RISK AND

RETURN
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Session Objectives

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Classification of Risks
Risk ●
Types of Risks

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HPR
Return ●
CAGR
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Portfolio Return

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AM & GM
Statistical Measures ●
Variance & Standard Deviation
of Return ●
Co-Relation & Co-efficient

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Risk Return Trade-off

￮ In the context of investments, risk

means ‘the actual return may be
different than expected’; it can be
lower/higher income or can be higher
RETURN

appreciation/diminution of value of
original investment or both.
￮ This risk is measured in terms of
volatility of income and value / price
of the investment over a time period.

RISK

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Classification of Risk
￮ Systematic/market risk affects all participants in the market who made similar investments –
interest rate risk, country risk, inflation risk – very difficult to avoid
￮ Unsystematic/specific risk affects only that class of investors who invested in that ‘specific’
class of investment – company risk, credit risk (risk of default), product risk – can be avoided
to an extent by diversifying across sectors, companies, time periods, geographies, currencies
etc
￮ Diversification – don’t put all eggs in one basket rule
￮ A well diversified portfolio should ideally have only systematic risk

Risk

Systematic Risk Unsystematic Risk

( Market Risk) Specific Risk

￮ Total risk = systematic risk + unsystematic risk

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Types of Risk

Market risk

Reinvestment risk

Inflation risk

Purchasing power risk

Liquidity risk

Political risk

Exchange rate risk 6

Market Risk
￮ Sudden increases or decreases could affect the value and return on your investments.
￮ This is more pronounced in the short term.
￮ Long term risk is generally lower.

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Reinvestment Risk
￮ This is the risk that a particular investment may mature at a time when no other lucrative
investment options are available
￮ The risk resulting from the fact that interest or dividends earned from an investment may not
be able to be reinvested in such a way that they earn the same rate of return as the invested
funds that generated them

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Inflation Risk
￮ This refers to the risk that the rising costs of inflation will outpace the growth of your
investment over time.

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Company Risk
￮ This is the risk that the individual company in which you invest will fail to perform as
expected.

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Liquidity Risk

The risk that the investments will lose their liquidity is the worry here.

Liquidity refers to the ease of conversion of investment to cash.

Some securities may become illiquid and difficult to sell.

Then it becomes cumbersome to dispose them off.

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Political Risk

The risk that there may be a political upheaval or unrest and the markets do not function.
While this is in the extreme level, it also covers legislative risk.

A change in law may affect your investments.

These laws could not only govern the securities markets, but also the industry in which the
company operates, whose securities you hold.

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Exchange Rate Risk
￮ Change in exchange rates could directly affect your overseas investments and
indirectly affect the securities of the companies, thus affecting the share value.

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Returns
Yield / return is measured on income generated

It can be the return on an investment at cost or market price

Income could be interest (if debt) or dividend (if equity) or rent (if real estate) etc; it is also
called nominal return; usually expressed in percentage terms

Income if adjusted for tax – post tax return or yield

Income if adjusted for one year – Annualized return

Capital gain / loss ; this is the change in value of the investment over the time period; it is a
gain if there is appreciation/growth; if there is a fall then there is a loss

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Total Returns

￮ Total return = Yield + capital gain or loss ÷ Investment at cost

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Holding Period Return
HPR means Holding Period Return

It is the total return an investors earns between the purchase date and the
sale or maturity date. HPR is calculated using the following formula:

HPR=(P1+D1)/P0 -1

P1= Price received for instrument at maturity

P0= Initial price of the instrument (Purchase price)

D1=Interest payment (distribution)

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CAGR
￮ CAGR-Compounded Annual Growth Rate.
￮ It is a mathematical formula that provides a “smoothed” rate of return. It is really a pro forma
number that tells you what an investment yields on an annually compounded basis; it
indicates to an investor what they really have at the end of the investment period.

Merits Demerits
CAGR is the best formula for evaluating how When using the CAGR, it is important to remember
different investments have performed over time. two things: the CAGR does not reflect investment
Investor can compare the CAGR in order to risk, and you must use the same time period
evaluate how well one stock performed against
other stocks in a peer group or against a market
index. The CAGR can also be used to compare the
historical returns of stocks to bonds or a savings
account

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Arithmetic mean (A.M)
￮ A.M. is simple average of total returns (income + capital gain/loss) over the investment at the
beginning of period
￮ For example is an investment of Rs 100 becomes Rs80 after 1 year and in year 2 end becomes
Rs 100 again and there was no other income during the 2 years, then the arithmetic mean is
-20%+25% divided by 2 = 2.5% whereas the return is actually ‘zero’.
￮ Demerits of AM:
￮ Extreme Values
￮ Unknown number of observation

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Geometric mean (G.M)
￮ Here the concepts of total return and relative return become important.
￮ Relative return is 1+ total return; in year 1, the relative return is 1 – 20% = 0.8; in Year 2,
relative return = 1+ 25% = 1.25
￮ Even if total return is negative, relative return will at worst be 0 and not negative
￮ GM is the nth root of the multiples of relative returns minus 1
￮ In the above example is (0.8* 1.25)1/2 – 1 = 0

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Variance & Standard Deviation
￮ Measures how much the average of the actual returns could deviate/vary/change from the
expected returns.
￮ Steps for calculation:
￮ Find the deviation of each return of the asset from its average/mean return.
￮ Square each such deviation
￮ Multiply each square by its probability
￮ Add up all such products (the result is variance)
￮ Finally take the square root of that sum/variance that will result in standard deviation.

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Covariance ,Correlation
Covariance between any 2 assets is the extent to which the returns of those 2 assets
change together.

Correlation reflects the simultaneous movement of the returns from their expected / mean returns
and the mathematical measurement is covariance divided by the product of the S Ds of the 2 assets.

Correlation is always between -1 and 1.

A positive correlation indicates movement in same direction

Negative indicate opposite direction movement

Zero correlation would indicate absence of any relationship between the variables/assets.
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Co-efficient of Variation
￮ Co-efficient of variation measures how much variation/deviation (standard deviation) an
investment shows per unit of expected return;
￮ CV = Standard deviation / expected return; lower this number, better it is from risk-return
trade off view point

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THANK YOU