Risk & Return

Dr. G.SAHOO
“The best way to forecast the future is to
invent it !”
- George Bernard Shaw, Man and Superman
 INVESTMENT

It is a commitment of fund
made in the expectation of
some positive rate of return.
 Characteristics of Investment

Return
Risk
Safety
Liquidity
 Objective of Investment
Maximization
of return
Minimization
of risk
Hedge against
inflation
 RISK

 The probability that the expected

return from the security will not
materialize.
 Expected outcome is less /more
what have expected.
 UNCERTAINTY

 Unexpected outcome due to

random variation of results.
 It is due to external factors
like, economic, political or
industry etc..
 RISK COULD BE:-

 TOTAL RISK = GENERAL RISK +

SPECIFIC RISK
 TOTAL RISK = MARKET RISK + ISSUER
RISK
 TOTAL RISK = SYSTEMATIC RISK +
UNSYSTEMATIC RISK
 TYPES OF INVESTMENT RISK

Systematic Risk
Unsystematic Risk
 Systematic Risks
Risk
due to
War like inflation Interest
situation rate risk

International
Political
events risk

Industrial Market
growth risk

Risk due to
govt.
monsoon policies

scams Natural
calamities
 Non – Systematic Risks

Business
risks

Non
Financial
Disputes systematic
risks risks

Risks due
to
uncertainty
 Systematic Risk:

 Market risk
 Interest rate risk
 Purchasing power risk
 Regulation risk.
 International risk.
 Un-Systematic Risk:

 Operational risk
 Liquidity risk
 Financial risk
 Business risk
 Default risk
 Types of Risks in Investment

 Credit Risk-The potential variability in returns resulting in

debt issues not making promised principal and interest
payments
 Purchasing Power Risk-The potential variability in return
caused by unanticipated changes in inflation
 Interest Rate Risk-The potential variability in returns
caused by changes in the level of interest rates.
 Liquidity and Marketability Risk-The risk of potential
variability in returns caused by the lack of marketability
represent a component of liquidity risk.
 Degree of risk & Risk-free return

 Risk free return

 Market rate of return
 Beta(β)
 Premium
 E(r)=Rf+ β(Rm - Rf)
 Causes of Risk:
 Wrong method of investment
 Wrong timing of investment
 Wrong quantity of investment
 Nature of investment instrument
 Nature of Industry
 Credit worthiness of issuer
 Natural calamities
 Measurement of Risk

Behavioral aspect
▪ Range/Sensitivity Analysis
▪ Probability Distribution
Quantitative/Statistical aspect
▪ Standard deviation
▪ Co-efficient of variation
 ❑What is Return?
Income received on an investment plus any change in market price,
usually expressed as a percent of the beginning market price of the
investment

❑Components of Return

Total Return

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Risk & Return Analysis
 Components of Return

▪ Yield
The most common form of return for investors is the
periodic cash flows (income) on the investment, either
interest from bonds or dividends from stocks.
▪ Capital Gain
The appreciation (or depreciation) in the price of the
asset, commonly called the Capital Gain (Loss).
 ❑Components of Return Analysis

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Risk & Return Analysis
 Total Return

Total Return = Yield + Price Change

where,
TR = Total Return
Dt = cash dividend at the end of the
time period t
Pt = price of stock at time period t
Pt-1 = price of stock at time period t-1
Ali purchased a stock for Rs. 6,000. At
the end of the year the stock is worth Rs.
7,500. Ali was paid dividends of Rs. 260.
Calculate the total return received by Ali.
 Solution

Total Return = Rs.[260+(7,500 - 6,000)]

Rs. 6,000
= 0.293
= 29.3%
▪The investor cannot be sure of the amount of return
he/she is going to receive.
▪There can be many possibilities.
▪Expected return is the weighted average of possible
returns, with the weights being the probabilities of
occurrence
 Formula:

E ( R ) =  X* P(X)

where X will represent the various values of return,

P(X) shows the probability of various return
 Example

Suppose, if you knew a given investment had a

50% chance of earning return of Rs.10, a 25%
chance of earning a return of Rs. 20 and there is
a 25% chance of bearing a loss of Rs.10.
What is your expected return?
 Solution

Return (X) P(X) E(X) =X * P(X)

10 0.50 5
20 0.25 5
-10 0.25 -2.5
TOTAL 7.5
The relative return is the difference between
absolute return achieved by the investment
and the return achieved by the benchmark
For example, the return on a stock may be 8%
over a given period of time. This may sound
rather high, BUT

If the return on the designated benchmark is

20% over the same period of time, then the
relative return on that stock is in fact -12%.
▪Also called real rate of return
▪Inflation-adjusted return reveals the
return on an investment after removing
the effects of inflation.
▪Formula:
▪ Return on Investment = R = 7%
▪ Inflation rate = IR = 3%
▪ Inflation Adjusted Return =?

Solution:

Inflation Adjusted Return = [(1+ R)/(1+IR)] – 1

= [(1+0.07)/(1+0.03)]-1
= 1.03883 – 1
= 0.0388
= 4% approximately
▪ A simple approximation for inflation-adjusted
return is given by simply subtracting the
inflation rate from the rate of return

▪ Inflation Adjusted Return = R – IR

= 7% - 3%
= 4%
THANK YOU