Risk and Return

Course Title: Financial Management

Course Code: BBA 2313

Benazir Rahman
Lecturer, Business Administration
Northern University Bangladesh
Return
Return represents the total gain or loss
on an investment.
Income received on an investment plus
any change in the market price.
Risk
Risk is defined as the chance of suffering
a financial loss.
Variabilityin the return from those that
are expected.
Probability Distribution
 A listingof all possible outcomes or events with a
probability assigned to each outcome.
Measurement of Risk & Return
Expected Rate of Return
The rate of return expected to be realized from an
investment; the mean value of the probability
distribution of possible result.
^
k  expected rate of return

^ n
k   k i Pi
i 1
Standard Deviation
A measure of the tightness or variability/dispersion of
return/outcome around its mean value.
Variance

The standard deviation squared.

  Standard deviation

 Variance  2
n
  i
(k
i1
 k̂ ) 2
Pi
Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of return.
Shows relative dispersion of risk or a measure of
risk per unit of expected return (Relative risk).

Std dev 
CV   ^
Mean k
Portfolio Risk and Return
 Portfolio
Combination of two or more
securities/assets.
Portfolio Expected Return
 For a portfolio, the expected return
calculation is straightforward. It is
simply a weighted average of the
expected returns of the individual
securities: N
E k P    i E ki 
i 1

 Where i is the proportion (weight) of

security i in the portfolio.
 Portfolio Expected Return (cont.)
 Suppose that we have three securities in the
portfolio. Security 1 has an expected return of
10% and a weight of 25%. Security 2 has an
expected return of 15% and a weight of 40%.
Security 3 has an expected return of 7% and a
weight of 35%. (Note that the weights add up
to 100%.)
 The expected return of this portfolio is:

E k P   0.250.10  0.400.15  0.350.07  0.1095  10.95%

 Investor attitude towards risk
Risk aversion – assumes investors dislike risk and
require higher rates of return to encourage them
to hold riskier securities.
Risk lover/Risk Preference- Those investors who
want to take risk at a lower rate o return.
Risk premium – the difference between the return
on a risky asset and less risky asset, which serves
as compensation for investors to hold riskier
securities.
Breaking down sources of risk
 Breaking down sources of risk

Stand-alone risk = Market risk + Firm-specific risk

Market risk – portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Also known as Systematic Risk.
Firm-specific risk – portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.
Also known as Unsystematic Risk.
Risk and Return: The Capital Asset
Pricing Model (CAPM)
A model that describes the relationship between
risk & expected return;
In this model expected return is risk-free rate
plus a premium based on the systematic risk of
security.
Risk and Return: The Capital Asset
Pricing Model (CAPM)
ki = kRF + (kM – kRF) βi
Assume kRF = 8% and kM = 15% and
market risk or beta is 1.30.
ki = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
Risk and Return: The Capital Asset
Pricing Model (CAPM)
The required return for all assets is
composed of two parts: the risk-free rate
and a risk premium.
The risk premium is a function of
both market conditions and the asset
itself.
The risk-free rate (RF) is usually
estimated from the return on T-bills
Risk and Return: The Capital Asset
Pricing Model (CAPM)
The risk premium for a stock is
composed of two parts:
The Market Risk Premium which is the
return required for investing in any risky
asset rather than the risk-free rate
Beta, a risk coefficient which measures
the sensitivity of the particular stock’s
return to changes in market conditions.
Beta
Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
Denoted by βi or β p

Indicates how risky a stock is if the stock

is held in a well-diversified portfolio.
Expected vs. Required returns

^
k k
^
HT 17.4% 17.1% Undervalue d (k  k)
^
Market 15.0 15.0 Fairly val ued (k  k)
^
USR 13.8 14.2 Overvalued (k  k)
^
T - bills 8.0 8.0 Fairly val ued (k  k)
^
Coll. 1.7 1.9 Overvalued (k  k)
Comments on beta
If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Security Market Line (SML)
SML is a line that shows the linear
relationship between expected returns for
individual securities & systematic risk(βi).
 Risk and Return Graphically

The security Market Line

Rate of Return

Slope or βi

RFR

Risk
THANK YOU……….