RISK & RATES OF RETURN

FINANCE

Finance is concerned with ARRANGEMENT and UTILIZATION of financial

resources (Cash).

 Arrangement From where

 Utilization Where to
 CAPITAL STRUCTURE

 The capital structure is the particular combination of debt and equity used by a

company to finance its overall operations and growth. DEBT comes in the form of
bond issues or loans, while EQUITY may come in the form of common stock,
preferred stock, or retained earnings.

 EQUITY (Dividend)

 DEBT (Interest)
INVESTING DECISION FINANCING DECISION

1. New establishment 1. Equity

2. Expansion • Internal (Profit)

• External (Shares)
3. Replacement

2. Debt

• Securities
• Financial institutions
 INVESTMENT RETURNS
The rate of return on an investment can be calculated as
follows:

Return 
 Expected ending value  Cost 
Cost

For example, if $1,000 is invested and $1,100 is returned after

one year, the rate of return for this investment is:
($1,100 – $1,000)/$1,000 = 10%.
 WHAT IS INVESTMENT RISK?

 Two types of investment risk

 Stand-alone risk
 Portfolio risk
 Investment risk is related to the probability of earning a low
or negative actual return.
 The greater the chance of lower than expected or negative
returns, the riskier the investment.
 STAND-ALONE RISK

The stand-alone risk is the risk associated with a single

operating unit of a company, a company division, or asset, as
opposed to a larger, well-diversified portfolio.
 PORTFOLIO

A combination of two or more securities or assets.

 PORTFOLIO INVESTMENT

Portfolio investments are investments in the form of a group

(portfolio) of assets, including transactions in equity,
securities, such as common stock, and debt securities, such as
banknotes, bonds, and debentures.
DIVERSIFICATION

 The concept of diversification makes such common sense

that our language even contains everyday expressions that
exhort us to diversify (“Don’t put all your eggs in one
basket”).
 RISK IN A PORTFOLIO CONTEXT

In a portfolio context, an asset's risk can be divided into two

components:
(1) A diversifiable risk component, which can be diversified away
and hence is of little concern to diversified investors, and

(2) Market risk component, which is caused by broad market

movements that cannot be eliminated by diversification.
 TYPES OF RISK
Whenever you invest, you face these basic types of risk.

SYSTEMATIC RISK:
Purchasing-power risk,
Interest-rate risk, Market risk and
Exchange-rate risk.

UNSYSTEMATIC RISK:
Unsystematic risk is diversifiable risk.
 SELECTED REALIZED RETURNS, 7-13

1926-2007

Average Standard
Return Deviation
Small-company stocks 17.1% 32.6%
Large-company stocks 12.3 20.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2008 Yearbook (Chicago: Mornin gstar, Inc., 2008), p 28.
 COMMENTS ON STANDARD
DEVIATION AS A MEASURE OF
RISK
 Standard deviation (σi) measures total, or stand-alone, risk.

 The larger σi is, the lower the probability that actual returns
will be closer to expected returns.
 INVESTOR ATTITUDE TOWARDS
RISK

 Risk aversion – Assumes investors dislike risk and require

higher rates of return to encourage them to hold riskier
securities.
 Risk premium – The difference between the return on a
risky asset and a riskless asset, which serves as
compensation for investors to hold riskier securities.
RETURNS DISTRIBUTION FOR TWO
PERFECTLY NEGATIVELY CORRELATED
STOCKS (Ρ = -1.0)
RETURNS DISTRIBUTION FOR TWO
PERFECTLY POSITIVELY CORRELATED
STOCKS (Ρ = 1.0)
Stock A Stock B Portfolio AB

25 25 25

15 15 15

0 0 0

-10 -10 -10

EFFECT OF DIVERSIFICATION ON
PORTFOLIO RISK
TOTAL RISK