Republic of the Philippines

BATANGAS STATE UNIVERSITY

Batangas City
College of Accountancy Business Economics and
International Hospitality Management

GRADUATE SCHOOL

NARRATIVE REPORT

Name of Presenter: Orville Jay B. Bermas

AY / Sem: 2019-2020/ Second Semester
Course Code: BA – 507
Course Title: Financial Management
Schedule: 7:00 am to 10:00 am
Section: MBAN 1218
Topic: Risk and Rates of Return
Topic Objectives: This topic aims to help the MBA student to learn how to present the risk and rates of
return was done in a certain company. What are the benefits and drawbacks and it will
expand the knowledge of the MBA student that can be their reference in the future.

Topic Content/Discussion:
Chapter 8
Risk and Rates of Return

Learning Objectives

Explain the difference between stand-alone risk and risk in a portfolio context.
 
Describe how risk a version affects a stock’s required rate of return.
 
Discuss the difference between diversifiable risk and market risk, and explain how each type of risk affects
well-diversified investors.

Describe what the CAPM is and illustrate how it can be used to estimate a stock’s required rate of return.
 
Discuss how changes in the general stock and bond markets could lead to changes in the required rate of return
on a firm’s stock.
 
Discuss how changes in a firm’s operations might lead to changes in the required rate of return on the firm’s
stock.

The Risk-Return Trade Off

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle,
individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk
with high potential returns. According to the risk-return tradeoff, invested money can render higher profits
only if the investor will accept a higher possibility of losses.

Portfolio – is a collection of investment securities.

Risk – is defined Webster’s Dictionary as a “hazard; a peril; exposure to loss or injury”.

Risk – the chance that some unfavourable event will occur.

There are two ways to analyze asset’s risk
1. Stand Alone basis – where the asset is considered by itself
2. Portfolio Basis – where the asset is held as one of the number of
assets in a portfolio
Stand Alone Risk – the risk an investor would face if he or she held only one asset.

Statistical Measures of Stand-Alone Risk

Here are six key item that are covered:

1. Probability distributions - listing of possible outcomes or events with probability assigned to each
outcome.
2. Expected Rates of Return, - the rate of return to be realized from an investment; the weighted average
of probability distribution of possible results
3. Historical, or past realized, rates of return
4. Standard Deviation – a statistical measure of variability of a set of observations.
5. Coefficient of variation (CV) – the standardized measure of the risk per unit of return; calculated as the
standard deviation divided by the expected return.
6. Sharpe Ratio – the measure of stand-alone risk that compares the asset’s realized excess return to its
standard deviation over a specified period

Investor Attitude towards risk

Risk Aversion – risk averse investor dislike risk and require higher rates of return as an inducement to riskier
securities.
Risk Premium - the difference between the expected rate of return on a given risky asset and that on a less
risky asset.

Capital Asset Pricing Model (CAPM)

A model based on the proposition that any stock’s required rate of return is equal to the risk-free rate of return
plus a risk premium that reflects only the risk remaining after diversification

Diversification – is the process of allocating capital in a way to reduces the exposure to any one particular
asset or risk.
Expected Return on a Portfolio – the weighted average of the expected returns on the assets held in the
portfolio

 Example of Expected Return on a Portfolio

Portfolio Risk - is a chance that the combination of assets or units, within the investments that you own, fail
to meet financial objectives. Each investment within a portfolio carries its own risk, with higher potential
return typically meaning higher risk.

Two tendency of two variables to move together:

Correlation – the tendency of two variables to move together.
Correlation Coefficient, p – a measure of the degree of relationship between two variables.

2 Parts of Portfolio’s Total Risk

Diversifiable Risk – the part of security’s risk associated with random events; it is eliminated by proper
diversification. This risk is also known as company specific or unsystematic risk
Examples: lawsuits, strikes, successful and unsuccessful marketing and R&D program etc.

Market Risk – the risks remains in a portfolio after diversification has eliminated all company-specific risk.
This risk is also known as nondiversifiable or systematic or beta risk.
Examples: war inflation, recessions, high interest rates, and other macro factors.

 Market Portfolio – A portfolio consisting of all stocks.

Risk in a Portfolio Context: Beta Coefficient

Relevant Risk – the risk that remains once a stock is in a diversified portfolio is its contribution to the
portfolio’s market risk. It is measured by the extent to which the stock moves up or down with the market.

Beta Coefficient, b – a metric that shows the extent to which a given stock’s returns move up and down with
the stock market. Beta measures market risk

Average Stock’s Beta, bA=1 – because an average-risk stock is one that tends to move up and down in step
with the general market.

Market Risk Premium RPM – the additional return over the risk-free rate needed to compensate investors
for assuming an average amount of risk.
Required return on stock = Risk-free return + Premium for the stock’s risk

Security Market Line (SML) Equation = an equation that shows the relationship between risk as measured
by beta and the required rates of return on individual securities.

The Impact of Expected Inflation

A nominal interest rate refers to the interest rate before taking inflation into account. It is the interest rate
quoted on bonds and loans. The nominal interest rate is a simple concept to understand. If you borrow $100 at
a 6% interest rate, you can expect to pay $6 in interest without taking inflation into account. The disadvantage
of using the nominal interest rate is that it does not adjust for the inflation rate.

2 Elements of Inflation Rate

Real Inflation free rate of return (r*)

Inflation Premium (IP)

Some key ideas that all investors should consider:

1. There is a trade-off between risk and return.
2. Diversification is crucial.
3. Real returns are what matters.
4. The risk of an investment often depends on how long you plan to hold the investment.
5. Although the past gives us insights into the risk and returns on various investments, there is no
guarantee that the future will repeat the past.

Prepared by: Checked and Verified by: Approved by:

Orville Jay B. Bermas Atty. Sheena Mara R. De Villa, CPA

Student Faculty