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Risk and Return2

Risk and Return2

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Risk and Return

What are investment returns?
nInvestment returns measure the financial results of an investment. nReturns may be historical or prospective (anticipated). nReturns can be expressed in: lRupee terms. lPercentage terms.

Return
• Single period return P o = Rs.300, P1 = Rs.350
   

Return for the period is ………. % P2 = 250

Return for the entire period ….? Period-wise return ?

Ex-post Returns
• Return = current income + capital gains • [(P2 – P1 ) + D2] / P1

Expected Return
• Different scenario • Chance / probability • Return in case of each chance
    

Chance 10% 23% 67% Expected

return 30% 40% 25% return ?

Expected return from pf
 

E =E1W1 + E2 W2 + E3 W 3

E expected return W proportion of money invested

Return
Return : It is the primary motivating force that drives investment. § It represents the reward for undertaking the investment. In security analysis we are primarily and particularly concerned with returns from investors’ perspective. § The return of an investment consists of two components : (i) Current return (ii) Capital return. 1 Current return: Periodic cash flow (income) such as dividend and interest. This can be zero or positive. 2 Capital return: The price appreciation or price changes. This can be zero, positive and negative also. Thus Total Return = Current return + Capital return

What is investment risk?
nTypically, investment returns are not known with certainty. nInvestment risk pertains to the probability of earning a return less than that expected. nThe greater the chance of a return far below the expected return, the greater the risk.

Probability distribution
Stock X

Stock Y

-20

0

15

50

Rate of return (%)

nWhich stock is riskier? Why?

Risk
• Variability of security returns • Standard deviation, variance • SD is extent of deviation from the average value of return = square root of variance and variance is the average of squares deviations of observed returns from expected value of returns

Assume the Following Investment Alternatives
Economy Recession Below avg. Average Prob. T-Bill Alta 0.10 0.20 0.40 Repo Am F. MP 8.0% -22.0% 28.0% 8.0 8.0 8.0 8.0 -2.0 20.0 35.0 50.0 14.7 0.0 -10.0 -20.0 10.0% -13.0% -10.0 7.0 45.0 30.0 1.0 15.0 29.0 43.0

Above avg. 0.20 Boom 0.10 1.00

What is unique about the T-bill return?
nThe T-bill will return 8% regardless of the state of the economy. nIs the T-bill riskless? Explain.

In this context of security analysis, we interpret risk essentially in the terms of the variability of the security return. The most common measures of risk ness of security is SD and Variance of return. Given below returns of two stocks X and Y .

Period

Return of stock X(%) Return of stockY(%)

1 -6 4  2 3 6  3 10 11  4 13 15  5 16 19 Calculate which stock is more risky ?

Period 1 2 3 4 5 Sum

X -6 3 10 13 16 36

Y 4 6 11 15 19 55

(X – X) -13.2 -4.2 2.8 5.8 8.8

(Y – Y) -7 -5 0 4 8

(X – X)2 174.24 17.64 7.84 33.64 77.44 310.84

(Y – Y)2 49 25 0 16 64 154

Mean of X = 36/5 = 7.2 =X Mean of Y = 55/5 =11=Y Variance of X = ∑(X- X)2/(n -1)= 310.80/(5-1)= 77.7 and the S.D =√77.7=8.815

Economic scenario Boom Stagnation Recession

Probability of Return from occurrence stock A(%) 0.25 0.50 0.25 36 26 12

The expected return would be E(R) = (0.25*36)+(0.50*26)+(0.25*12) = 25% The risk of the stock : σ2 =∑P *[R – E(R)]2 i i =(36-25)2 *0.25 + (26-25)2 * 0.50 + (12-25)2 * 0.25  = 73% SD = 8.54%

Calculate the expected rate of return on each alternative.
^ r = expected rate of return.

r =

∑ rP .
i i

n

i=1

^ rAlta = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%.

Alta Market Am. Foam T-bill Repo Men

^ r 17.4% 15.0 13.8 8.0 1.7

nAlta has the highest rate of return. nDoes that make it best?

What is the standard deviation of returns for each alternative?
σ = Standard deviation σ = Variance =
  = ∑  ri − r  Pi .  i =1 
n ∧ 2

σ

2

  σ = ∑  ri − r  Pi .  i =1 

n

∧ 2

Alta Inds:  = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10)1/2 = 20.0%. σ = 0.0%. σ σ Alta = 20.0%. σ
T-bills

= 13.4%. = 18.8%. AmFoam σ Market = 15.3%.
Repo

Prob.

T-bill

Am. F. Alta

0

8

13.8

17.4

Rate of Return (%)

Expected Return versus Risk
Security Alta Inds. Market Am. Foam T-bills Repo Men Expected return 17.4% 15.0 13.8 8.0 1.7 Risk, σ 20.0% 15.3 18.8 0.0 13.4

Coefficient of Variation: CV = Expected return/standard CVT-BILLS =deviation. = 0.0. 0.0%/8.0%
CVAltaInds CVRepoMen CVAm Foam . CVM = 20.0%/17.4% = 1.1. = 13.4%/1.7% = 7.9.

= 18.8%/13.8% = 1.4. = 15.3%/15.0% = 1.0.

Expected Return versus Coefficient of Variation
Security Alta Inds Market Am. Foam T-bills Repo Men Expected return 17.4% 15.0 13.8 8.0 1.7 Risk: σ 20.0% 15.3 18.8 0.0 13.4 Risk: CV 1.1 1.0 1.4 0.0 7.9

Return vs. Risk (Std. Dev.): Which investment is best?
20.0% 18.0% Alta 16.0% Mkt USR 14.0% 12.0% 10.0% 8.0% T-bills 6.0% 4.0% 2.0% Coll. 0.0% 0.0% 10.0% 20.0%

n r u t e R

30.0%

Risk (Std. Dev.)

σ
35

p

(%)

Company Specific (Diversifiable) Risk Stand-Alone Risk, σ
p

20

Market Risk
0 10 20 30 40 2,000+

# Stocks in Portfolio

Stand-alone Market = risk + Diversifiable risk risk
Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.

.

Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

Reduction of risk through Diversification
Security Analysis: Measuring risk & return. Portfolio Mgt: minimize risk or maximize return. Example: Concept of Covariance: the degree to which the return of two securities vary or change together. Concept of Correlation: the degree of relationship between two variables.

Can an investor holding one stock earn a return commensurate with its risk? • No. Rational investors will minimize risk by holding portfolios. • They bear only market risk, so prices and returns reflect this lower risk. • The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.

How is market risk measured for individual securities? • Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. • It is measured by a stock’s beta coefficient. For stock i, its beta is:  bi = (ρ iM σ i) / σ M

How are betas calculated?
• In addition to measuring a stock’s contribution of risk to a portfolio, beta also which measures the stock’s volatility relative to the market. •

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