RISK AND RETURN

FINANCIAL MANAGEMENT

By – Tanya Sanjeev Joseph

20020033
CONTENTS
• Risk and Return

• Kinds of Risk

• Portfolio Risk

• Risk of Rate of Return

• Variance and Standard Deviation

• Portfolio Variance and Standard Deviation

• CML and SML

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 INTRODUCTION
• Risk : The degree of uncertainty and/or potential financial loss
associated with an investment choice is referred to as risk. In general,
when investment risks increase, investors desire bigger returns to
compensate for the risk they are taking. Each saving and investment
option comes with its own set of risks and rewards.
• Return : Income from an investment plus any changes in market price,
commonly stated as a percentage of the investment's initial market
price.
The components of returns are yield and capital gains.

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 RETURNS

Total Return Expected Return Relative Return Real Rate of Return

Total Return = yield + Price The expected return is a The difference between the Also referred to as the real rate of return.
Change weighted average of all potential investment's absolute return and The return on an investment after
returns, with the weights the benchmark's return is known inflation is removed is known as inflation-
[𝐷𝑡 + 𝑃𝑡 −𝑃𝑡−1 ] indicating the likelihood of each as the relative return. adjusted return. Simply subtracting the
TR = inflation rate from the rate of return gives
𝑃𝑡−1 one occurring.
a simple approximation for inflation-
TR= Total Return E(R) = 𝚺 𝐗 * P(X) adjusted return.
𝐷𝑡 = Cash dividend at the end of where X will represent the (𝟏+𝑹𝒆𝒕𝒖𝒓𝒏)
I – AR= (𝟏+𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒆𝒕𝒖𝒓𝒏) − 𝟏
the time period t various values of return, P(X)
shows the probability of various I = Inflation
𝑃𝑡 = Price of stock at the period
t return AR = Adjusted Return

𝑃𝑡−1 = Price of stock at the time

period t-1

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 Market Risk
Interest Rate Risk

Financial Risk

TYPES OF RISK
Liquidity Risk Country Risk

Foreign Exchange
Risk

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KINDS OF RISK
Systematic Risk
The risk inherent in the entire market or a
segment of the market is referred to as
systemic risk. The undiversifiable risk, market
risk, or volatility are all terms used to describe
systematic risk. It has an impact on the entire
market, not just a single stock or industry.
Unsystematic Risk
The inherent uncertainty of an investment in a
corporation or industry is known as
unsystematic risk. A new market competitor
with the potential to take significant market
share from the company being invested in, a
legislative change, a management change,
and/or a product recall are examples of
unsystematic risk.
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PORTFOLIO RISK
Portfolio risk refers to the possibility that the assets or units in your investments will fail to satisfy
your financial goals. Each investment in a portfolio has its own level of risk, with a bigger potential
return often implying a larger level of risk.

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R I S K O F R AT E O F
RETURN High
Risk
Risk and rate-of-return are, in general, inextricably linked.
When an investment's risk level rises, the potential return
usually rises with it. The investing risk pyramid depicts the risk Moderate
and reward associated with various investing opportunities. As Risk
investors progress up the pyramid, they face a greater risk of
losing money while also having the opportunity to earn more
money.

Low Risk

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 S TA N D A R D D E V I AT I O N

A standard deviation is a statistic that measures a

dataset's dispersion from its mean. By calculating σ𝑛𝑖=1(𝑥𝑖 − 𝑥)ҧ 2
each data point's divergence from the mean, the
𝜎=
𝑛−1
standard deviation is calculated as the square root
of variance. There is a bigger variance within the
data set if the data points are further from the 𝑥𝑖 = Value of the 𝑖 𝑡ℎ point in the data set
mean; consequently, the more spread out the
𝑥ҧ = The mean value of the data set
data, the larger the standard deviation.
𝑛 = The number of data points in the data set

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VA R I A N C E

2
2
σ 𝑥𝑖 − 𝑥ҧ
𝜎 =
𝑛 −1

𝜎 2 = sample variance
𝑥𝑖 = the value of the one observation

𝑥ҧ = The mean value of all the observation

𝑛 = The number of observations

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P O R T F O L I O VA R I A N C E
Portfolio variance is a risk indicator that
shows how the aggregate real returns of
a portfolio's assets fluctuate over time.
The standard deviations of each asset in
the portfolio, as well as the correlations
of each security pair in the portfolio, are
used to compute this portfolio variance
statistic.
Portfolio variance =w12σ12 +w22σ22 +2w1w2 Cov1,2
w1 = the portfolio weight of the first asset
w2 = the portfolio weight of the second asset
σ1= the standard deviation of the first asset
σ2 = the standard deviation of the second asset
Cov1,2 = the covariance of the two assets, which can thus be
expressed as p(1,2)σ1σ2, where p(1,2) is the correlation coefficient
between the two assets
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P O R T F O L I O S TA N DA R D D E V I AT I O N

Portfolio Standard Deviation = 𝑤1 2 𝜎1 2 + 𝑤22 𝜎2 2 + 2𝑤1 𝑤2 𝐶𝑂𝑉1,2

Portfolio Standard Deviation is the standard

deviation of an investment portfolio's rate of
return, which is used to assess an
investment's intrinsic volatility. It calculates
the risk of an investment and aids in the
analysis of a portfolio's return stability.
w1 = the portfolio weight of the first asset
w2 = the portfolio weight of the second asset
σ1= the standard deviation of the first asset
σ2 = the standard deviation of the second asset
Cov1,2 = the covariance of the two assets, which can thus be
expressed as p(1,2)σ1σ2, where p(1,2) is the correlation coefficient
between the two assets

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 C A P I TA L M A R K E T L I N E ( C M L )

The capital market line (CML) depicts portfolios that have the best risk-reward ratio. For efficient portfolios, the capital asset
pricing model (CAPM) displays the risk-return trade-off. It's a theoretical notion that encompasses all portfolios that combine the
risk-free rate of return and a market portfolio of hazardous assets in the most optimal way. According to CAPM, all investors will
adopt an equilibrium position on the capital market line by borrowing or lending at the risk-free rate, which maximizes return for a
given degree of risk.

𝑅𝑝 ​ = portfolio return

𝑟𝑓 ​= risk free rate

𝑅𝑇 −𝑟𝑓
𝑅𝑝 = 𝑟𝑓 + X 𝜎𝑝 𝑅𝑇 ​ = market return
𝜎𝑇
𝜎𝑇 = standard deviation of market returns
𝜎𝑝 ​ = standard deviation of portfolio returns​

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 SECURITY MARKET LINE (SML)
The security market line (SML) is a graphical representation of the capital asset pricing model (CAPM)—which plots various degrees of
systematic, or market risk, of various marketable securities against the projected return of the entire market at any one time.

The security market line is a tool for evaluating investments that is derived from the CAPM—a model that describes the risk-return
relationship for securities—and assumes that investors must be compensated for both the time value of money (TVM) and the risk
premium associated with any investment.

The formula for plotting the SML is:
Required return = risk-free rate of return + beta (market return -
risk-free rate of return)
The CAPM and the SML both use the concept of beta. A security's
beta is a measure of its systematic risk, which is unaffected by
diversification. The entire market average is defined as a beta
value of one. A beta value larger than one indicates a higher risk
level than the market average, while a beta value less than one
indicates a lower risk level than the market average.

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THANK YOU

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