COURSE CODE AND TITLE: FINP 6 – CAPITAL MARKETS

LESSON NUMBER : MODULE No. 10

TOPIC 10 : OVERVIEW OF RISK AND RETURN ( Part 1)

LEARNING OBJECTIVES

At the end of this lesson, the student should be able to:

1.Discuss the concept of risk and the different types of risks;
2.Explain the concept of return and related risk and return;
3.Illustrate the different methods of calculating rates of return;

PRE-ASSESSMENT:
In a yellow sheet of paper, answer the following questions. (for about 2 to 3 sentences Explain the
ff:, cite an example for each in order to justify your answer.
1.Systematic Risk
2.Unsystematic Risk

LESSON PRESENTATION:

CONCEPT OF RISK
Risks refers to chances that the outcomes of an event is unfavorable or undesirable.
Returns, on the other hand, refers to yields or earning on an investment. Generally, the higher the
risks, the higher the required returns on an investment. Risk is a chance or possibility of danger,
loss, injury, and the like. It is uncertainty of the expected outcomes. It is the consequences or the
stake of doing things. It is oftentimes associated with the game of chance.

Investment risks force investors to evaluate the return and risk characteristics of each investment
alternative before making a decision. Investors, however, differ in their attitudes toward risks.
Some like taking risks, while others efforts to avoid or minimize risks. Risk-averse investors include
a premium for risk in the return that they desire in their investments, that is, they use an adjusted
rate of return as their discount rate or desired yield.

The risk for short-term investments like 3-months deposits, bonds purchased 6 months before
maturity, 1-year T-bill, and other money market instruments is very minimal since the outcome is
more certain due to the shortness of the period or term involves. Risks for long term investments,
which mature in more than a year, are more likely to be present due to the length of their term.This
is attributed to the different kinds of risks.

Risks are further classified as systematic risk (Fabozzi and Modigliani 2009)

1.Systematic risk-also called undiversified risk or market risk. Systematic risk results from the
general market and economic conditions that cannot be diversified away.

2. Unsystematic-Sometimes called diversifiable risk, residual risk, or company specific risk. This is
the risk that is unique to a company such as a strike, the outcome of unfavorable litigation or a
natural catastrophe,

Measurement of Risk

It is axiomatic that “ if it can’t be measured, it can’t be managed” this is perhaps the reason
why experts try to measure risks. Following are the different standards for risks:

BS 25999 -Risk is an average effect by summing the combined effect of each possible
consequence weighted by the associated likelihood of each consequence

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 ISO 27005 -risk estimation is the process to assign values to the probability and
consequences of a risk

NFPA 1600 -Risk assessment categories threats, hazards, or perils by both their relative
frequency and severity.

In scope

ISO 27005 is broader in scope than merely addressing the risk management requirements
identified in ISO/IEL 27001. However, the standard does not specify, recommend, or even name
any specific risk management method. It does however imply a continual process consisting of a
structured sequence of activities, some of which are iterative (ISO21001 Security.com)

 Establish the risk management context (e.g., scope, compliance obligations,

approaches/methods to be used, and relevant policies and criteria such as the
organization’s risk tolerance.
 Quantitatively or qualitatively assess (e.i., identify, analyze, and evaluate) relevant
risks, taking into account the information assets, threats, existing controls, and
vulnerabilities to determine the likelihood of incidents or incident scenarios, and the
predicted business consequences if they were to occur to determine a level of risk;
 Treat (e.i., modify {use third parties}) the risks appropriately using those levels of risk
to prioritize them.
 Keep stakeholders informed throughout the process; and
 Monitor and review risks, risk treatments, obligations, and criteria on an ongoing
basis, identifying and responding appropriately to significant changes.

NFPA 1600 is considered by many to be an excellent benchmark for continuity and

emergency planners in both the public and private sectors. The standard addresses
methodologies for defining and identifying risks and vulnerabilities and planning guidelines
which address (Davislogic.com)

 Stablishing the restoration of the physical infrastructure

 Protecting the heath and safety of personnel
 Crisis communication procedures; and
 Management structures for both short-term recovery and ongoing lon-term
continuity of operations.

Spurred by the financial crisis in late 2008, risk management experienced increased importance as
a function within the financial services industry. Accordingly familiarity with the basic of
methodologies for measuring, assessing, and controlling risk is vital those wishing to get ahead in
finance. Some of these methods are (Kolakowski 2016)

1.Loss of principal and/or interest

The crudest yet most conservative measurement of risk is the total sum of money invested
or loaned. The worst possible outcome is that the entire investment becomes worthless or that the
borrower defaults.

2.Probability

A refinement is the introduction of probabilities to the analysis. The mathematical theory of

probability deals with patterns that occur in random events.

Probability is a set of all possible outcomes like an 80% probability of success and a 20%
probability of failure.

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3.Volatility and variability

Volatility is a basic measure for risks associated with a financial market’s instrument. It
represents an asset’s price fluctuation and is accounted as the difference between maximum and
minimum prices within trading session. Trading day, month, and the like, The wider range of
fluctuations (higher volatility) means higher trading risks involved. Standard deviation is the typical
statistic used to measure volatility. Historical volatility equals to standard deviation of an asset
values within a specified time frame.

Variability, on the other hand, is the extent to which data points in a statistical distribution or
data set diverge from the average or mean value. It also refers to the extent to which these data
points differ from each other. There are four commonly used measure of variability:
Range,Mean,variance, and standfard deviation. Range is the highest data minus the lowest data,
Mean is also known as the arithmetic average, which is the result when you add up all the
numbers, then divide by how many numbers there are. Variance is a measure of how close the
scores in the data set are to the middle of the distribution. It is mainly used to calculate the
standard deviation. Standard deviation is measure of how spread out numbers are. It is the square
root of the variance (mariano 2016). The risk perception of an asset class is directly proportional to
the variability of its returns.

4.Assessment of counterparty risk

Counterparty risk,which includes default risk ,is the risk that the other party to a transaction,
such as another firm in the financial services industry ,will prove unable to fulfill its obligation on
time. Examples of these obligation include delivering securities or cash to settle trades ,repaying
short term loans as scheduled. Assesment of counterparty risk often are made based on the
analyses of companies’ financial strengths provided by rating agencies. However ,as the financial
crisis of late 2008 demonstrated,the methodologies used by the rating agencies are deeply flawed
(as are consumer Fair Isaac Corporation [FICO] scores) and subject to grave error .Additionally ,in
a general financial panic,events can spiral out of control very swiftly, and small counterparty
failures can rapidly accumulate to the point where large firms with supposedly ample financial
cushions are rendered insolvent. Lehman Brothers , Merrill Lynch , and Wachovia were such
casualties of the 2008 crisis; the first went out of business and the others were acquired by
stronger firms. A large part of the problem in the assessing counterparty risk is that the analyses
performed by rating agencies are not dynamic enough. They typically adjust to new realities only
relatively slowly .Furthermore ,once a counterparty that was previously considered sound suddenly
moves toward insolvency,it is extremely difficult to get out transaction already entered into.

5.The role of actuaries

Actuaries are most associated with analyzing mortality tables on behalf of life insurance
companies and any other venture which involves measurement of risks. It plays a critical part in
setting of premium on policies and payout schedules on annuities. Actuarial science ,as it is often
called, is an application of advanced statistical techniques to huge data sets which themselves
have high degrees of measurement accuracy.

CONCEPTS OF RETURNS

Returns are the revenues, earings, yields, proceeds, income, or profit from some
undertakings made, like financial investment, capital investment, and business operation. They are
measured based on the net income from business operations.Net cash flows refer to the difference
between the cash flows received from an investment and the cash flows expended on an
investment. Net income from an investment. they are normally translated in the form of
percentages, which are called rates of return .Rate of return is used to compare the outcomes of

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different investment and estimating cost of capital investment decision.It shows the return made on
an investment .

In the foregoing example,the computation of the interest rate would be:

r = I/P

where r = Interest rate

I = Interest received

P = Principal or cost of investment

r = 80/1,000=8%

The increase in value or capital gain ,which is the growth (g) in the investment would be:

g = (CP-P)/P

where CP = Current price

P = Principal or cost of investment

Therefore ,the rate of return (ROR) = r+g

= 8%+10%

=18%

Our discussion will focus on returns measured in the form of cash flows realized or expected to be
realized.

RISK AND RETURN

Risk and return are interrelated because the returns from an investment should equate the risk
involved .As stated earlier ,the risk averse investor .before making investment in a risky asset,
requires a higher return than the risk-free asset .Returns computed from historical data can be
used in measuring future returns ;however the uncertainty of the occurrence or the risk involved
should also be taken into account .

Risk is the possibility that actual return will deviate or differ from what is expected .The
actual returns can go up or down , then the risk is not worth taking .Taking risks involves
knowledge of expected returns,terminal value ,present value, and rate of return. Expected returns
are the future cash flows assiocated with the investment .Terminal value is returns .Rate of return
is the ratio of the net cash flows and the principal or initial investment . the different risk that
financial intermediaries face are the same risk that the public and the government ,as borrowers
and lenders,also face.

METHODS OF CALCULATING RATES OF RETURN

There are several methods of calculating the rate of return on an investment. Some of these are:

1.Holding period return –rate of return measured for a given period which can be in a month or in
a year. The period covers 1 month to several months or 1 year to several realistic rate of return.

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This is used when the holder of the security does not hold on to the security until maturity. The
holding period is the time the investor holds the investment from the time of acquisition to time of
sale generally prior to maturity .The formula is

Where R = returns for the period

EV = Ending value of the investment after an interval

I = Income received from investment (Dividend for stock;Interest for bonds)

IV = Initial value of the investment at the beginning of the interval

Example: The market value of the stocks of bright Corporation at the beginning of year 1 is 120 per
share. What is the holding period return from the said investment?

2.Average rate of return –measures the return across months or years.

a. Arithmetic average –an unweighted average of the returns which formula is:

where AR= Average rate of return

n= Number of intervals

RoR = Holding period return for each month or each year

For the month of January ,returen is computed as ( February value –January value )/January value
: php122 – php120 = php2 /php 120 = .01667=1.667%

Then , for the month of February ,return is computed as ( March value –February value)/February
value : php120-php122 =(php2)/php122=(.01639)=(1.639%).

Take note that the return for February is negative because the value of return for march is less
than value of return for February .

For the succeeding months, the same procedure will be followed.To compute for the average rate
of return , the sum of calculated returns for each month is divided by the number of intervals which
is 12.In our example , the computed average of return is.68% for the 12-month period.The
average rate of return for the first 5 months would be .38%, computed as [(1.67%-1.64%+0.82%
+1.63%/5]

Month R in Amount R in Decimals R in Percent

(%)

January Php 120 Php 2 .0167 1.67%

February Php 122 (2) (.0164) (1.64)

March Php 120 2 .0167 1.67

April Php122 1 .0082 0.82

May Php123 2 .0163 1.63

June Php125 3 .0240 2.40

July Php128 1 .0078 0.78

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 August Php129 1 .0078 0.78

September Php130 (2) (.0154) (1.54)

October Php128 2 .0156 1.56

November Php130 0 0.0000 0.00

December Php130 0 0.0000 0.00

January Php130 .

AR= ∑0.0813/12 8.13%/12

.006775 .6775% = .685

B . Geometric average – measures the compounded growth rate of the initial investment which
formula is:

C . Internal rate of return (IRR)/yield to maturity –In computing for the IRR of the
investment ,the present value of the expected cash flows is taken into account. We have to use the
present value table ( present value of php1.00 per year for each of n years) if the future returns are
all the same; if they are not the same ,we have to use the discount table (present value of php1.00
to be received after n years) .Internal rate of return (IRR) is a metric used in capital budgeting
measuring the profitability of potential investments. Internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows from a particular investment equal to zero .
Net present value is the difference between the present value of future cash inflows and the
present value of the investment is accepted ; if negative the investment is rejected.

However,this method will require trial and error and interpolation. Yield to maturity is the IRR for
bonds.Since it will require trial and error ,the computation can start with finding the estimated yield
to maturity (Mejorada 1999). The approximate yield to maturity (YM) would be:

Where C=Coupon/Interest payment

F= Face value

P=Price or principal

n = Years to maturity

Example: A 10-year, 8% bond of php10,000 each was purchased at 98. What is the yield to
maturity of the bond?

Interest= php 10,000 x 8% = php800

= 800 + [(10,000 – 9,800)/10]

(10,000 + 9,800)/2

= 800 +(200)/10 = 800 + 20 = .0828 =8.28%

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 19,800/2 9,900

The yield to maturity (YM) or the IRR is between 8% and 9%. To Compute for the exact YTM,
compute the present value using the said rates which should equal to the initial value od the
investment which is php 9,800.00.

At 8% At 9%

PV of interest = php800 x PV of ordinary annunity for 10 years

= php800x6.710 php 5,365

= php800x0.418 php5,134

PV of principal = php10,000 x PV factor

= php10,000 php4,632

= php10,000 ________ php4,224

Total PV php 10,000 php9,358

Using interpolation,

Difference Difference Exact Rate

At 8% = 10,000 8%

? = 9,800 642 200 200/642 = + .31

At 9% = 9,358 YM 8.31%

The 642 is the difference between 10,000 and 9,358 and the 200 is the difference between 10,000
and 9,800 .Dividing the differences with the first difference as the denominator and the second
difference as the numerator ,we get .31, which we add to the 8% (inasmuch,we are getting the rate
between 8% ad 9%).This helps as arrive at 8.31%, the exact rate of interest.

Another example of determining the YM by trial and error or through the use of a formula would be
us follows:

I . Trial and error

What we need to do is to try different rates until we find the rate that will make the price of the
bond equal to present value of the interest payvment plus present value of the principal upon
maturity . if the bond is trading below par (at a discount), we can assume the YM (discount rate)
to be above the nominal rate on the bond vice versa.

Assume a 15-year php1,00 bond paying interest php 110 (11%) .The current price of the bond is
php932.21. We find the YM.

Since the bond is trading at a discount , we assume that the YM is higher than the 11% nominal
rate . So,let us try 12%:

Present value of =php 110 x ordinary annuity PV factor at 12% for 15 years
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payments php 110 x 6.811 = php749.21

Present value of principal = php1,000 x PV factor at 12%for 15 years

= php 1,000 x .183 php 183.00

Total present value or price of the bond = php 932.21

The YM is exactly 12% as the price of the bond is equal to the total present values of interest
payments and principal.

ii. Approximate YM

C+ F-P

Approx. YM n

= ____________

F+P

Applying the formula to our example ,

Php100 + (php1,000-php932.21)

Approx . YM = 15 =php 110+ 4.52 = 11.85%

996.10

Php 1,000 + php 932.21

You will see that the 12% we got from the trial and error process is very near the 11.85% we got
using the formula.

It is said to be at a discount if the purchase price is lower than the face value of the bond like a php
10,000 bond acquired at php 9,800,and at a premium if the purchase price is higher than the face
value, like php 10,000 bond purchased at php 10,200. Bonds purchased at a discount have higher
yield than the nominal rate, because the principal is higher than the face value , which is the
maturity

SUMMARY:

 Making an investment decision involves setting objectives, identifying available resources,

evaluating investment alternatives, and choosing the best investment alternative.

 Risks refer to chance that the outcomes of an event will be negative or undesirable; returns
refers to yields or earnings on an investment.

 Types of investors include risk-averse, risk-takers, and risk-neutral

 Measurement of risk involves methodologies such as loss of principal, probability, volatility,
assessments of counterparty risk, and role of actuaries.

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  Net cash flows refers to the difference between the cash flows received from an investment
and the cash flows expenses spent on an investment.

 There are several methods of calculating the rate of return on an investment, They are
holding period return, average rate of return, and internal rate of return.

REINFORCEMENT/ ASSIGNMENT:
Write your answer clearly and neatly in clean sheet of paper (Discuss the different standards of
Risk:)
1.BS 25999
2. ISO 27005
3. NFPA 1600

ACTIVITY/ EVALUATION:

IDENTIFICATION :Write your answer in one whole sheet of yellow paper.

____________________1.) Is a basic measure for risks associated with a financial market’s instrument.
____________________2.) is a set of all possible outcomes like an 80% probability of success and a 20%
probability of failure.
____________________3).Are deliberately risk-aligned, meaning, organizations are encouraged to assess
the security risks to their information
____________________4.)is a measure of how close the scores in the data set are to the middle of the
distribution.
____________________5.)is also known as the arithmetic average, which is the result when you add up all
the numbers, then divide by how many numbers there are.

,
True or False – Write True if the statement is correct and False if incorrect
____________1.The first step in making an investment decision is evaluating the different
investment alternatives.
____________2. Market value (price) risk is the risk that the price of goods may increase due to
inflation
____________3.Default risk is the risk of not having enough cash when needed.
____________4.Business risk is the risk in which the issuer of the security may fail to pay interest
and principal.
____________5.Systematic risk is company – specific risk.

Reference/resources:

1)Mariano, Norma Dy Lopez, PhD, Capital Market, Rex Book Store, 2017

2) Saunders, Anthony; Cornett, Marcia M, The Financial Markets and Institutions, Mc Graw Hill
Education, 2011

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