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Contents
Risk and return go together
Probability distribution of all possible outcomes in terms of return
Measuring risk so as to expect adequate return – Weighted average return, Standard deviation and the
Co-efficient of variation
Risk in a portfolio context – introduction to a portfolio of securities
Types of risk associated with investment in a portfolio – systemic and non-systemic
Concept of Beta and Capital Asset Pricing Model
Volatility and Risk
Some concerns about Beta and the CAPM
Numerical exercises in risk and return
♦ Besides interest, the enterprise should also have sufficient surplus after paying interest to repay the loan
amount
♦ Risk of project failure affects the owners more than the lenders for the same reason as mentioned in the first
bullet point
Thus we prove the point mentioned at commencing this chapter namely “risk and return go together”. The question
relevant here is that “can we define risk?’ Let us make an attempt here. We make an investment in bank’s fixed
deposit at 8% p.a. We have an agreement with the bank that if the market rate comes down the rate of interest offered
on the deposit would also come down. Is there a risk here? Definitely, if the market rate comes down. What is this
risk? The risk of not getting the expected return of 8%. Thus the first definition of “risk” is the “uncertainty”.
Uncertainty relating to what? In the given example, uncertainty relates to “outcome” of an “activity”, i.e., investment.
Is the “outcome” stated? Yes. Right in the beginning when we contracted with the bank to get 8% return.
So, we build up the definition of “risk”. We can define risk in general as “uncertainty relating to a stated outcome of a
specific activity”. The activity could be anything and the outcome automatically gets related to this. For example,
undergoing a post graduation course in “Management” could be the activity and the risk could be relating to the
stated outcome of landing oneself in a well-paid job. In finance terms, the “risk” obviously relates to the activity of
investment and the stated outcome relating to this would be the “return” on this investment. Thus going back to our
example of investment in a bank deposit, the activity is “investment in a bank deposit”. The risk relates to the
outcome of return on this investment namely interest not coming down from the expected rate of 8%.
Is risk related only to possible reduction in rate of return? Or in other words, is there no risk in case
the return is higher than the expected rate of return?
Suppose the bank deposit referred to above fetches us higher return than expected rate of 8%. Is there no risk? There
apparently is no risk from the point of view of the depositor. However this is not the correct picture. The very fact
that the return is higher than the expected rate due to increase in market rate of interest could also bring the rate
down in future any time. Thus going by the accepted definition of “risk” relating to investment, it relates to
uncertainty of the return from the investment and not specifically to whether the deviation (fluctuation) is positive
(return being higher than expected) or negative (return being less than expected). In both the cases of deviation or
fluctuation from the expected rate of return, risk exists. Let us examine the following graph.
Return
On
investment
The above graph shows returns deviating from the expected rate of return both positively and negatively. Does it
mean that when it deviates positively there is no risk for us? There is a risk of uncertainty that the returns could go
down and be less than the expected rate of return.
Conclusion:
The higher the uncertainty the higher the risk. The higher the risk the higher the return expectation. This is because
the investors are risk averse and would expect a higher return in case the risk increases. In terms of probability of
return, the higher the probability, the less the uncertainty and less the risk. Conversely the less the probability, the
more the uncertainty and higher the risk.
In this chapter, we are going to study the return on investment in stock markets, i.e., in shares and bonds and not any
other investment as these are subject to market risk and fluctuations. This enhances the risk associated with
investment into equity market and bond market. We will examine as to what kind of risk can be minimized and what
cannot be minimized. We are also going to see how the risk of an individual stock (share) can be minimized by
including the same in a bunch of securities (investment instruments) that is called “portfolio”.
Example no. 2
Date of purchase of the above share = Dec. 2001
Dividend for the year ended 31-03-2002 = 100/-
Date of sale = Dec. 2002
Market value = Rs. 1030/-
The total return on investment = Amount received on sale of investment – Amount invested at T0
----------------------------------------------------------------------------------------------------------------
Amount invested at T0
Thus the return on our investment for a period of one year = 130/1000 = 13% p.a1.
Return on investment in shares = dividend + market appreciation during the period of holding the security
(difference between selling and purchase prices). Suppose the holding period is two years, the return is determined
cumulatively for a period of 2 years and divided by 2 to arrive at annual return.
Standard deviation
1
Return is always expressed on annual basis. For example if the return for holding a security is 13% for a period of six months, the annualised
return would be 26% = 2 x 13%
Investment is about selection of one stock (share or bond) in preference over another, after due consideration of the
risks associated with them respectively. Let us say for example investment in shares of two limited companies A and
B. In this case we should understand the implication of probability distribution of expected returns for a given period
for both the stocks. Let us examine the probability distribution and understand the concept of risk. We are examining
below the expected value of return and standard deviation of return for a chosen stock.
2
Total = 1.00 ∑ = .090 = R σ = 0.00703 and σ = 0.0838
th
Where Ri is the return for the i possibility, Pi is the probability of that return occurring and n is the total number of
possibilities. Thus the expected value of return is simply a weighted average of the possible returns, with the weights
being the probabilities of occurrences. For the above distribution of possible returns, the expected weighted average
return is 9% and the standard deviation of the return is 0.0838 or 8.38%. We can easily see that the higher the
standard deviation the higher the risk; the higher the risk, the higher the expected rate of return in future. Thus the
standard deviation is a simple measure of risk based on the distribution of returns in the past by assigning
probabilities to them. The probabilities represent the % times the return has been so. In this case the probability is
10% for 20% return, this means that 10% of the times, the return has been 20%.
Coefficient of Variation
The standard deviation can at times be misleading in comparing the risk, or uncertainty relating to the alternative
returns, if they differ in size. Consider two alternative investment opportunities, A and B, whose normal probability
distributions of one-year returns have the following characteristics:
____________________________________
Investment
A B
____________________________________
Expected Return R 0.08 0.24
Standard deviation σ 0.06 0.08
Co-efficient of variation CV 0.75 0.33
We have mentioned earlier that higher the standard deviation, the higher the risk and vice-versa. Now looking at the
above table, can we say that since the standard deviation of stock B is more than that of stock A, the risk associated
with it is higher? Yes and No. Yes if the sizes of investment is the same in both the stocks. This is best explained by
taking two persons having widely different incomes with the same standard deviation. Let us assume that the
average monthly income of the first person is Rs.10,000/- while that of the second person is Rs. 1,00,000/-. Both of
them are having standard deviation of say 3,000/-. We can very easily see that while this standard deviation would
affect the first person much more than it does the second person. This is what establishes the need for determining
the co-efficient of Variation. How does one do it?
To adjust for scale or size, the standard deviation can be divided by the expected value of return to compute the
coefficient of variation (CV). Co-efficient of variation (CV) = σ/R. This in the above table gives us the values of 0.75 =
0.06/0.08 for stock A and 0.33 = 0.08/0.24 for stock B. Thus using the co-efficient of variation (CV) we find that the
riskiness of stock A is more than the riskiness of stock B while by standard deviation method, we would have found
stock B to be more risky than stock A.
Portfolio Return
The expected return of a portfolio is simply the weighted average of the expected returns of the securities
constituting that portfolio. The weights are equal to the proportion of total funds invested in each security (the total
of weights must equal to 100 percent). The general formula for the expected return of a portfolio Rp is as follows:
Rp = ∑ Aj x Rj
J=1
Where Aj is the proportion of total funds invested in security j; Rj is the expected return for the security j and m is the
total number of different securities in the portfolio. The expected return and standard deviation of the probability
distribution of possible returns for two securities are shown below:
Security A Security B
2
For details of different markets and instruments, please refer to the chapter on “Financial Sources”
If equal amounts of money are invested in these two securities, the expected return of the portfolio containing two
securities namely A and B is 0.5 x 14% + 0.5 x 11.5% = 12.75%.
Portfolio Risk
The portfolio expected return is a straightforward weighted average of returns on the individual securities; the
portfolio standard deviation is not the weighted average of individual security standard deviations. We should not
ignore the relationship or correlation between the returns of two different securities in a portfolio. This correlation
however has no impact on the portfolio’s expected return. Let us understand what we mean by “correlation”
between securities.
Suppose we have two stocks “A” and “B” in our portfolio. During a given period the return of “A” increases say by
1% while that of “B” increases by 0.5% in the same period. This means that both are moving positively in the
direction of increasing returns. This is described as “positive” correlation. However the quantum of increase is not
the same in both the cases. Hence this is imperfect but positive correlation. In case the quantum of increase is 1% in
both the cases, then the correlation is said to be positive and perfect correlation.
If the returns move in the opposite direction, say one increasing and the other decreasing, then the correlation is
negative. Still the relationship could be perfect in the sense that the quantum of increase in return say in the case of
“A” is the same in the case of “B” but in the opposite direction. This means that while stock “A” has increased its
return, stock “B” has lost its return by the same percent. Let us try to put these in the form of equations.
“Δ” represents the increase in return and (“Δ”) (within brackets indicate that the return is decreasing). Keeping these
in mind let us attempt the following:
Δ of stock A = 1% for a given period = Δ of stock B = perfect and positive correlation
Δ of stock A = 1% for a given period; Δ of stock B = greater than or less than 1% but the return has increased and not
decreased = positive but imperfect correlation
Δ of stock A = 1% for a given period; (“Δ”) of stock B = 1%. Then stock A and stock B are said to have perfect but
negative correlation.
Δ of stock A = 1% for a given period; (“Δ”) of stock B less than or more than 1%. Then stock A and stock B are said to
have imperfect and negative correlation.
We have consciously omitted the fifth possibility of both the stocks A and B losing to the same percent during a given
period. Any portfolio would avoid such stocks unless the future is going to be completely different in which case the
past is not the basis on which stock selection is being made.
We have also tried to present these concepts in as simple a manner as possible. The students are advised to go
through these repeatedly to grasp the essence of the underlying concept in correlation between one stock and
another. This is required because the concept of correlation is the fundamental based on which the selection of stocks
for a portfolio is done. The students will appreciate that positive correlation between two stocks would mean
increased risk especially if the relationship is perfect. Negative correlation stocks are not desirable. What is then left is
positive but imperfect correlation. The risk-averse investors would invariably choose such stocks as show positive
relationship between them (or among them in view of the number of stocks in a portfolio being more than 2, which is
usually the case) but not perfect relationship. Then only the risk in a portfolio is reduced. For a given period, same
degree of movement in return on different stocks in the same direction only increases the risk in a portfolio.
Now going back to the standard deviation of a portfolio, we will appreciate that it is not merely the weighted average
of the standard deviation numbers for each stock in the portfolio. Suppose there are five stocks in a portfolio. We can
appreciate that there are quite a few possible combinations of these five stocks depending upon the proportion of
investment in each of them; for each combination, the weighted average of the standard deviation numbers has to be
etermined first and then the ultimate average standard deviation should be found out for all possible combinations.
This involves a very complicated calculation and hence not presented here.3 However before we end this topic it
3
This is better explained by any standard textbook on “Security Analysis and Portfolio Management”. Any student interested on the topic of
“Investment” is well advised to refer to any standard textbook on SAPM.
should be mentioned that the complicated calculation is worth the time invested in, as the ultimate result is reduction
in the total risk of the portfolio. This is the very objective of a portfolio.
Total risk of a portfolio = market risk of the portfolio + specific risk of the portfolio
Is there any readymade portfolio whose return represents the market return? Yes. The BSE sensex represents the
market portfolio and the return on this for a given period is the market rate of return. The difference between this
market rate of return (12.5%) and risk free rate (6.5%) represents the market premium (6%). Is BSE sensex the only
portfolio? No. NSE’s 50 stock index is another one. However let us bear in mind that BSE sensex or NIFTY FIFTY
does not include any debt instrument like debenture or bond or short-term money market instruments. Hence the
parameter of market premium as applicable to BSE sensex etc. relates only to investment in equity shares.
Example no. 3
Let us say that the risk-free rate is 6.5% as assumed in the above paragraphs. Let us say that the market premium is
also 6% as assumed before. The Beta of a given stock is 1.2. Then the expected rate of return from this stock is = R j =
Risk free rate + (Beta of selected stock x market premium) = 6.5% + 6% x 1.2 = 13.7%. This means that the expected
rate of return from selected stock is 13.7%. This equation is the famous equation called “Capital Asset Pricing
Model (CAPM)”
The higher the Beta, the higher the risk and the higher the risk premium in comparison with the market premium and
vice-versa. In the preceding paragraph we saw that the Beta for RIL is less than 1. What does it mean? The risk
associated with RIL stock is less than the risk associated with market portfolio. It is safer. Beta is a true measure of
the relative volatility of the return of a given stock in comparison with the volatility of return of market portfolio.
4
Datum is singular and data is a plural of datum. Hence data and are should be used and not data and is.
The CAPM model as detailed above is very useful without any doubt. However this has certain limitations. One of
the most important limitations is that most of the times the trend in the past based on which Beta is determined may
not influence the returns of the future. There could be other factors happening only in the future that could alter the
rate of return expectation in a given stock either by reducing or increasing the risk associated with it. As a result of
this, stocks’ Betas most of the times do not have any relationship with the returns in future. There have been
successful attempts to overcome this constraint in the CAPM model and it is beyond the scope of this book to discuss
these attempts. However before closing this point, it will be relevant to mention that two distinguished factors
influence the market return of a selected stock. They are:
The firm’s size – the smaller the size the higher the returns and
Market value to book value ratio – the lower the ratio the higher the returns
Let us conclude this topic by giving a formula for book value of equity share:
Book value of equity share = Paid up capital + Reserves and Surplus
Number of equity shares issued