Risk and Return

Week 3 - Financial Market

The Relationship between Risk and Return
What is return?
Income received by an investor on an investment.

Question
Rate of return
The annual income earned expressed as the percentage of the average
principal amount invested.

Current value - Initial value = Increase in value

Increase in value/ Initial value = Percentage return
Increase in ROI: Increase in Sales; Reduce expenses; & Reduce assets
Drawbacks of ROI: Ignores the firm’s cost of raising capital hence
managers may forego significant investments.
Residual Income
The amount that remains after subtracting the required rate of return.

RI = Operating Income - (Invested Capital x Imputed interest)

Increasing RI : Increase in profit; decrease capital investment; less risk

Drawbacks: cannot be used in comparing different sized investment
centers
Gusion Company provided the following annual data for 2020:
Sales P 8,000,000
Net Operating Income 1,000,000
Ave. Operating assets 4,000,000
Minimum required rate of return 15%
1. ROI, Turnover and Sales Margin
2. RI
Return on Investment
Cost of Investment
What is RISK?
The chance that an unwanted and detrimental event will take place.
Different investments returns and risks
involved
1. Investments with the least risk
This type of investments carries the lowest returns. They usually carry
a very minimal risk (the chance of losing the value or decreasing the
value of your investments).
Examples:
a. bank deposits
b. cash and cash equivalents
c. time deposits
d. government bonds
2. Investments with higher risks

This type of investments carries a higher return but also the higher risk
of losing the value of your investments. This usually includes:

a. high income bonds

b. stocks
c. equity mutual funds
 Types of Risks
Interest Risk (Price Risk) - the risk that the value of the investment will
change over time as a result of changes in the market.
Reinvestment rate risk - the risk that the invested money cannot be
reinvested into in another investment that will provide the same, or
higher, level of return.
Purchasing Power Risk - purchasing power of a fixed amount of money
will decline as the result of an increase in the general price level.
Liquidity Risk - the possibility that an investment cannot be sold
(converted into cash) fo its market value.
Foreign Currency Exchange Risk - the risk that a transaction that has
been denominated in a foreign currency will be impacted negatively by
changes in the exchange rate.
Credit Risk (Default risk) - risk that a borrower of money will not be
able to pay interest and repay the principal on its debt as it becomes
due.
Business Risk - the variability of the firm’s earnings before interest and
taxes
Unsystematic Risk - risk that is specific to a particular or the industry in
which the company operates.
Systematic Risk - risk that all investments are subject to.

Market Risk - risk that an investment that is traded on a market has

simply because it is traded on a market and thus it is subject to market
movements.

Industry Risk - risk that is specific to a particular industry.

The Portfolio Theory
Defines investment risk in a measurable way and relates it to the
expected level of return from an investment

Risk is measured by the standard deviation of returns which can be

thought of as the average difference from the average return

- If there are large deviations from the average , the standard

deviation is high meaning the returns are very volatile or
uncertain.
Role of Capital Market Theory
Capital market theory attempts to explain the relationship between
investment returns and risks.

Addresses both individual investments and multiple investments

Uses
1. Portfolio Construction: How should a portfolio of assets be
constructed given the variety of different assets available for an
investment?
2. Asset Valuation: How much is an asset worth given the
characteristics of the other assets in the market?
3. Performance Measurement: How did an asset perform historically
relative to the other assets in similar markets? How are risk and
return attributed?
Capital Asset Pricing Model (CAPM)
CAPM assumes that markets are “efficient” - all information is freely
available and reflected instantaneously in asset prices.
It also work well when measuring and evaluating performance.
It relates the risk measured by beta to the level of expected or required
rate of return on a security.
It is also called the security marketline (SML)
Formula: rj = rf + b (rm - rf)
Where: rj = the expected return (or required) return on a security
rf = the risk free security
rm = the expected return on the market portfolio
b = beta, an index of nondiversifiable risk
Assuming that the risk free rate of return is 8 percent, the required
rate of return for the market (rm) is 12 percent, compute the expected
return of a security if beta is:
1. 0 (risk free)
2. 0.5
3. 1.0 (market porfolio)
4. 2.0