CHAPTER -4 RISK AND RETURN

RETURN
What we will get back when we sacrifice today after a specified time period. Objective of the investment. Motivating force. Concerned with benefits.

Factors of Return
Compare the alternative investment. Measurement of historial return. Helps in estimation of future.

Types of Return

Realized Return Expected Return

Determinants of Return
Risk free real rate. The expected rate of return. The risk associated with the investment. thus, reqd rate= risk free real rate + inflation premium + risk premium

Rate of Return
Income from security in the form of cash flows. The difference in the price of security between the beginning and end of the holding period. Expressed in percentage.

Measurement of Rate of Return

Genral equation for calcualting R.O.R K = dt + (Pt Pt-1)

Pt-1
where, Dt = income or cash flow receivables from the security at time t. K= rate of return. Pt = price of the security at time t i.e end of holding period.

Pt-1 = price of the security at time t-1 i.e. Beginning of the

holding period or purchase period

Example
If the share of ACC is purchased for Rs. 3580 in feb 8 of last year and sold for 3800 on feb 9 of this year and the company paid a dividend of Rs 35 for the year. What is R.O.R. Ans = 7.12%

Probability of Rate of Return

K = Pi x Ki

where I = 1 to n
K = expected R.O.R Pi= probability associated with the ith possible outcome. Ki = R.O.R from the ith possible outcome. n= number of possible outcome

Example The probability distribution and

corresponding rates of return for alpha company are shown below:
Possible Outcomes Probability of occurrence - Pi .10 Rate of return (%) - Ki

50

2 3 4

.20 .40 .20

30 10 -10

.10
1.00

-30

Risk
Difference between actual and expected outcome. It is a variance. Expected return from the security may not be materialize. Uncertainties could be due to the political, economic and industry factors.

sources of risks
Interest rate risk Market risk

Inflation risk

Business risk

Financial risk Liquidity risk

Measurement of total risk

Different ways to calculate risks: 1. range of return = highest possible return lowest possible return 2. variance = var (k) = Pi (Ki- K)^2 3. S.D = sqrt (var)

Ques- calculate the standard deviation for the alpha companys rate of return
Possible outcomes 1 2 3 Probability Pi .10 .20 .40 K in % 50 30 10

4 5

.20 .10

-10 -30

Ans- 21.9%

Risk Return Relationship

Return High risk Low Risk Average risk

Rf

Risk