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Risk and Return

This document discusses risk and return, including the different types of risk. It defines risk as the variation between expected and realized returns. There are two main types of risk: systematic and unsystematic. Systematic risk cannot be eliminated by diversification and includes market risk, interest rate risk, and inflation risk. Unsystematic risk can be reduced through diversification and includes business risk and financial risk at the company-level. Various methods are presented for measuring risk, including standard deviation, variance, beta, and correlation. Expected return is defined as the probability-weighted average returns. Historical returns and risks can be measured using past prices, dividends, and the variance or standard deviation of returns.

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58 views18 pages

Risk and Return

This document discusses risk and return, including the different types of risk. It defines risk as the variation between expected and realized returns. There are two main types of risk: systematic and unsystematic. Systematic risk cannot be eliminated by diversification and includes market risk, interest rate risk, and inflation risk. Unsystematic risk can be reduced through diversification and includes business risk and financial risk at the company-level. Various methods are presented for measuring risk, including standard deviation, variance, beta, and correlation. Expected return is defined as the probability-weighted average returns. Historical returns and risks can be measured using past prices, dividends, and the variance or standard deviation of returns.

Uploaded by

JagrityTalwar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Risk and Return

Risk
The difference between expected and realized return is called
risk.

Probability of variation between Actual/Realized and Expected


returns.

Types of Risks
Systematic Risk
Unsystematic Risk

Systematic Risk
The risk inherent to the entire market or an entire market
segment.
Also called undiversifiable risk, volatility or market
risk,
Affects the overall market, not just a particular stock or
industry.
Unpredictable and impossible to completely avoid.
It cannot be mitigated through diversification, only through
hedging or by using the right asset allocation strategy.

Unsystematic Risk

Company- or industry-specific hazard that is inherent in each investment.

Also known as nonsystematic risk, "specific risk," "diversifiable risk" or


"residual risk,"

Can be reduced through diversification.


By owning stocks in different companies and in different industries, as well
as by owning other types of securities such as Treasuries and municipal
securities, investors will be less affected by an event or decision that has a
strong impact on one company, industry or investment type.

Examples
a new competitor,
a regulatory change,
a management change and
a product recall.

Types of Systematic Risk

Interest Rate Risk


The changes in the interest rates
As the interest rates goes up, the market prices of existing fixed
income securities falls.
For eg. A debenture has a face value of Rs.100 with a coupon
rate of 10%.
Now if the market rate of interest on the Security increases upto
12%, no investor will be ready to buy it.
Hence, its value will decrease in secondary market by 2Rs. (it
will sell at discount)

Market Risk
Market Risk is consistent with the fluctuations seen in the
trading prices of any particular share or security.
1.
2.
3.
4.
5.

Boom or Low Period


Global Financial Crisis
Terrorist Attack
Political and Economic Disbalance
Investors Psychology

Purchasing Power Risk/Inflationary Risk


The risk that unexpected changes in consumer prices will
penalize an investor's real return from holding an investment.
Because investments from gold to bonds and stock are priced
to include expected inflation rates, it is the unexpected
changes that produce this risk.
Fixed income securities, such as bonds and preferred stock,
subject investors to the greatest amount of purchasing power
risk since their payments are set at the time of issue and
remain unchanged regardless of the inflation rate.

Types of Unsystematic Risk

Unsystematic
Risk

Business Risk
(Operational
Leverage)
Financial Risk
(Financial
Leverage)

Business Risk

The impact of the operating conditions is reflected in the costs of the company.

The operating cost can be segregated into fixed costs and variable costs.

A larger proportion of fixed cost is disadvantageous to a company.

If the total revenue of such company declines due to some reasons or the other,
there would be more proportionate decline in the operating profits because the
company will not be able to recover its fixed costs.

Such a company will face more of business risk. It simply means such
company has high Operating Leverage.

For eg. Taking factory plot on lease of 10 years for Rs. 12 Lac. In case if
company has earned less operating revenue then it will not be able to recover
its fixed cost.

Financial Risk

The presence of debt in the capital structure creates fixed payments in the form
of payments of interest which is a compulsory payment they have to make
whether the company suffers profits or losses.

The fixed payment of interest creates more variability in Earning Per Share
(EPS).

If Rate of Return (Operating Profit) > Interest payable (Higher EPS)

If Rate of Return (Operating Profit)< Interest Payable (Lower EPS)

Such Risk is faced by the company which are highly Levered.

Methods Of Measuring Risk


Risk

Unsystematic
Risk

Standard
Deviation

systematic
Risk

Variance

Regression

Beta

Correlation

Measuring Historical Return


Total
return

cash payment
= received during
the period

price change
over the period

Price of the investment at the beginning

Example:
Price at the beginning of the year : Rs.
60.00
Dividend paid at the end of the year : Rs.
2.40
Price at the end of the year : Rs. 69.00
Total Return = 2.40 + (69.00 -60.00) /

Measuring Historical Risk


Risk refers to variability or
dispersion.
Variance and standard deviation are
the measure of risk in finance.
Standard Deviation is given by:

( Ri - R )2 / (n-1)
i=1

Example
Period

Return

Deviation (R
R)

Square of
Deviation

15

25

12

20

10

100

-10

-20

400

14

16

-1

60
R = 10

= (536/6-1)1/2
= 10.4

536

Measuring Expected Return


There is always likelihood that
possible returns vary. Therefore, it
should be considered in terms of
probability.
Probability of an event represent the
likelihood of its occurrence.
Expected rate of return is the
weighted average of all possible
returns multiplied by their respective
probabilities.

R = ( Ri )( Pi )
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
Standard deviation of return
n

[( Ri - R )]2 (Pi)
i=1

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