Chapter 5

Risk and Return

1. Definition of risk and return
2. Risk and return relationship
3. Security Market Line
 1. DEFINITION OF RISK AND RETURN
What is Return?
• "returns" on investments,
referring to either
1. historical returns (what we got
in the past) or
2. expected returns (what we can
"expect" to receive in the
future).
• We can't make accurate
predictions in an uncertain
world.
• As a result, we must discuss in
terms of anticipated outcomes
(expected return)
• The expected return on an
investment can be expressed as
a weighted average of all
possible returns, weighted by
the probability of each
occurring.
• Return is defined as the
outcome or profit from
investment over a period of
time.
• It considered as compensation
of accepting the risks
 1. DEFINITION OF RISK AND RETURN
What is Risk?
• It is the chance that actual return
will be different from the return
that is expected.
• It is the uncertainty which is the
potential variability in future
• cash flows
• If projects have greater
probability of loss, it is viewed
as more risky than projects that
have a lesser probability of loss.
Example
1. An RM1,000 government bond
that guarantees its holder RM5
interest after 30 days has no risk,
because there is no variability
associated with the return.
2. An RM1,000 investment in a
firm’s common stock, the value of
which over the same 30 days may
move up or down a great deal, is
very risky because of the high
variability of its return.
 2. RISK AND RETURN RELATIONSHIP
• When discuss return, we will always
discuss risk at the same time. Because
risk and return have a relationship.
• The Basic rules state that: “Higher risk
associated with higher returns and vice
versa”
• Thus there is a positive relationship in a
way that “the higher the risk we are
willing to face, the bigger the return we
can expect.”

Types Of Risks
1. Systematic Risk/ External/
Uncontrollable / Non Diversifiable/ Non
specific Risk
• external environment which
financial managers can not control
• It results from forces outside the
firm’ control and is therefore not
unique to the given security.
• It is defined as variability of return
on stocks or portfolios associated
with changes in return on the
market as a whole
2. Unsystematic risk/
Internal/Controllable/Specific/ Diversifiable
Risk
• Variability of returns on stocks
that is not the results of general
market movements
• Risk that are specific to a
particular firm or industry and it
does not affect other firms or
industries in the economy.
 Sources of Inflation (Purchasing Power
Systematic Risk Risk)
Interest Rate (Money-Rate
Risk)

Market Risk

Business risk
Sources of
Unsystematic Risk
Liquidity Risk

Default Risk

Event Risk
 Total
Risk
+

Total risk = Measured by standard deviation

Systematic risk = measured by Beta (β)

3. SECURITIES Expected
return
MARKET LINE SM
L
• a graphical representation of the capital
asset pricing model (CAPM), which plots
various degrees of systematic risk, of
various investment alternatives against the x%
expected return of the entire market at any RISK
one time. PREMIUM
• the return line that reflects the attitudes of
investors regarding the minimum R ------------------------------------------------------------
acceptable return for a given level of f
RISK FREE
systematic risk associated with a security. INVESTME
• If β = 1 (as per market): expected return = NT
x% (market return)
0 1 Beta
• Risk premium is the excess return above
the risk-free rate that investors require as
compensation for the higher uncertainty
associated with risky assets.
 What is Capital Asset Pricing Model
(CAPM)?
• Model that uses
1. the risk-free rate (r )
f
CAPM FORMULA
2. beta (β) • Required Rate of Return (Ri)
3. market return (rm) = Risk-free Rate + Beta (Market Return –
Risk free Rate)
• to help investors defined the
required return on an investment.
(Graphically is the SML).
• The specific method of = Rf + β(Rm –
calculating the additional returns
needed to compensate for
additional risk.
Rf)
• It describes the way prices of Notes: Rm – Rf = refers to risk premium
individual investment adjust to
investors’ behavior.
 3. SECURITIES MARKET
Expected Return
LINE
E (R)
Assume; Rf = 5%, Rm = 13% UNDERPRICE
SM
determine Ri = Rf + β(Rm – Rf) D/UNDERVAL
L
21 - -------------------------------------------
UED

--------------------------------------
1. If β = 0, Ri = 5% X Y
Expected Market
2. If β = 1, Ri = 13 (as per market) Return
13% ---------------------- OVERPRICE
3. If β = 2, Ri = 21 = 13%

-------------------------
X D/OVERVAL
Y Market risk UED
6 - premium
Rf = 5% ----------------------------------------------
=13 – 5 = 8%
4 -
RISK FREE

2 - INVESTME
NT
1. Fairly priced assets lie on SML. |
| | |
2. Assets: above the SML are UNDERPRICED (X)
0.5 1.0 Beta
3. Assets : below the SML are OVERPRICED (Y)0 1.5 2.0
Undervalued? Overvalued?

• Investment/shares/assets lying ABOVE the SML - undervalued

because they give GREATER EXPECTED RETURNS at a given value of
risk.

• Investment/shares/assets lying BELOW the SML - overvalued because

they give LOWER EXPECTED RETURNS at a given value of risk.
 Risk-Return Trade Off for Various Investment
Expected Return

SM
X L
Derivatives
X Common
stock
X Long-term corporate
bond
X Long-term govt.
bonds
X Commercial
R X----------------------------------------------
T.
papers
bills RISK FREE
f
INVESTME
NT
Ris
Investment regarded as risk free (example Treasury Bills) have very
k low return.
Investment above risk free - very risky and give high returns.
Advantages and Disadvantages of SML
• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can estimate beta
• Disadvantages
• Have to estimate the expected market risk premium, which does vary over
time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is not always reliable

14-13
 Past Year Questions FIN430 – SML
SEMESTER QUESTION NO SEMESTER QUESTION NO
3b * Solution
FIN430 Jun 18 provided @ recording
slides
FIN430 Dec 18 3b
FIN430 Jun 19 3b
FIN430 Dec 19 3a