FIN 5134:Financial Management and Practices

W3 Lecture 03: Risk and Return

Dr. M. Anwar Ullah, FCMA

Southeast University Bangladesh
Faculty of Business
MBA Program: Summer 2016

anwarullah@hotmail.com Or anwar2023@yahoo.com.sg

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Review of the Previous class

We have discussed on:

1. Simple Interest
2. Compound Interest
3. Future Value (FV)
4. Present Value (PV)
5. Annuities
6. Amortization

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We will discuss today

1. Risk

2. Return
And
3. Financial Market

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 Risk, Return and Financial Markets

Risk
Risk is the variability of the actual return from the expected
return associated with a given investment.

Types of Risk
1. Business risk
2. Liquidity risk
3. Default risk
4. Market risk
5. Interest rate risk
6. Purchasing power risk

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 Risk, Return and Financial Markets
• Total risk = Systematic risk + Unsystematic risk
  (market) (diversifiable)
• The market risk is called systematic and the diversifiable risk is
called unsystematic.
• The unsystematic risk is asset-specific and relates to individual
investments which can be minimized through diversification.
• The systematic risk, or market risk, can affect all market investments.
A recession or a war, for example, might impact all investments in a
portfolio.
• Since we can usually eliminate the unsystematic risk, we focus
primarily on the systematic risk.
 
• Expected return of any asset , or E(Rasset), depends only on the
asset's systematic risk. We measure the systematic risk by the
beta coefficient, or .
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 Key Differences Between Risk and Uncertainty

Basis for
Risk Uncertainty
Comparison
The probability of Uncertainty implies a
winning or losing situation where the
Meaning
something worthy is future events are not
known as risk. known.
Ascertainment It can be measured It cannot be measured.
Chances of
The outcome is
Outcome outcomes are
unknown.
known.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned 6
 Risk and Probability: Key difference
Risk is essentially the level of possibility that an action or activity will lead to a loss or
to an undesired outcome. The risk may even pay off and not lead to a loss, it may lead
to a gain. A probability, on the other hand, is a measure or estimation of how likely is
it that an event will come to pass, or that a statement is true. In relation to risk,
probability is used to figure out the chance that taking a risk will pay off.
A probability, on the other hand, is a measure or estimation of how likely is it that an
event will come to pass, or that a statement is true. Probabilities are given a value
between 0 or 1, where 0 is a 0% chance of the event happening, i.e. it will not
happened, and 1 is a 100% chance of the event happening.
Example
•A or threat of damage, injury, liability, loss, or any other negative occurrence
that is caused by external or internal vulnerabilities, and that may be avoided
through preemptive action.
•Finance: The probability that an actual return on an investment will be lower
than the expected return.
•Insurance: A situation where the probability of a variable (such as burning down
of a building) is known but when a mode of occurrence or the actual value of the
occurrence (whether the fire will occur at a particular property) is not.
•Securities trading: The probability of a loss or drop in value.
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Risk, Return and Financial Markets
Methods of Calculating Total Risk

The risk associated with a single asset is measured

from both a behavioural and a statistical (quantitative)
point of view.

 The behavioural risk view is measured using:

• Sensitivity analysis and
• Probability distribution

The statistical risk view is measured using:

• Standard deviation and
• Coefficient of variation.

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Risk, Return and Financial Markets
• We can examine returns in the financial markets to help us
determine the appropriate returns on non-financial assets

• Lessons from capital market history

– There is a reward for bearing risk
– The greater the potential reward, the greater the risk
– This is called the risk-return trade-off
– BUT Unregulated gamble in the Capital market may
ruin the trust (Only happened in Bangladesh)

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 Risk, Return and Financial Markets
Return
Return is the primary motivating force, usually expressed in
percentage as annual income that drives the investment, and also
represents the reward for undertaking investment. Generally, the
return on an investment is measured by the following formula:

Return = Dt + (Pt - Pt - 1)
Pt - 1

D t
= Annual income or dividend at the end of time period, t
P t
= Ending/Closing security price at time period, t

P t-1
= Beginning/Opening security price at time period, t

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 Total amount Returns
• Total dollar return = income from investment + capital
gain (loss) due to change in price

• Example:
You bought a bond for Tk.950 one year ago. You have
received two coupons of Tk.30 each. You can sell the
bond for Tk.975 today. What is your total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950
= 25
Total return = 60 + 25 = Tk.85

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 Percentage Returns

• It is generally more intuitive to think in terms of

percentages than in total returns

• Dividend yield = income / beginning price

• Capital gains yield = (ending price – beginning price) /

beginning price

• Total percentage return = dividend yield + capital gains

yield

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 Example – Calculating Returns
You bought a stock for Tk.35 and you received dividends of
Tk.1.25. The stock is now selling for Tk.40.
– What is your Total return?
• Total return = 1.25 + (40 – 35) = Tk.6.25
– What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
Alternatively,

Return = 1.25 + ( 40-35)

35
Return = 6.25
35
= 17.86% 13
 What is Required Return?
• The required return is the same as the appropriate
discount rate and is based on the risk of the cash flows.
• We need to know the required return for an investment
before we can compute the NPV and make a decision
about whether or not to take the investment.

• We need to earn at least the required return to

compensate our investors for the financing they have
provided
• CoC also referred to as cut-off rate, target rate, hurdle
rate, minimum required rate of return, standard return,
etc.

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 Required Return and Risk

Assumption: that the firm’s business and financial

risks are unaffected by the acceptance and financing
of projects.
Business risk – is the risk to the firm of being unable
to cover fixed operating costs.
Measured by: (ΔEBIT/EBIT)/ (ΔSales/Sales)

Financial risk – is the risk of being unable to cover

required financial obligations such as interest,
preference dividends.
Measured by: (ΔEPS/EPS)/ (ΔEBIT/EBIT)

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 Meaning of Risk Premium

• The “extra” return earned for taking on risk

• Treasury bills are considered to be risk-free

– Risk-free in that there is “zero” risk of default, but
they still carry some price risk — govt. bonds are
traded in the market and prices may fluctuate as the
market fluctuates.

• So, the risk premium is the return over and

above the risk-free rate

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 Market Risk Premium

If we create a theoretical portfolio of all securities in the

market, which would therefore have a Beta of the market
average M = 1.0 we can evaluate the entire market risk
premium as
 
Market Risk Premium = E(RM) - Rf
Risk premium = Expected market return [E(RM )] – risk free rate (Rf)

Example: If the “going” market rate were 11.5% and the

T-bill (risk free) rate were 4%, then the market risk
premium is the difference of (11.5% - 4%) = 7.5%

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 Capital Asset Pricing Model (CAPM)
If we select any asset "i" in this market and assume that
trading in the market's assets has "normalized" the
expected return so that it equals the same reward to risk,
then the equation for any asset "i" in the market is:

Expected return = risk free rate + (risk premium x Beta)

E(Ri) = Rf + [E(RM) - Rf] x i.
 
This is called the Capital Asset Pricing Model or CAPM.
What is Beta?
Beta measures the risk or volatility of an individual asset relative to
the market portfolio. It is the covariance of the asset's return with the
market portfolio's return, divided by the variance of the market
portfolio.
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 CAPM Illustration (1):
If the Rf = 4% and the E(RM)=11.5%
Suppose we select an asset "i" with a i = 0.7
The expected return on this asset is therefore (using CAPM)
 
E(Ri)= Rf + [E(RM) - Rf] x i
= 0.04 + [0.115 - 0.04] x 0.7
= 0.04 + (0.075 x 0.7)
= 0.04 + 0.0525
= 0.0925 or 9.25%

Because the Beta is low risk (less than market), the expected
return is less than the market rate.

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 CAPM Illustration (2):
Expected Return = risk free rate + (risk premium) x Beta
E(Ri) = Rf + [E(RM) - Rf] x I

(Where, Rf = 4%, E(RM) = 11.5%

If the  = 1.0 then the expected return = 11.5%

(the market rate)
If the  = 1.5 then the expected return = 15.25 %
If the  = 2.0 then the expected return = 19%
(this is double the market risk!)

If the  = .5 then the expected return = 7.75%

If the  = 0 then the expected return = 4%
(the risk-free rate)

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 CAPM (3):Find the missing Variable
• As long as we have the following variables:
– The risk free rate
– The current market rate
– The asset’s Beta

• Then we can estimate the expected return for any

asset (investment).

• If we have the E(R) of an asset and any two of the

above, we can work backward and find the missing
variable.
• Example-if we knew the return on an asset over time, we could
estimate what its Beta should be.

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 Mid Term Exam
Do exercise from the given handout:
• Calculate FV, PV and Amortization = 3 Marks
• Risk-return calculation = This Slides or Handout (CAPM) = 3 Marks
• Risk-return calculation = Illustration 1to 4, any one = 5 Marks
• H# 5: Basic Valuation Model = Example 1, 2 and 3 = 4 Marks

Read from Handout

• Definition
• Define – Risk and Return
• Analyze Risk-return Trade-off
• CAPM and its Assumption
• Method/Approaches to Valuation
• Discuss Valuation of Shares under different Dividend valuation Models
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