Welcome

Presentation
on
Risk and Rates of Return

by
Dr. Sujit R. Saha
Former Professor & Director
Bangladesh Institute of Bank Management
I. Risk/ Uncertainty
– Possibility of Loss or injury
– Probability of variation in Expected outcome

 Investment Risk: Chances of Variability of Inv.

Return
 Evaluation of Risk on two Bases
 Standalone Risk: Risk associated with an
investment held by itself, but not in combination
with other assets.
 Portfolio Risk: Risk associated with an investment
when it is held in combination with other assets.
II. Probability Distribution:
 Prob: Chances of Occurring
 PD: Listing of all possible
outcomes/events with a prob.
assigned to each outcome
 State of the Economy
 Boom
 Normal [ Tab. 5.1 ]
 Recession
 Expected Rate of Return/ Expected Value
 Weighted Average of Outcomes
^
 K = Pr1 K1 + Pr2 K2 + ............ + P
n

=  Pri Ki
Tab. 5-2
 Continuous vs. Discrete Probability Distribution
 Discrete: No. of Possible Outcomes is Limited
 Continuous: Unlimited number of Possibilities
Fig. 5-1 ] Discrete
Fig. 5-2 ] Continuous
III. Measuring Standalone Risk: SD
 Tighter the PD of Exp. returns, the less its variability
• Smaller Risk
 SD/  A measure of the tightness of the Prob. Distribution

Tab. 5-3
n
 (Ki K ) Pr i
^
=
v δ = 2
- 2

n

^
SD = δ = (Ki - K )Pr i

Weighted Av. Deviation from expected value

Risk 
Cv = =
 Return ^
K
 Useful in comparing the two investments having diff. exp.
returns
• Higher the SD & CV, Greater the Risk
 Risk Aversion and Required Returns
Exp .Ev - Bv
 Expected Rate of Return = BV
 Risk Aversion = Choosing Less risky investment
 Risk Premium = Return demanded for additional risk
 Riskier Securities must have higher expected returns
IV. Portfolio Risk
 Risk arising from a Portfolio – holding
 Diversification and its Effect on Risk
 Portfolio Returns ^
 Expected return on a Portfolio K ( P)
^ ^ ^ ^
K = W1 K1 + W2 K 2 + .......... .... + Wn K n
n ^
=  Wi K i EXAMPLE
 Realized Rate of Return ] Actually Earned
 Portfolio Risk
 Combining two stocks depending on risk as
measured by SD
 P = 0
 Correlation Co-efficient (r)
 Measures the degree of relationship b/w
the variables
Fig: 5-4 Stock W Portfolio
Fig: 5-5 Stock M WM
 Perfect Neg. Correlation (r = -1)
 Perfect Positive Correlation (r = +1)
 Diversification works best when stocks are perfectly
negatively correlated
Firm-Specific Risk vs. Market Risk
 Portfolio Size affects Portfolio Risk
• Riskiness of a Portfolio consisting of average stocks
tends to decline and to approach some minimum limit as
the size of the portfolio increases.
• Market Portfolio: A portfolio consisting of all the stocks
in the market.
• Fig. 5-7: Almost half of the riskiness inherent in an
average individual stock can be eliminated if a well
diversified portfolio (40 or more stocks) is developed.
• Diversifiable/ Firm-Specific/ Unsystematic Risk: Part of
a stock’s risk can be eliminated by diversification
(Lawsuits, Strikes, and other events)
• Non-diversifiable/ Market/ Systematic Risk: Part of
risiness that cannot be eliminated. (Economic or Market
• Investors demand a premium for bearing risk.
• Ind. Stock’s risk can be measured by CAPM.
•CAPM
A model used to determine RR on an asset.
RR = RF + RP (to cover non-div. risk)
Relevant Risk = Market Risk
• Concept of Beta ()
 The measure of a stock’s sensitivity to market
fluctuations.
 Key elements of CAPM.
  = 1] Market & Ind. Stock move up & down by same
degree.
  = 0.5 ] Stock only half as volatile as the market.
  = 2 ] stock is twice as volatile as the market.
 Fig: 5-8 ] Relative Volatility of Stocks
H = High Risk  = 2
A = Av. risk  = 1
• Summary of Analysis of Portfolio Risk – CAPM
Two Risk Components: Market and Firm Specific
FS Risk can be eliminated while Mkt. Risk: Relevant
Risk for Rational Investor.
Greater the riskiness of a stock, the higher its RR.
Premium is asked for non-Div. Risk.
Mkt. Risk of Stock measured by 
 is the most relevant measure of a stock’s risk.

• Portfolio Beta
 Weighted Av. of Ind. Securities’ betas.
 p = W1 1 + W2 2 + .................. + Wn n
 Example
 Adding a low-beta stock would reduce the riskiness of
the portfolio.
Relationship b/w Risk and Rates of Return
 For a given level of beta, what rate of return will
investors require to compensate for the risk?
 Defining the Terms : jth stock
^
K j = Expected rate of Return
Kj = RRR
KRF = Risk free Rate of Return
j = Beta Coefficient
Km = Market Return or RR on Average or BA = 1.0
RPM = Km – KRF [Market Risk Premium]
RPj = (KM – KRF) j [Risk Premium on the jth stock]
Eq. 5-8
RRR/Kj = KRF + (Km – KRF) Bj
 CAPM Equilibrium Pricing/SML
 SML
Fig. 5-9 ] Graphical Depiction of CAPM
RRR shown on V/axis
Riskless Security ]=0
Slope of SML reflects degree of risk aversion
 Steeper the Slope,
 Greater the RP
 Higher the RRR
 Values with  = 0.5,  = 1.0 &  = 2.0
 SML and Company’s position change over time
 Change in Int. Rate/ Inflation (Fig. 5-10)
 Change in Risk Aversion (Fig. 5-11)
 Change in Stock’s Beta (Fig. 5-11)
Thank
You
All