Risk and Return

Risk is the chance that some unfavorable event will occur or

Potential variability in future cash flows.
“Assets risk can be analyzed in two ways”
1. Stand Alone basis: Risk investor would face if he or she
held only one asset.
2. Portfolio Basis: where the asset is held as one of a
number of assets.
Types of Risks
3. Diversifiable/Un-Systematic/Company Unique Risk:
Part of a security’s risk associated with random events.
4. Market/Systematic Risk: Risk that cannot be
eleminated by diversification
Probability Distribution: A listing of all possible outcomes
or events, with a probability assigned to each out come.
For e.g OUTCOME PROBABILITY
Rain 0.4 = 40%
No Rain 0.6 = 60%
1.0 = 100%
EXPECTED RATE OF RETURN ON “STAND ALONE BASIS”

Expected Rate OF Return

The rate of return expected to be realized from an investment:
weighted average of the probability distribution of possible
results.
Denoted as Kˆ
 Kˆ = ∑ Ki . Pi
 Probability Company (rate of return)
A B
0.3 100% 20%
0.4 15% 15%
0.3 (70%) 10%

Kˆ = ∑ Ki . Pi
Kˆ = K1.P1+K2.P2+…….+ Kn.Pn
For A Kˆ = 100% . 0.3 + 15% . 0.4 + (70%) . 0.3
For A Kˆ = 15%
Same procedure for B as well
For B = 15%
A= 80%, -50% B= 11.13%, 18.87% C= 9.5% Risk free
rate
Standard

Deviation
A statistical measure of the variability of a set of observations.

Std Div or б = √∑ (Ki-Kˆ)^2 . Pi

FOR A б = √ (K1-Kˆ)^2 . P1 + (K2-Kˆ)^2 . P2 + …… + (Kn-Kˆ)^2 . Pn

б = √ (100% - 15%)^2 . 0.3 + (15% - 15%)^2 . 0.4 + (-70%-15%)^2. 0.3

= √4335 => 65.84%
Std Deviation Sigma for B = 3.87%
HOW FAR ABOVE OR BELOW THE ACTUAL RATE WILL BE
15% + 65.84% or 15% - 65.84%
80.84% , - 50.84%
For B = 15%+3.87% and 15-3.87%
18.87%, 11.13%
Coefficient of Variation
Standardized measure of risk per unit of return:
calculated as the std.dev divided by expected return
Kˆ.
CV = б / Kˆ
CV= 65.84% / 15%
CV= 4.39 for company A
CV
Project X=> Std.dev 15%, K^=60%
Project Y=> Std.dev 3%, K^= 8%
Portfolio Basis
A combination of one or more securities or assets.

Expected Rate of return on portfolio basis

The weight of an asset in a portfolio is the percentage
of the portfolio’s total value that is invested in an asset.
Kp^ = ∑ wi . Ki^
Kp^ = w1.k1^ + w2.k2^+…….+ wn.Kn^
Expected ror on Portfolio Basis
Recall from the previous section that Company A had
an average expected rate of return of 15% and company
B had also 15%. Now suppose you have a company C
and D having an average expected rate of return of 13%
and 14% respectively. Find the Expected rate of return
on the portfolio i.e. Kp^ Company K^
 We assume that we have invested $2000,000 equally in all 4
companies which means that weight would be A
distributed 15%i.e.
equally
B 15%
¼ = 0.25 or 25%
 Kp^ = 0.25*15% + 0.25*15% + 0.25*13% + 0.25*14% C 13%
D 14%