Risk and Return –

Concept and
Calculation
Learning Objectives
After the study of this lesson, the reader should be able to:-
• Understand the meaning of returns and risk involved in securities
investment decision
• Analyze the impact of different types of risk on investment decisions
• Learn the different techniques available for measuring risk and
returns
• Apply the CAPM model to calculate the relationship between
expected returns and systematic risk with the help of beta coefficient.
Introduction
• Every financial decision has two aspects these are risk and return as
these are the two main determinants of security prices.
• They have their impact on the share prices as well as the valuation of
firm.
• Every decision involves some degree of risk, so an investor has to take
his financial decision rationally to optimize his returns through the
calculations of risk and return.
What is Return?
• It is associated with gain or loss on money invested in the market
• The rate of return on a security is the annual income received plus any change
in the market price of an asset
• Return is required to maximize the market price of the share but return is
associated with risk because the greater the return, higher the expectation of
risk
• An investor has to consider the risk of different financing patterns to balance his
decision between risk and return
• Like the return is expected to be high for investing in purchase of an equity
share in the market, but such a return is associated with high risk.
• Govt securities have a low risk as they provide stable return but at very low rate.
• Thus the investor has to pay the price in term of loss of return in order to invest
in safe securities having minimum risk.
Pure Risks
• Pure risks are a family of risks in which all possible outcomes are
harmful in some way.
• In other words a pure risk is a situation that can only end in a loss. For
example, the risks of an accident, a car theft or earthquake are pure
risks.
Speculative risks
• Speculative on the other hand are a family of risks in which some
possible outcomes are beneficial.
• In other words a speculative risk is a situation that might also end in a
gain.
• For example, the risks of Gambling and stock investment or business
venture are speculative risks.
Financial Vs Non-financial Risks
• Financial risk refers to uncertainty which can be measured in terms of
money.
• Non-financial risks can not be measured in terms of money or
currency.
Financial Risk Types
1. Market Risk
• Arises from movements within the financial market environment. Such
movements include shifts in share prices, interest rates, exchange rates,
commodity prices and other economic or industry market factors.
2. Credit Risk
• Credit risk is the risk of loss due to the failure of one party to pay the other an
outstanding obligation. Credit risk may be defined as default risk or counterparty
risk. Defaults and bankruptcies have long-term implications for borrowers and may
be irrecoverable.
3. Liquidity Risk
• Liquidity risk is the risk of a severe downward price revision when attempting to
sell a particular asset. In stressed market conditions, the seller may have to accept
a price well below their perception of value.
Non-Financial Risks Types
1. Settlement Risk: Closely related to default risk, it is the risk around the timing of payments between
counterparties.
2. Legal Risk: This is the risk of being sued, particularly in litigious environments, or the risk that a counterparty will
not uphold a contractual obligation.
3. Compliance Risk: Compliance risk is made up of regulatory risk, accounting risk, and tax risk. An update of laws
and regulations may create the need for financial restatements, back-taxes or other penalties.
4. Model Risk: This is the risk of valuation error when the valuation of a particular security is based on a mis
specified price model.
5. Tail Risk: The likelihood or probability of a material negative outcome is often understated in financial models
and it is, in most cases, related to model risk. Financial markets do not follow a normal distribution of returns
but tend to have “fat tails”. In case the internally selected model does not account for this, tail risk is introduced.
6. Operational Risk: This risk is related to the people and processes of an organization. The employees of an
organization can make errors which are financially costly or act fraudulently due to lack of proper oversight and
control. Companies may also be subject to business interruptions attributable to natural calamities or terrorism.
7. Solvency Risk: A company may not survive if it runs out of cash and becomes insolvent. In times of solvency
pressure, a company may be forced to liquidate assets at unfavorable prices simply to raise the necessary cash.
Solvency risk can easily be mitigated by making use of less leverage, using more stable sources of funding, and
incorporating solvency measures at the governance level of the business.
Static Vs Dynamic Risks
• Static remains indifferent in changing economic environment. They
would occur even there is no change in the economy. For instance,
risk of dishonesty of employees, nature of perils.
• Dynamic risks result from change in the economy. For instance
change in inflation rates, income level, technological level, Change in
consumer tastes.
• Affect large number of people
• Difficult to predict
Fundamental Vs Particular Risks
Objective Vs Subjective Risks
Diversified Vs Non-diversified
Risks
1. Diversifiable Risk (unsystematic Risk)
• Arise because of price change of unique features of the particular
security.
• Diversifiable risk can be partially or entirely eliminated by
diversification of the portfolio.
2. Non-diversifiable Risk (Systematic Risk)
• Are applicable to the entire class of assets or liabilities.
• The value of an investment in non-diversifiable risks declines over the
period due to any other change that affects the major portion of the
market, such as changes in the economic conditions of the country.
 Historical & Expected
Returns
• Realized, Historical or ex – post returns
• The return actually received on investment
• Expected or ex – ante returns
• Based on probability of getting a particular rate of
return in future
• Considers uncertainty or risk associated with
returns
• Components of returns
• Periodic cash receipts (Dividend or interest)
• Capital gains
 Ex – Post (Historical)
Returns
• The return from investment includes two components
• Dividends (Current yield)
• Capital Gains
• Returns represent the annual total income & capital
gains as a percentage of investment
• In bond investment maturity is fixed & returns are
expressed in form of YTM
• The maturity of common stock is not fixed so return
will be dividend yield + capital gain divided by initial
price
 Measuring the Rate of Return

• Dividends during holding period + (Price at the close of

holding period – Purchase Price)/ Purchase price
• Unrealized capital gains/ losses must be considered while
calculating returns

Rate of return Dividend yield  Capital gain yield

DIV1 P1  P0 DIV1  P1  P0 
R1   
P0 P0 P0
Annual rate of return

•
 Ex – ante (Expected) Return
• Being calculated as total of expected returns
• E = ΣXiPi
• Where X is the rate of return in particular period
• P is the probability of that particular scenario adding up to 1
• Expected returns of portfolio
• Weighted average of the return on individual securities in
portfolio
• E p = W1 E 1 + W2 E 2
• Ep = ΣWiEi
Risk – concept and measurement

•The chance that the actual outcome from an investment

will be different from the expected outcome
•The broader the range of expected outcomes the greater
the risk
•We can think of risk as variability in the rate of returns
•This variability can be defined as the extent of deviations
(dispersions) in rates of return from the average rate of
return
• Risk means variability in returns being measured in terms
of Variance & Standard Deviation
• σ2 = ΣPi (ri – E)2
• σ = √Variance
Sources of Risk
• Interest Rate Risk. It is the variability in a security's return due to
changes in the level of interest rates.
• Market Risk. Refers to the variability of returns due to fluctuations in
the securities market.
• Inflation Risk. With rise in inflation there is reduction of purchasing
power, hence this is also referred to as purchasing power risk and
affects all securities.
• Business Risk. This refers to the risk of doing business in a particular
industry or environment and it gets transferred to the investors who
invest in the business or company. It may be caused by a variety of
factors like heightened competition, emergence of new technologies,
development of substitute products, shifts in consumer preferences,
etc.
• Financial Risk. Financial risk arises when companies resort to financial
leverage or the use of debt financing.
• Liquidity Risk. This risk is associated with the secondary market which
the particular security is traded in.
 Risk
• Identification of risk
• Share M : 30% 28% 34% 32% 31%
• Share N : 26% 13% 48% 11% 57%
• Average rate of return is equal in both cases i.e. 31% but
share N is more risky
Reduction of Risk Through Diversification

• There are several sources of risk

• Some of which affect only one security
• Some affect both in opposite direction
• Some affect both in same direction
• Statisticians use coefficient of correlation to find out
the strength of relationship & magnitude of
movement in both securities
 Variance of Portfolio

• Standard deviation of portfolio is not the weighted

average of standard deviations because the variance
of portfolio depends on correlation coefficient
between returns
• σ2p = W12σ12 +W22σ22 + 2W1W2σ12
• Or σ2p = W12σ12 +W22σ22 + 2W1W2 r12 σ1 σ2
• As r12 = σ12 /σ1 σ2
• So σ12 = r12 σ1 σ2
 Measurement Of Risk In
Portfolio Context
• Unsystematic or Diversifiable Risk
• The firm specific risk factors like poor management,
productivity, cost structure of a company
• Effect of such factors can be canceled by taking sufficient
number of securities in portfolio
• Systematic or non – diversifiable risk
• Risk in a well diversified portfolio equals the average co
variance of securities in a portfolio
 BETA
• According to modern portfolio theory the riskiness of
a security is its vulnerability to market risk
• This is measured as sensitivity of security return vis –
a –vis market return expressed as β
• The Beta measures the systematic risk of security &
also gives indication of changes in security return due
to changes in market return
• The higher the riskiness the higher the Beta
• Beta > 1 » Aggressive Security
• Beta < 1 » Defensive Security
Estimating BETA
• Beta is the slope of Characteristics regression line
• CRL represents linear relationship between return on
security & market returns
• rit = ai + βirmt + eit
• βi = Cov im /σ2m
• Beta of Portfolio
• β = Σ βi Wi
Return on Equity (in Percent
Value)
 Class Exercise-1 Analyzing Real-
World Securities
• Instructions:
• Each student can take any one publicly traded stock listed on NSE.
Download the historical price data for the last year.
• Calculate the monthly returns for their assigned security.
• Using the monthly returns, have them calculate the average return,
variance, and standard deviation (risk) for the security.
• Present your results, explaining what your calculations reveal about
the risk and return of the security.
 Class Exercise 2- Portfolio Risk
and Return Simulation
• Instructions:
• Create group of 3-4 students each.
• Each group can take historical data for 3-5 different stocks (including their
returns and standard deviations).
• Each group to create a portfolio by choosing a combination of stocks and
deciding the proportion of investment in each stock.
• Have them calculate the expected return and standard deviation (risk) of their
portfolio using the formula for a portfolio's expected return and the
covariance/correlation matrix.
• Groups should then present their findings, discussing how their portfolio's risk
and return compare to the individual stocks and the impact of diversification.
Class Exercise- Risk Identification
and Classification
• Activity Structure:
• Divide the class into small groups (3-4 students each).
• Assign each group a specific scenario from the list.
• Ask each group to discuss the scenario and determine:
• The primary type of risk involved (systematic or unsystematic).
• How this risk could impact a company's operations, financial performance, or stock price.
• Potential strategies to mitigate this risk.
 Some real-life Risk Scenarios
• Interest Rate Hike by the Central Bank:
• The central bank increases interest rates by 2% to combat inflation. How does this affect companies with
large amounts of debt?
• Company-Specific Scandal:
• A major technology company is accused of data privacy violations, leading to a loss of consumer trust and
potential legal action.
• Government Regulation on Emissions:
• A new government regulation mandates stricter emission controls for all manufacturing companies. How
does this impact industries with high carbon footprints?
• Natural Disaster in a Key Manufacturing Region:
• A significant earthquake disrupts operations in a region known for its concentration of semiconductor
manufacturing plants. What are the broader implications for the technology industry?
• Technological Disruption by a Competitor:
• A startup introduces a revolutionary new product that renders a traditional company’s main product
obsolete. How does this affect the established company?
• Global Economic Recession:
• The global economy enters a recession, leading to widespread declines in consumer
spending and business investments. How does this impact different industries?
• Cybersecurity Breach:
• A financial services company experiences a significant cybersecurity breach, leading
to the loss of sensitive customer data and a hit to its reputation.
• Sharp Increase in Commodity Prices:
• The price of a key raw material, such as oil or copper, suddenly spikes due to
geopolitical tensions. How does this impact companies reliant on these commodities?
• Pandemic Outbreak:
• A new pandemic emerges, leading to global supply chain disruptions and shifts in
consumer behavior. How are businesses in the retail and hospitality sectors affected?
• Currency Depreciation in an Export-Dependent Country:
• The currency of an export-dependent country depreciates significantly against major
global currencies. How does this impact companies within that country?
Thank You