Risk & Return estimation

Return

Risk
Ajay Kumar Chauhan
 Returns
Returns refers to something earned over and above the initial investment
made.

Returns can be categorized into two categories: Corporate Benefits and

Capital Gains. The first being received by the investors on periodical basis and
second component comes at the time of selling of the financial security.

Motivation for investment

Holding period returns

 Type of Returns

• Actual realized returns

• Single period
• Multi periods = Arithmetic mean and Geometric mean
• Expected Return - the return that an investor expects to earn on an asset, given its price,
growth potential, etc.
• Probability distribution of different scenarios.

• Required Return - the return that an investor requires on an asset given its risk.
• Discrete return and continuously compounded return
• Risk free return and risk premium
• Real and nominal rate return
• Security return and portfolio return
For a Treasury security, what is the
required rate of return?
 = Risk-free rate of return

 Since Treasury’s are essentially free of default risk, the

rate of return on a Treasury security is considered the
“risk-free” rate of return.
 For a corporate stock or bond, what is the required
rate of return?

Required Risk-free Risk

rate of = rate of + Premium
return return

How large of a risk premium should we require to buy a corporate security?

 Return Calculations
Returns = Selling price – Buying price + Corporate Benefits
Buying Price

Expected Return of a Portfolio is the weighted sum of the individual returns

from the securities making up the portfolio:
 Nominal & Real Rate of Return

r = R – i

The exact relationship can be expressed as:

r = (R – i) / (1 + i)
 Arithmetic vs. Geometric Return

20%, -10%, 30%, -20%, 10%, 20%, -30%

AM = 20 – 10 + 30 - 20 + 10 + 20 – 30
7
= 3%
Net Value of the portfolio = Rs 103
Discrete vs. Continously Compounded Return

DR = (P1-p0)+ Y
po

CCR = ln (P1/p0)
 Risk

Investors are willing to take some amount of risk since it is the only way
to earn higher return.

In Normal Life, Risk often means a negative return.

Three scenarios of Future investment

Certainty

Uncertainty

Risk
Risk : in holding the securities is generally associated that
realised returns will be less that the expected returns.
 Risk

Systematic Unsystematic
Risk Risk

External to the firm => internal to the firm

Cannot be controlled => Controllable to large extent
=> Known as non-diversifiable risk => also known as diversifiable risk
Affect large no of securities

Market Interest Purchasing Business Financial

Risk rate risk power risk risk risk
 Market Risk

Stock variability due to the changes in investor's attitude and expectations.

Caused by investor’s reaction towards tangible and intangible events.

real basis psychological basis

political events emotional instability

Social events fear of loss
International reasons excessive selling pressure
Economic reasons market sentiments
 Interest rate risk

Refers to uncertainty of future markets values and of the size of

future income caused by the fluctuations in the general level of
interest rates.

Increase in interest rates

Increase in cost of capital ( cost of borrowed capital)

Lower earnings , dividends

Decline in the share prices

 Purchasing power risk

Refers to the impact of inflation or deflation on an investment

 Unsystematic risk

Is that portion of total risk that is unique to a firm or an industry and

affecting securities market in general.

Factors such as management capability, consumer preferences and

labour strikes can cause unsystematic variability of returns for a
co’s stock

Examined separately for each company

Two sources of unsystematic risk:

Business risk
Financial risk
 Business Risk

Is a function of operating conditions faced by the firm and the

variability these conditions injects into operating and income and
expected dividends.

Internal business risk : wrong mgmt decisions, strikes and

lockouts, obsolete products, dependence on few large customers.

External business risk : Fiscal policy, monetary policy, exchange

rates, political environments.
 Financial risk

Arises when the firm uses the debt in the capital structure

Create problems in recessions or period of low demands.

Spread of bad words/news in the market.

Higher employee turn over

Buyer’s dilemma.
 Assigning risk premiums

R=I+p+b+f+m+o

Where R = required rate of return

I = risk free rate of return
P = purchasing power allowance
B = business risk allowance
F = financial risk allowance
O = allowance for other risk
 Stating predictions “scientifically”

Analyst must try to quantify the risk that a given stock will fail to realize its expected return.
Quantification of risk is necessary to ensure uniform interpretation and comparison.

Example : Consider two stocks A & B. Expected return of both the stocks is 10%. The security
analyst assign probabilities to different returns to stock A & B. The probability distribution of
stock A & B are as follows:

Stock A Stock B

Return Probability R*P Return Probability R*P

7 0.05 0.35
8 0.10 0.80 9 0.30 2.7
9 0.20 1.80 10 0.40 4
10 0.30 3 11 0.30 3.3
11 0.20 2.20
12 0.10 1.20
13 0.05 0.65
Total 10 Total 10
• Stocks A & B have identical expected average returns of 10%. But the spreads for stocks A & B
are not the same.

Range (A) = 7 to 13 %
Range (B) = 9 to 11 %

Higher the dispersion , higher the risk

Stock A Stock B

Return – Square of Prob 2*3 Return – Square of Prob 2*3

expected the expected the
return difference return difference
7-10 9 0.05 0.45
8-10 4 0.10 0.40
9-10 1 0.20 0.20 9-10 1 .3 .3
10-10 0 0.30 0 10-10 0 .4 0
11-10 1 0.20 0.20 11-10 1 .3 .3
12-10 4 0.10 0.40
13-10 9 0.05 0.45
Variance 2.10 Variance 0.60
S.D 1.45 S.D .77
 Total Risk

Total risk of investment consists of two components:

1. Diversifiable risk
2. Non-diversifiable risk

Total risk = Diversifiable risk + Non-diversifiable risk

Can be eliminated by proper diversification managed with the help of Beta

Markowitz model
 What Beta means

Beta is a risk measure comparing the volatility of a stock's price movement to the general
market.

Beta measures systematic risk. It shows how the price of a security responds to market
forces.

The beta of the market is one and other betas are viewed in relation to this value.

Beta can be positive and negative.

Beta = Covariace ( Xi, Yi)

Variance (yi)

Where, Xi is the stock return

Yi is the index return
Beta = n XY – x y
2
ny –y
Calculating Beta

bhel
 Value At Risk

 Quantile of a distribution

 q is the value below which lie q% of the values.

 ie with a prob of p% we can expect a loss equal to or

greator than the VAR.

Conditional Tail Expectation

Assuming the terminal value of the portfolio falls in the
bottom 5% of possible outcome , what is its expected value
?
 Lower Partial Standard Deviation

 Is an appropriate measure of risk for non-normal

distributions

Is the SD computed solely from values below the Expected

Return

 measure of downside risk

 Volatility

 SD in the error terms

 Where,

Error terms = Actual Return – Expected return