Module III

• 3.1 Concepts of risk and return - factors

contributing to risks - risk and risk aversion
• 3.2 Types of risks - systematic and unsystematic
risk
• 3.3 Measurement of risks – Capital Asset Pricing
Model (CAPM)
• 3.4 Return and risk of securities and portfolio
and calculation of security and portfolio beta to
be covered.
 Module III
Risk and Return
Risk comes from not knowing what you’re
doing’

Warren Buffet
• The return on any stock traded in a financial
market is composed of two parts.
• The normal, or expected, part of the return is
the return that investors predict or expect.
• The uncertain, or risky, part of the return
comes from unexpected information revealed
during the year.
 What are the main categories of risk we should be concerned about when making any financial investment?

▪ Inflation risk
▪ Interest Rate risk
▪ Credit risk
▪ Currency risk
▪ Liquidity risk
▪ Political risk
▪ Operational risk
▪ Non-diversification risk

4
 Risk
Is there a truly risk free investment?

▪ Cash

▪ National Savings Certificates

▪ Post Office?

5
 Types of Risk
Systematic risk is risk that influences a large
number of assets. Also called market risk.

Unsystematic risk is risk that influences a single

company or a small group of companies. Also
called unique risk or firm-specific risk.

Total risk = Systematic Risk and Unsystematic Risk

 Systematic Risk

Systematic Risk – also known as Market Risks are those risks which
affect all companies within a market in one way or another.

For example:
 
▪ Inflation
▪ Covid -10 Pandemic
▪ Recession
▪ Interest Rates
▪ Political Instability
▪ Exchange Rates
▪ War

7
 Risk
1. Systematic Risk
• Interest rate risk
• Market Risk
• Purchasing power risk
2. Unsystematic Risk
• Business Risk
• Financial Risk
 Measurement of Risk

• Return(R)
= Forecasted Dividend + Forecasted end of the period Stock price
Initial Investment - 1
Or

R= D + P1 – P0
P0 P0

Expected Return
- Probability weighted average of all the possible returns
Total Risk

• Variance
 Measurement of Systematic risk

• Systematic Risk- Variability in security

returns caused by changes in the
economy or market
• Measured by relating security’s
variability with the variability in the
stock market index.
• Statistical Measure- Beta
 Beta
Two Methods
a. Correlation method
b. Regression method
a. Correlation method
• Regression method
• The Beta coefficient (β) measures the
relative systematic risk of an asset
– Assets with Betas larger than 1.0 have more systematic risk than
average.
– Assets with Betas smaller than 1.0 have less systematic risk than
average.

• Because assets with larger betas have greater systematic risks,

they will have greater expected returns.
•
https://www.topstockresearch.com/BetaStocks/HighBetaStocks
.html
 Unsystematic Risk
Unsystematic Risk – also known as Specific Risk are risks which
are unique to the company.

▪ Strength of Management ( Marks & Spencer)

▪ Range of Products (Unilever)
▪ Geographic Location (McDonald’s)
▪ Financial Position ( Bosh india)
▪ Innovational Factor (Apple)

Total Risk = Unsystematic Risk + Systematic Risk

15
 Capital Asset Pricing Model
Assumptions
• Investors are risk averse
• Investors are utility maximisers rather than return maximisers
• All investors have the same time period as the investment horizon
• Investors can borrow and lend without any limit at a risk free rate of
return
• Investors have homogeneous expectations regarding the means,
variances, and co-variances of security returns since all information
is available to all investors instantaneously without any cost
• No taxes and no transaction costs exist in the market
 Capital Asset Pricing Model

• Market risk premium = Market portfolio expected return -

Risk free-rate
• Security's risk premium = Market risk premium X Security's
beta
• Security's expected return = Risk free rate + (Market risk
premium X Security's beta)
 Capital Asset Pricing Model
Where
Ri is the expected return on
security i
RF is the risk free rate
βi is the security's beta
RM less RF is the market risk
premium
• The risk free rate, which
measures the compensation
for investing money without
taking any risk
• AND
• The expected reward for
bearing risk, which is equal
to the market risk premium
multiplied by the security's
beta coefficient.
Security Market Line
Portfolio Beta
 Example

Portfolio risk = 2.601

• Risk free rate = 4 per cent Portfolio expected return = Rf
• expected market return = 22 per + (Rm – Rf) * βp
cent. = 4% + (22 – 4) * 2.601
= 4% + (18% * 2.601)
Security1 SI S2 S3 S4 S5 S6 S7 S8 S9 S10 = 4% + 46.818
Market value
Beta
100
1.6
50
1.8
200
2.9
800
3.4
400
2.5
300
2
60
0.60
40
0.50
100
1.3
150
2.6 = 50.818%.

Weights 0.05 0.02 0.09 0.36 0.18 0.14 0.03 0.01 0.05 0.07
Weighted
0.08 0.036 0.261 1.224 0.45 0.28 0.018 0.005 0.065 0.182
beta