RISK & RETURN

By
Aditya Menon J082
Prabudh Bansal J080
Divyani Sarjekar J074

Overview
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

Risks

Systematic
OR Non
diversifiable

Non
systematic
OR
diversifiable

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
Currency
risk

Risk
due to
inflati
on

Interest
rate risk

Commodity
risk

Political
risk

Industrial
growth

Market
risk
Risk due
to govt.
policies

Business
Cycle risk
Scams

Natural
calamitie
s

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 Risks

Business
risks

Disputes

Non
systemat
ic
risks
Risks due
to
uncertaint
y

Financial
risks

Risk and Return Analysis

Return is the total gain or loss experienced on an
investment over a given period of time.
Return = Cash Flows from the asset + Capital
Appreciation/Depreciation
R = {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

Analysis
Investors 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.

Security Market Line

It 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
Pricing Model (CAPM)

of

Capital

Asset

Mathematically,
E(Ri)= Rf + (E(Rm) - Rf)
where E(Rm)=Expected
Investment
Rf=Risk-free Return
= Beta

Return

from

the

If > 1 then Aggressive Stock

If < 1 then Defensive Stock

Applications of SML
Identifying undervalued securities
Determining the ideal market price of the
security
Testing the market efficiency

Risk & Return for Single

Asset (Ex-Post)

Average

Return, R = /N

Risk= Standard Deviation= (Variance)

Variance: It is the sum of squares of the
deviations of actual returns from average
returns .
Variance = (Ri R)2

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=1
Variance 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
risk

Reduction 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.

THANK YOU