

● Reliance on a Single Risk-Free Rate: CAPM assumes a risk-free rate that is

constant for all investors. However, in practice, different investors may have
access to different risk-free rates depending on their circumstances, leading
to variations in required returns.

● Lack of Consideration for Transaction Costs and Taxes: CAPM assumes

frictionless trading without considering transaction costs or taxes. In
reality, buying and selling securities incurs costs, such as brokerage fees and
taxes, which can impact the actual returns on investments.

Key takeaways

● CAPM is a financial model used to estimate the expected return on an

investment based on its systematic risk or beta.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

● It assumes that markets are efficient, investors are rational, and there is a
linear relationship between risk and return.

● The model incorporates the risk-free rate, beta, and market risk premium to
calculate the expected return.

● Beta measures the sensitivity of an investment's returns to the overall

market.

● The market risk premium represents the additional return investors expect
for taking on the average level of risk in the market.

● CAPM helps investors evaluate whether an investment's expected return

justifies the risk taken.

● It provides a framework for understanding the trade-off between risk and

return and assists in portfolio allocation decisions.

● CAPM has limitations, including assumptions of market efficiency and

homogeneous expectations.

● It does not consider non-market risks, transaction costs, taxes, or

individual preferences.

Measurement of Risk

1. Range

Range is a basic measurement of risk that provides a simple estimate of the

variability or dispersion of rate of returns. It represents the difference between the
highest and lowest returns indicating the spread of returns. In the context of risk
assessment, the range can give an idea of the potential magnitude of fluctuations
or outcomes.

It is the difference between two extreme ends of returns

Range = Highest return - Lowest return

Range has limitations as a standalone measure of risk. It does not take into account
the distribution or frequency of different outcomes within the range. Additionally,
it does not provide information about the probability of specific events occurring.

2. Variance & Standard Deviation

Variance plays a crucial role as a measure of risk or volatility. It helps quantify the
spread of potential returns around the expected return of an asset, providing
insight into the asset's level of uncertainty

A higher variance indicates a wider range of possible outcomes, implying greater

uncertainty and higher risk. Conversely, a lower variance suggests more consistent
returns and lower risk
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

The square root of the variance is known as the standard deviation (σ), which is
another commonly used measure of risk. The standard deviation provides a more
intuitive understanding of risk as it is in the same unit as the returns, making it
easier to interpret and compare across different assets.

a) Based on Historical data

Variance of an asset based on historical data

Standard deviation of an asset based on historical data

Therefore,

b) Based on probability distribution

Variance of an asset based on historical data

Standard deviation of a stock based on probability

Covariance and Correlation

Covariance measures the extent to which the returns of two assets move together.
It indicates the joint variability of two assets and can be positive or negative. A
positive covariance suggests that the returns of the assets tend to move in the same
direction, while a negative covariance implies they move in opposite directions.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

● It is a measure of relationship between two stocks

● Positive covariance means if one stock’s price is up the other stocks price is
also going up. Negative covariance means if one’s stock is up the other stock
price is going down

● To Compare and interpret we use correlation

Correlation is a standardised measure of the linear relationship between two

assets' returns. It ranges between -1 and 1, where -1 indicates a perfectly negative
correlation, 1 indicates a perfectly positive correlation, and 0 indicates no linear
correlation. It is also called the coefficient of correlation.

Or

Therefore,

Note : Correlation is also represented as r. So rij indicates correlation.

Variance of of a two stock portfolio

Standard deviation of a two stock portfolio

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

How to calculate portfolio risk and return in Excel / Analyzing stock ret…

3. Beta

Beta (β) is a valuable tool in finance that helps quantify the risk associated with an
investment. Specifically, it measures systematic risk, also known as market risk.
This refers to the volatility of a security's price movements compared to the overall
market movement.

Here's how beta works,

● Beta > 1: The investment is more volatile than the market. Its price tends to
fluctuate more significantly than the market average, suggesting potentially
higher risk and potentially higher returns.
● Beta = 1: The investment's volatility is equal to the market. Its price
movements tend to follow the market's average.
● Beta < 1: The investment is less volatile than the market. Its price
movements tend to be smaller than the market's average, indicating
potentially lower risk and potentially lower returns.

Beta is calculated by comparing the security's return volatility to the market's

return volatility. It essentially asks how much the security's price moves relative to
the market.

Unsystematic risks, specific to a company or industry (e.g., product liability

lawsuit), are not captured by beta because they can be diversified away by investing
in a variety of assets. Beta focuses on systematic risks that affect the entire market.

Benefits of Using Beta

● Risk Assessment: Beta helps investors understand how sensitive an

investment is to broad market movements. This allows for building a
portfolio with a desired risk-return balance.

● Portfolio Diversification: By comparing betas of different investments,

investors can choose assets with varying levels of market correlation,
reducing overall portfolio risk.

Limitations of Beta

● Historical Measure: Beta is based on past performance and doesn't

guarantee future results.

● Focus on Systematic Risk: It ignores unsystematic risks, which can be

significant for specific investments.

● Limited View of Risk: Beta is just one factor to consider. Other aspects like
financial health and industry trends also play a role in risk assessment.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 3: Risk & Return

Imagine the market is like the ocean, and individual stocks are like boats on the ocean.
Waves (market movements) will cause all the boats to bob up and down to some degree
(systematic risk). But some boats may also be tossed around by factors specific to that
boat, like a malfunctioning engine (unsystematic risk). Beta only measures how much a
boat moves with the waves, not how much it moves due to its own internal issues.

Additional Information:

Alpha

Alpha signifies an investment's performance that surpasses what's expected

based on its risk level. Calculated against a benchmark like a market index, a
positive alpha indicates the investment outperformed the benchmark,
generating higher returns than anticipated. Conversely, a negative alpha reflects
underperformance. Alpha is often associated with active investment strategies
where managers try to beat the market, while passive investing following a
benchmark index typically has an alpha of zero. Understanding alpha alongside
beta (a risk measure) offers a more complete picture of an investment's
performance.

Alan Job Jose

St.Francis College, Bengaluru