Risk and Return Learning Objectives To know the meaning and types of risk and return, and relationship thereof To understand the role of risk in valuation of return To study the various methods to evaluate return on investments To have knowledge on different methods used in risk determination 10.1. Introduction In earlier four units of this book, the discussion has been made on major four decisions taken under financial management, repeating the same, viz., financing decisions, investment decisions, profit distribution decisions, and working capital decisions. It is to worthy to note that all decisions cover almost each item of a Balance Sheet, be it on assets side, or on capital and liability side. Moreover, each decision has common and ultimate objective that is to maximise the wealth of the shareholders. We have understood all the four decisions from the prospective of internal management, thereby mean, what will be the cost of a source if it is used in business, in which alternative the funds be invested, how to select the best alternative, and whether the generated earnings (profits) be distributed or retained. It implies that the focus was on internal management of financial resources and their applications In this unit, we will make discussion, from an investor point of view, especially the case, where an individual or firm wants to make investment in shares in, or debts of a200 || Finance for Non-Finance Executives company. The prime objective will be again same, ie., maximisation of wealth. Now, before making investments in a company’s securities, a few questions may arise in the mind of an investor as follows: (i) Will it be a safe to make investments in securities of other companies? (ii) What are the maximum benefits that one can drive from these investments? (iii) What types of securities are more beneficial, debt or equity? (iv) Which type of security one should buy? (v) What are the growth trends followed by these securities” Whether they always do grow, or decline sometime? Above said few questions that may arise in the mind of an inquisitor investor are addressed in the coming discussion 10.2. Risk and Return There are unlimited options to make investments in securities of companies. This is first challenge for an investor to select or shortlist securities on some parameters. The first norm is risk and return. The term return refers to income from a security after a defined period either in the form of interest, dividend, or market appreciation in security value. On the other hand, risk refers to uncertainty over the future to get this return. In simple words, it is a probability of getting return on security. A higher probability leads to certainty of occurrence of return, and contrary to that low probability means higher chances of not getting return on investments, or situation of loss. Now, it makes essential for an investor to study risk-return characteristics of every individual security before making investment therein. Therefore, selection or shortlisting of security may be made on the basis of risk and return relationship. A basic discussion has already been made under point 1.9 of chapter-1 of this book The term risk refers to the possibility of occurring something unpleasant, undesirable or unwelcome. It is a situation involving exposure to danger, loss, harm, or other adverse consequences to investments already made, future earnings, or present holdings. From the view point of an economist, risk refers to a state when actual outcomes are low as compared to expected outcomes. Thus, risk is a part of every economic transaction, human endeavour. Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction. While some of these risks may seem trivial and other make a significant difference of actual outcome. To understand the term ‘risk’ in a better way, let consider some view point of renowned authors given below: Risk means uncertainty about future loss or, in other words, the inability to predict the occurrence or size of a loss. Risk can be classified as pure or speculative risk. —Frederick G. CraneRisk and Return || 201 Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for: —Emmett J. Vaughan, and Therese Vaughan Risk is defined as uncertainty concerning the occurrence of a loss. —George E. Rejda At its most general level, risk is used to describe any situation where there is uncertainty about what outcome will occur. —S.E. Harrinton, and G.R. Michaus Risk may be defined as combination of hazards measured by probability. —Lrving Fisher Of many definitions, nvo distinctive ones are commonly used, One defines risk as the variation in possible outcomes of an event based on chance. That is, the greater the number of different outcomes that may occur, the greater the risk. The second definition of risk is the uncertainty concerning a possible loss. —Mark S. Dorfman Risk, which is often used to mean uncertainty, creates both problems and opportunities for business and individuals. Risk regarding the possibility of loss can be especially problematic. If loss is certain to occur, it may be planned for in advance and treated as a definite, known expense. It is when there is uncertainty about the occurrence of a loss that risk becomes an important problem. —James S. Trieschmann, Robert E. Hoyt and David W. Sommer From the above definitions, followings characteristics may be drawn: 1. Risk refers to chance of loss, or uncertainty of occurrence of returns. 2. Risk is a possibility of an adverse deviation of expected income or output, 3. Risk is always uncertain, if it is certain than it can be treated as expense against revenue. 4. Risk is measured with the help of a statistical technique probability. 5. Risk creates both problems and opportunities for business. Itis to emphasise that the term risk under insurance business and other-than insurance business has similar connotations but different applications. Under insurance business, generally, risk is managed by transfer to risk, but in other business, risk is managed by discounting future incomes or value of investments. Under insurance business, the pooling of risk and sharing of loss is the fundamental principal but in case of other business, no such application is there, however it may be reduced by effective portfolio management. 10.3 Types of Risks The magnitude of risk varies from its nature and type, thus, its impact on return on investments do the same. The essence of risk in an investment is the variation in its returns. This variation in returns is caused by a number of factors. These factors constitute the elements of risk. The source of risk may be internal or external. Various types of risks are shown in Figure 10.1202 || Finance for Non-Finance Executives ‘Types of Risks (On the basis of chance of occurrence On the basis of chance of measurabilty On the basis of chance of behaviour ‘Speculative Pure ] On the bi flexibility Financial Non-nancial] Subjective} (On the basis of coverage Diversified or unsystematic Objective ] (On the basis of diversification Non-diversified or systematic Fundamental ] | Particular Figure 10.1: Various Types of Risks Due to limited scope this book, only relevant types of risks are discussed in detail! (i) On the Basis of Occurrence: Pure and Speculative Risk There are two types of risks involved in a risk classified on the basis of occurrence. The pure risk exists when there is uncertainty as to whether loss will occur or not. No possibility of gain is presented by pure risk. The possible outcomes are either adverse (ie., loss) or neutral (i.e., no loss). Nothing good can come from an exposure of pure risk. Damage of property by fire, illness, job-related accidents are few examples of pure risks. On the contrast to pure risk, speculative risk exists when there is uncertainty about an even that could produce either profit or loss. These are risks which offer the possibility of gain or loss. Business or investment trading risks fall under this category. For example, an investor makes investment of 100 shares in company at price of 7200 per share, with prospect of increase in prices up to 250 per share after three months. But on the value date, the price of share falls below %200 to 7180, In this case he suffers losses at $20 per share. Another example on speculative risk is of lottery. A person purchases a lottery ticket of 100 and won prize of 71000000, has definitely overcome the risk and his speculation resulted into gain of Flexibility: Static and Dynamic Risk Another way of classifying risk is the extend to which uncertainty changes over time Static risk remains indifferent in changing economic-environment. These risks would For detail discussion on risk and its types, reader may refer book titled ‘Insurance and Risk Management’, by the same author, JSR Publishing House LLP, 2019.Risk and Return || 203 certainly occur even if there is no change take place in the economy, e.g., risk of dishonesty of employees, nature of perils etc. on the other hand, dynamic risks are those resulting from changes in the economy, e.g., changes in inflation rates, consumer tastes, income level, and technological changes may cause loss to the business enterprise. The dynamic risks affect a large number of persons but with different degree. These types of risks are difficult to predict as they don’t occur with any precise degree of regularity. In making an investment decision, generally, static risks are taken into consideration, On the Basis of Measurement: Financial and Non-Financial Risk In a widest sense, risk includes all adversity including financial losses. Financial risk refers to uncertainty which can be measured in terms of money. There are three features of financial risks, (a) there is adversity due to occurrence of an even, (b) the assets or income is likely to be exposed to a financial loss from the occurrent of an even, or decline in economic value of the assets or property, and (c) there is direct relationship between peril and its cause of loss. On the contrary, the risks which cannot be measured in money terms are called as non-financial risks. The lack of measurement is an incomplete preposition of non-financial risk rather the actual position is that such losses are complex in nature and difficult to measure. In an investment decision, financial risks are important than non-financial risk (iv) On the Basis of Coverage: Fundamental and Particular Risk The fundamental risks are those risks which tend to affect large section of society, entire economy, large number of persons, rather than individuals. The impact of particular risk is much restricted as compared to fundamental risk. For example, loss due to terrorist attack at Twin Tower of World Trade Centre is a fundamental risk, its coverage was much wider. On the other hand, death of a Member of Parliament in a car accident is a particular risk. The fundamental risk affects the market as a whole therefore, it has very limited scope in investment decisions. The particular risk may be associated with an industry, firm, or an investment option, therefore, its measurement and impact both play vital role in determining rate of return (v) On the Basis of Behaviour: Subjective and Objective Risk Subjective risk refers to the mental state of an individual who experiences doubt or worry as to the outcome of a given event. Subjective risk is a psychological uncertainty based on a person’s mental ability especially perceiving different outcomes of identical situations. The subjective risk perceptions have become an important factor in investment decision making. The interpretation on the basis of such behaviour viz. risk- taker, risk-conservative, or risk-avoider are crucial in decision-making. Symbolically, the subjective behaviour is presented as below: Subjective Risk co Conservative Behaviour Objective risk is more precise, observable, and thus measurable. In general, objective risk is the possible variation of actual from expected experience. This term often used in connection with pure and static risk. Objective risk is calculated as shown below.204 || Finance for Non-Finance Executives Objective risk © Number of exposures Itis to note that the objective risk is based on probability or likelihood of occurrence of chance of exposure. The reciprocal is calculated to determine the attitude or behaviour of the person who is exposed to risk (vi) On the Basis of Diversification: Diversified and Non-diversified Risk The most commonly risks used in investment decisions are diversified and non- diversified risk. The diversified risk is called as unsystematic risk, and non-diversified risk is known as systematic risk. In simple words, the risk which is very much inherent in the system, and cannot be separated from the system (system may be an organisation, industry, class of securities etc.) is called systematic or non-diversified risk. A risk the level of which can be reduced or managed by diversifying investment is called diversified risk, such risks are not rooted in the system, therefore also known as unsystematic risks. Interest rates, recession, taxation policy, and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification, Systematic risk can be mitigated only by means of hedging, Systematic risk underlies all other investment risks. If there is inflation, investor can invest in securities in inflation resistant economic sectors. If interest rates are high, investor can sell stocks and move into bonds. However, if the entire economy under performs, then the best that one investor can do find investments opportunities that at-least cover minimum cost of operations. Every security or holding of assets have inherent bearing of risk which cannot be avoided through diversification. However, other risks, such as unsystematic could be reduced through diversification. The mechanism of diversification has been presented in Figure 10.2 given below. Y Unsystematic Risk Systematic Risk ©! No, of exposures or level of diversification Figure 10.2: Systematic and Unsystematic Risks Figure 10.2 explains the relationship between level of risk and level of diversification, The horizontal line parallel to x-axis shows the in-build/ inherent/ systematic risk ofRisk and Return || 205 a company which cannot be diversified. Y-axis states the level of risk or total risk The are above the horizontal line moving downwards shows the declining level of unsystematic risk by increasing the number of exposures, or level of diversification In investment decisions, both Systematic and Un-systematic risks play important role. Systematic risk includes: (a) market risk, (b) interest rate risk, (c) inflation rate risk (purchasing power risk) (a) Market Risk is caused by investors reaction to tangible as well as intangible events. The stock prices fluctuate due to various reasons. The frequency of change in prices may be high or short in time, or remain unchanged over a period. A general rise in stock prices is referred to as bullish trend, and vice- versa situation is referred as bearish trend. An investor can record these changes from the share price indices of stock-markets. There are various factors which influence market risk ranging from economic to political, entrepreneurial to social, The causes of these phenomenon are varied, but its magnitude depends upon investors’ attitude. The initial reaction signals a fear of loss, but following a herd instinct builds a situation that seems all investors will take exit, such emotional instability of investors collectively leads to a snowballing overreaction. The market risk is the major constituent of systematic risk (b) Interest Rate Risk refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates. The interest rate risk particularly affects debt securities. An increase in interest rate causes decline in the prices of debt security, and vice-versa. It means there is inverse relationship between interest rate and prices of debt securities. For example, a debt security of face value of 7100 issued with a coupon rate of 10% when the prevailing interest rate in the market was also 10%. Subsequently, the interest rate in the market increases to 12.5%, now at this situation, no investor will buy debt security yielding 10% interest rate as it is not sufficient to cover up the cost to be increased due change in general level of prices i.e., 12.5%. This will cause decline in the price of the debt security up toa level which could yield same amount of interest at 12.5% ie., 780. Thus, an investor will ready to buy such debt only at 780 in order to earn return equal to market interest rate. From above, the following formula can be drawn for determining value of debt security after change in market interest rate Coupon Rate of Debt Security . 3 Value of Bond Debt Price = “Market Interest Rate 10% ioe = x 100=80 Debt Price 125% In addition to the direct, systematic effect on debt securities, there are indirect effects on common stocks. First, higher interest rates make the purchase of shares less attractive. Higher interest rate reduces the margin of investors who made investments in equities from the interest earned from debts. Secondly, many firms, especially public institutions, are heavily financed their business206 || Finance for Non-Finance Executives operations with debt securities, an increase in interest rate amounts to increase in cost of capital, and reduces their earning capacity. A decline in earnings for shareholders tends to decline share price of the company. (c) Purchasing Power Risk (or Inflation Risk) refers to the impact of inflation ‘on an investment. A general increase in price level of goods and services called inflation. The immediate impact of inflation is that it postpones the consumption. In investment management, investment in securities is also considered as consumption. Thereby mean that an increase in inflation rate declines the purchasing power of investors, and vice-versa. Rational investors should include. in their estimate of expected return, an allowance for purchasing power risk. Inflation risk impacts both debt securities and equity market in same direction, Unsystematie Risk are, generally, indicated by leverages of a firm. Unsystematic risk includes the following types of risk: (a) Business risk, and (b) Financial risk. (a) Business Risk is a function of the operating conditions faced by a company and a variability in operating income caused by the operating conditions of the economy. An increase in business operating income lower down the business risk, and on contrary a high fluctuation in operating income over a future period amounts to uncertainty, thus, increase business risk. Since this risk is largely associated with internal investments and return thereon, therefore known as operating risk of the company. The operating income is the resulted ‘outcome of operating revenue over operating variable expenses and operating fixed expenses. Larger the portion of fixed operating expenses in a firm’s total expenses means more operating risk. The business risk of firm is calculated with the help of operating leverage, as shown below. Operating Risk = Degree of Operating Leverage Dewree of Operating Leverage = Petznlage change in operating income Percentage change in sales You may refer chapter on Leverages for detail discussion on degree of operating leverage (b) Financial Risk is associated with financing activities of a firm. As we have made discussion in earlier chapters that a company may have two types of securities in its capital structure, viz., equity capital and debt securities. As the number of debt securities increases in total capital the fixed charge, i... interest on such debt securities, also increases. Since, payment of interest on debt securities is mandatory therefore, amount remaining after such fixed charges also come down and reduces the EPS of equity share. The financial risk of a company may be measured with degree of financial leverage Financial Risk = Degree of Financial Leverage Percentage change in EPS De f Financial Li eeree of Minancial éverabe~ Percentage change in EBITRisk and Return || 207 Incase when DOL>1, it reveals existence of operating risk, similarly a situation where DFL > |, it also an indication of financial risk The total risk in a firm, from investment management point of view, is sum of systematic and unsystematic risk, as shown below. ‘Total Risk = ystematic Risk + Unsystematic Risk 10.4 Returns or Income The prime objective of making investment in any security is either to yield income on that investment in form of dividend/ interest or appreciation in the investment value. Return is the motivating force and the principal reward in the investment. An appreciation in the investment can also be considered as capital gain on investment. A rate of return on investment provides a basis of comparison among given alternative investment opportunities. There are two types of returns are, commonly, discussed under investment management, first, realised return and second, expected return. The realized return is the actual outcome on investment, on the other hand expected return is the probable return on investment over future period. The expected return is calculated for both purposes i.e., annual return, as well as capital growth in investment over a given future period. The term yield is often used in connection with return. Yield refers to the income component in relation to the price paid for a security, as well as change in price of the investment (at the time of selling such security) in relation to the price at which it was bought. In order to compute total return, one has to consider probable decrease or increase in the principal amount of investment along with annual income on such investment, thus, Total Return = Income + Change in Price of Investment (+/-) Return on equity (in percent value) will be computed as given below: Income Change in price of a security over a period Reng ee comer “turn Price paid for security Price paid for security Income + Change in price of security over a period | Price paid for security Or, Return (%) = 100 Dee (heat) Or, Retuin = 5+ D+(B-P, Or, Return (4) = AARP) 109 > Where, R(%) = Rate of return, ie, yield. D, = Dividend received at the end of year, denoted by 1 P, = The value of investment made in year ‘0” P, = The value of investment in year ‘1’, to be considered as the year in which security will be realised/sold.208 || Finance for Non-Finance Executives Similarly, the yield on fixed interest-bearing securities may also be computed by replacing ‘D’ with ‘I’ ie., interest A+(R-A) Return (%) on debt security = hy Mlustration 1: Mr. X subscribed shares in ABC Co, Ltd. at a price of 2100 each Company paid dividend of 20 after one year. Compute return on investment. What would be your opinion if Mr. X paid a premium of 210 on subscription of these shares and shares are fully paid up Solution: D, ‘The return on shares in ABC Co, Lid = = % = 22 10% 100 In case of premium paid at the time of subscription then P,, will be equal to 7110. 20 Thus return on shares = 9 718 18% Ilustration 2: Mr. X bought 10 shares in Swastik Co. Ltd, at price of @150 per share After a year, company declare dividend at 220 per share. Mr. X wants to sell these shares, and the realisable value of each share is 7180. Calculate total return on the security along with income and capital yield Solution: The total return from the share +(R-P, Return per share (%) = Bo «100 % 2 Return per share (%) = = 33.34% per share 20 , (180-150) 150 150 = 13.34% + 20.00% Thus, Mr. X earn yield on dividend at the rate of 13.34% and 20% on capital appreciation. Return = Illustration 3: Mr. X extracts the price of shares in ABC Co. Ltd from Stock-Exchange Indices over the last nine years as given below. Year | 2011 [ 2012 | 2013 | 2014 [ 2015 | 2016 | 2017 | 2018 | 2019 Price | 140 [| 150 | 162 | 152 | 170 | 200 | 188 | 195 | 205 Compute the annual return (yield) for Mr. X if he has made investment in shares in 2010 for a sum of 7130,Risk and Return || 209 Solution: Year Price P)-Py (=F) Po 2010 130 - - 2011 140 10 7.69 2012 156 16 11.42 2013 162 6 3.84 2014 152 =10 6.17 2015 170 18 11.84 2016 200 30 17.64 2017 188 -12 6.00 2018 195 7 3.58 2019 205 10 5.12 Illustration 4: Mr. X submits you the details on dividend and value of shares in PQR Co, Ltd. for a period of ten year starting from 2010, below Year Price Dividend 2010 135 15 2011 175 I8 2012 210 20 2013 180 32 2014 190 20 2015 200 4 2016 215 4 2017 220 8 2018 200 16 2019 220 20 Compute total return on the basis of above information, Solution: Year | Price | P)-P, Dividend es ead 2011 175 10 18 1333. | 21.02 2012 | 210 35 20 143 | 31.43 2013 | 180 -30 32 1524 | 095 2014 | 190 10 20 i | 1667 2015 | 200 10 14 737 | 12.63 2016 |_215 Is 4 z.00__|_14.50210 || Finance for Non-Finance Executives err irrriceda |e (aie ome) ay iaeeals (eee poral Py Return 2017 220 5 2.33 8 3.72 6.05 2018 200 -20 9.09 16 727 —1.82 2019 | 220 20 10.00 20 10.00 | 20.00 From the above results, it can be concluded that in first two years total return was very good but in third year it was declined substantially. A steady recovery and increase have been observed in years from 2014-2016 followed by decline in 2017 and 2018 The company regain its position nearly which it had eight years back 10.5 Types of Return There are different methods to compute return, some are based on measure of central tendency, or others are on probability distribution. These methods are used when the data on investments spread over number of years, and it becomes difficult to draw a conclusive inference on the basis of individual/yearly results on investments. The selected methods are discussed in the following part of this chapter. (i) Simple Average Method Simple average method is arithmetic mean of the yield over number of years. Simple average is equal to sum of all given observations divided by number of observations Thus, ERI X= N Where, R, = Total return on investment, N = Number of observations. ‘Taking the results of illustration 10.4 the average rate of return is 13.49% i.e. = 21.02 + 31.43 + 0.95 + 16.67 + 12.63 + 14.50 + 6.05 -1.82+ 20 9 Simple average method follows inherent limitations. Thus, it is not advisable to take help of simple average method while taking decision in investment management A critical issue of investment management, i.e., compounding factor is not addressed by simple average method. For example, take the data of last three years of illustration 4-as reproduced below. x Year Price P,-P, (Pu=Ri) P 2017 220 5 2.33 2018 200 20 9.09 2019 220 20 10.00Risk and Return || 211 The simple average return is (2:33-9-09+10) _ | oge, But, an observation of 3 share price reveals that there is no change in actual value of the share and thus no capital appreciation. To overcome the limitations of simple average method, Geometric Mean can be computed for estimating return. (ii) Geometric Mean The advantage of using geometric mean is that it accounts compounding factor or cumulative returns over time in calculation. It is used in investments to reflect the realized change in wealth over multiple periods. The geometric average is defined as the N“ root of the product resulting from multiplying a series of returns together, as shown below G=[(FR)(FRy) ce FR) 1 Where, Total returns, N= Number of periods. Illustration 5: Compute return (yield) for Mr. X who has made investment in PQR Ltd, and provides you the following data on the basis of arithmetic and geometric mean. ‘Year Share Price P,-P, 2015 210 a 2016 250 9 2017 323 22 2018 386 23 2019 455 49 Solution: Year | Share Price | Py-P; (P=) Py 2015 210 = 2016 250 9 0.190 2017 323 22 0.292 2018 386 23 0.195 2019 455 49 0.179 (0.190 + 0.292 + 0.195 + 0.179) 4 = 0.21407 or 21.40% Simple Average =212 || Finance for Non-Finance Executives Geometric Mean = [(1 + 0.190)(1 + 0.292)(1 + 0.195)(1 + 0.179)]" = (2.1667)! —1 = 1213-1 = 21.3% (iii) Return Based on Probability In case the expected return is to be computed for a long period, then it symbolises probable weighted average return. The expected return of the investment is the probability weighted average of all the possible returns, as shown below. x= DX; A(X) a Where, X = expected return X, = possible return over a period of time P(X,) = probability of occurrence of return n= time of period of investment Illustration 6: An investor expects future dividend from his investments in a company, and probability associated with the distribution of dividend at the expected level is given below. Compute expected return from such investments. Possible return 40 30 35 52 45 Probability 0.60 0.55 0.40 0.70 0.76 Soluti Expected Returns Possible Return (X;) Probability p(X.) Expected Return X,p(X)) 40 0.60 24 30 0.55 165 35 0.40 14 2 0.70 36.4 45 0.76 34.2 Sum of X, = 202 EXp(X) = 125.1 10.6 Measurement of Risk Measurement of risk is as essential as measurement of return on the investment. Risk is a variation in the expected return. Thus, it is incorrect to estimate return on investment in the absence of risk associated with it. Since it indicates variation in expected return, therefore, the statistical techniques of dispersions may be used to estimate risk on securities. A range of risk is shown through figure 10.3 shown below.Risk and Return \| 213 Expected Return Variation in Expected Return Le., Risk Return Risk Figure 10.3: Risk and Return (Variation in Return) If expected return is average or mean value then variation can be measured with standard deviation or with the help of variance analysis. This is to repeat that there are two types of risk, mostly considered in investment analysis, i.e., systematic and unsystematic risks. The systematic which is inherent or can not be diversified and uunsystematic which can be diversified. It means systematic risk are fixed or inherent, unsystematic varies depending upon degree of diversification or management. Let’s discuss selected method of risk measurement (i) Standard Deviation Standard Deviation measures the variation in actual return from the expected average return. A low value of standard deviation indicates actual return likely to be close to average retum, on the other hand, a high value of standard deviation shows lesser possibility of actual return close to average return. The standard deviation (SD) is symbolized with sigma, ‘0’. The statistical formula to calculate standard deviation is Dh%-*) sD= Where, X; = Actual return on investment, X, = Average return, and N= Number of observations Illustration 7: The expected returns of last five years are provided below. Compute expected risk on these returns. Year Return 1 50 2 70 3 80 4 100 5 90214 || Finance for Non-Finance Executives Solution: Year Return (Xi) (x, -X) (= xy 1 30 28 784 2 70 8 64 3 80 2 4 4 100 22 484 5 90 12 144 Mean = 78 1480 = 17.20% SsD= 10 Thus, the variance in expected return is 17.20%. (i) Measurement of Systematic Risk The systematic risk of a security is measured by a statistical measure called beta. The value of the beta may be computed from the historical data. To compute beta, there are two methods in statistics, first, correlation method, second, regression method. Under the correlation method, beta is computed with following formula: = JimFi Om Paras Where, f = Beta, or measurement of systematic risk Correlation coefficient of returns of stock and returns of the market index Standard deviation of return of stock i Standard deviation of returns of the market index 0°, = Variance of the market returns. Regression Method The regression method is widely used method to compute beta. The beta shows a linear relationship between dependent and independent variable. There are two values computed under regression model viz., alpha (a) and beta (f). The value of alpha remains constant, and the value of beta makes change in expected return. The regression equation is written in the following form: Y=a+ BX; Where, Y = Dependent variable, i.e., expected return X, = Independent variables Alpha constant “B’ = Beta constant This equation is known as characteristic lineRisk and Return \| 215 ‘The value of alpha and beta is computed as shown below. a= ¥-pXi Number of observations Mean value of the dependent variable Mean value of the independent variable Dependent variable X = Independent variable ‘The same formula may be applied in stock market return, by rewriting equation of characteristic line as given below R=a+fR, Where, R, = Return on the individual security R,, = Return on the market index Estimated return of the security when the market is stationary, or a constant, “B’ = Change in the return of the individual security in response to change in the return of the market index. Illustration 8: The return on individual security (R,) and market return (R,,) is given below. Rey 4 [is] 6 [els [uu BOR eee ee ee ee Compute alpha and beta from the above. Soluti R Ra RR, R? 14 16 224 196 18 20 360 324 6 9 34 36 12 8 96 144 13 10 130 169 4 9 126 196 i Nl 121 121 6 18 108 36 9 17 153 81 8 15 120 64 ER, = 11 ER,, = 133 ER, * R,, = 1492 ER? = 1367 Mean (Rj) 11.1 | Mean (R,,) = 13.3216 || Finance for Non-Finance Executives = MER * Ry = (ER) (ER) nER? =Z(R, _ 10*1492-111*113 10* 1367 — (111) B= 0.1163 a= 11.1 —(0.1163 * 13.3) a= 12.00 From the above, the value of beta is 0.1163 which is less than I so it can be concluded that investment in the security is less aggressive. Now this way. total risk on a security may be computed. Moreover, the total variance can be explained by adding systematic variance as well as unsystematic variance. Review Questions 1, What do you understand from the terms risk and return? How both terms are related with each other? 2. What are the types of risk? Explain briefly. “Systematic and un-systematic risks are the most important risks in investment decisions’, comment and explain. 4. What are the different statistical techniques used in calculation of return? How far one is better than other? Explain various types of return? Suggest a better method. 6. Write short notes on the following (a) Business Risk (b) Financial Risk (c) Purchasing Power Risk (d) Interest Rate Risk (e) Market Risk 7. Explain the characteristic line in reference of alpha, beta, and expected return on. investment. 8. An investor has made investment in shares in X Co. Ltd., face value of share is 2120 including a premium of 220. From last five years he is recording the amount of dividend paid by the company and change in price of the share as follows Year 2014 2015 2016 2017 2018 Dividend 25 20 10 0 15 Share Price 150 160, 185 200 175 From the above information compute total yield on his investment.Risk and Return || 217 9. Mr. X has bought 10 shares in ABC Co. Ltd. at price of 7240 in 2012. The share price at the end of each year is given below, Company is making payment of dividend of 215 per share. Year 2019 | 2018 | 2017 | 2016 | 2015 | 2014 | 2013 SharePrice | 410 | 390 | 385 | 390 | 310 | 280 | 265 Compute: (i) Average return using simple average method (ii) Average return method using geometric method 10. Taking data of question 9, what will be impact on the total value of the share if company has not paid any dividend, 11. From the following information, calculate expected return following probability method Probable Return Probability of Occurrence 4 0.32 21 0.52 23 0.25 10 0.90 9 0.95 12. A data of ten days of change in a company’s share price and the related market index is given below. You are required to compute alpha and beta from the information. Days _| Change in Price of Security ‘Change in Market Index 1 1.25 0.90 2 -4.23 -3.45 3 3.05 2.45 4 $21 421 3 1.32 321 6 4.68 -1.65 qi 9.24 8.45 8 6.53 178 9 4.30 425 10 -23 =1.93 agg