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    What Is Risk?: Risk Return Trade Off

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    Lavanya Kasetty
    The document discusses various concepts related to risk and return in investments. It defines risk as the possibility that an investment's actual outcome differs from expected returns, including the possibility of losing some or all of the original investment. Return is defined as the money made or lost on an investment over time. It also discusses the risk-return tradeoff, where higher risk is associated with potential for higher returns but also greater probability of loss, while lower risk investments have less potential for high returns but also less probability of loss. Several methods for measuring risk and return like standard deviation, beta, value at risk, and conditional value at risk are also summarized.

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    What Is Risk?: Risk Return Trade Off

    Uploaded by

    Lavanya Kasetty
    52 views8 pages
    The document discusses various concepts related to risk and return in investments. It defines risk as the possibility that an investment's actual outcome differs from expected returns, including the possibility of losing some or all of the original investment. Return is defined as the money made or lost on an investment over time. It also discusses the risk-return tradeoff, where higher risk is associated with potential for higher returns but also greater probability of loss, while lower risk investments have less potential for high returns but also less probability of loss. Several methods for measuring risk and return like standard deviation, beta, value at risk, and conditional value at risk are also summarized.

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    Risk and planning

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    The document discusses various concepts related to risk and return in investments. It defines risk as the possibility that an investment's actual outcome differs from expected returns, including the possibility of losing some or all of the original investment. Return is defined as the money made or lost on an investment over time. It also discusses the risk-return tradeoff, where higher risk is associated with potential for higher returns but also greater probability of loss, while lower risk investments have less potential for high returns but also less probability of loss. Several methods for measuring risk and return like standard deviation, beta, value at risk, and conditional value at risk are also summarized.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    52 views8 pages

    What Is Risk?: Risk Return Trade Off

    Uploaded by

    Lavanya Kasetty
    The document discusses various concepts related to risk and return in investments. It defines risk as the possibility that an investment's actual outcome differs from expected returns, including the possibility of losing some or all of the original investment. Return is defined as the money made or lost on an investment over time. It also discusses the risk-return tradeoff, where higher risk is associated with potential for higher returns but also greater probability of loss, while lower risk investments have less potential for high returns but also less probability of loss. Several methods for measuring risk and return like standard deviation, beta, value at risk, and conditional value at risk are also summarized.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
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    of 8

    What Is Risk?

    Risk is defined in financial terms as the chance that an outcome or


    investment's actual gains will differ from an expected outcome or return.
    Risk includes the possibility of losing some or all of an original investment.

    What Is a Return?
    A return, also known as a financial return, in its simplest terms, is the
    money made or lost on an investment over some period of time.

    A return can be expressed nominally as the change in dollar value of an


    investment over time. A return can also be expressed as a percentage
    derived from the ratio of profit to investment. Returns can also be
    presented as net results (after fees, taxes, and inflation) or gross returns
    that do not account for anything but the price change. It even includes
    a investment.

    WHAT IS TRADEOFF?
    A trade-off (or tradeoff) is a situational decision that involves diminishing
    or losing one quality, quantity or property of a set or design in return for
    gains in other aspects. In simple terms, a tradeoff is where one thing
    increases and another must decrease. Tradeoffs stem from limitations of
    many origins, including simple physics – for instance, only a certain volume
    of objects can fit into a given space, so a full container must remove some
    items in order to accept any more, and vessels can carry a few large items
    or multiple small items. Tradeoffs also commonly refer to different
    configurations of a single item, such as the tuning of strings on a guitar to
    enable different notes to be played, as well as allocation of time and
    attention towards different tasks.

    RISK RETURN TRADE OFF


    Definition: Higher risk is associated with greater probability of higher
    return and lower risk with a greater probability of smaller return. This trade
    off which an investor faces between risk and return while considering
    investment decisions is called the risk return trade off.
    For Example: Rohan faces a risk return trade off while making his decision
    to invest. If he deposits all his money in a saving bank account, he will earn
    a low return i.e. the interest rate paid by the bank, but all his money will be
    insured up to an amount of RS 1 lakh (currently the deposit insurance and
    Credit Guarantee Corporation in India Provides Insurance up to 1 lakh)

    UNDERSTANDING RISK-RETURN TRADEOFF


    The risk-return trade off is the trading principle that links high risk with high
    reward. The appropriate risk return trade off depends on a variety of factors
    including an investors risk tolerance, the investors years to retirement and
    the potential to replace lost funds. Time also plays an essential role in
    determining a portfolio with the appropriate levels of risk and reward.

    Investors use the risk-return trade off as one of the essential components
    of each investment decision, as well as to assess their portfolio as a whole.
    At the portfolio level, the risk-return trade off can include assessments of
    the concentration or the diversity of holdings and whether the mix presents
    too much risk or a lower-than-desired potential for returns.

    RISK-RETURN TRADEOFF IN-DEPTH


    Risk is inherent in every investment, though its scale varies depending on
    the instrument. Return, on the other hand, is the most sought after yet
    elusive phenomenon in the financial markets. In order to increase the
    possibility of higher return, investors need to increase the risk taken. On the
    other hand, if they are content with low return, the risk profile of their
    investment also needs to be low.

    METHODS OF MEASURING RISK


    A rate of return (ROR) can be applied to any investment vehicle, from real
    estate to bonds, stocks, and fine art. ROR works with any asset provided
    the asset is purchased at one point in time and produces cash flow at some
    point in the future. Investments are assessed based, in part, on past rates
    of return, which can be compared against assets of the same type to
    determine which investments are the most attractive. Many investors like to
    pick a required rate return before making an investment choice.

    The Formula for Rate of Return (ROR)


    The formula to calculate the rate of return (ROR) is:

    \text{Rate of return} = [\frac{(\text{Current value} - \text{Initial value})}


    {\text{Initial value}}]\times
    100Rate of return=[Initial value(Current value−Initial value)]×100

    Example of a Rate of Return (ROR)


    The rate of return can be calculated for any investment, dealing with any
    kind of asset. Let's take the example of purchasing a home as a basic
    example for understanding how to calculate the ROR. Say that you buy a
    house for $250,000 (for simplicity let's assume you pay 100% cash).

    Six years later, you decide to sell the house—maybe your family is growing
    and you need to move into a larger place. You are able to sell the house for
    $335,000, after deducting any realtor's fees and taxes. The simple rate of
    return on the purchase and sale of the house is as follows:

    \frac{(335,000-250,000)}{250,000} \times 100 = 34\%250,000(335,000−250,000)


    ×100=34%

    Now, what if, instead, you sold the house for less than you paid for it—say,
    for $187,500? The same equation can be used to calculate your loss, or
    the negative rate of return, on the transaction: 

    \frac{(187,500 - 250,000)}{250,000} \times 100 =


    -25\%250,000(187,500−250,000)×100=−25%

    Return on Investment (ROI)


    Return on Investment (ROI) is a performance measure used to evaluate
    the efficiency of an investment or compare the efficiency of a number of
    different investments. ROI tries to directly measure the amount of return on
    a particular investment, relative to the investment’s cost. To calculate ROI,
    the benefit (or return) of an investment is divided by the cost of the
    investment. The result is expressed as a percentage or a ratio .

    How to Calculate ROI


    The return on investment formula is as follows:

    \begin{aligned} &\text{ROI} = \dfrac{\text{Current Value of


    Investment}-\text{Cost of Investment}}{\text{Cost of Investment}}\\
    \end{aligned}ROI=Cost of InvestmentCurrent Value of Investment−Cost of In
    vestment

    "Current Value of Investment” refers to the proceeds obtained from the sale
    of the investment of interest. Because ROI is measured as a percentage, it
    can be easily compared with returns from other investments, allowing one
    to measure a variety of types of investments against one another.

    Capital Asset Pricing Model (CAPM)


    The capital asset pricing model (CAPM) is used to calculate the
    required rate of return for any risky asset. Your required rate of return is the
    increase in value you should expect to see based on the inherent risk level
    of the asset.

    How Does the Capital Asset Pricing Model (CAPM)


    Work?
    As an analyst, you could use CAPM to decide what price you should pay
    for a particular stock. If Stock A is riskier than Stock B, the price of Stock A
    should be lower to compensate investors for taking on the increased risk.

    The CAPM formula is:

    ra = rrf  + Ba (rm - rrf)


    where:

    rrf = the rate of return for a risk-free security 

    rm = the broad markets expected rate of return 

    Ba = beta of the asset

    CAPM can be best explained by looking at an example.

    Assume the following for Asset XYZ:

    rrf = 3%
    rm = 10%
    Ba = 0.75

    By using CAPM, we calculate that you should demand the following rate of
    return to invest in Asset XYZ:    ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 =
    8.25%

    Common Methods of Measurement for Investment


    Risk Management
    Risk management is a crucial process used to make investment decisions.
    The process involves identifying and analyzing the amount of risk involved
    in an investment, and either accepting that risk or mitigating it. Some
    common measures of risk include standard deviation, beta, value at risk
    (VAR), and conditional value at risk (CVAR).

    Standard Deviation
    Standard deviation measures the dispersion of data from its expected
    value. The standard deviation is used in making an investment decision to
    measure the amount of historical volatility associated with an investment
    relative to its annual rate of return. It indicates how much the current return
    is deviating from its expected historical normal returns. For example, a
    stock that has high standard deviation experiences higher volatility, and
    therefore, a higher level of risk is associated with the stock.

    Alpha
    Alpha measures risk relative to the market or a selected benchmark index.
    For example, if the S&P 500 has been deemed the benchmark for a
    particular fund, the activity of the fund would be compared to that
    experienced by the selected index. If the fund outperforms the benchmark,
    it is said to have a positive alpha. If the fund falls below the performance of
    the benchmark, it is considered to have a negative alpha.

    Beta
    Beta is another common measure of risk. Beta measures the amount of
    systematic risk an individual security or an industrial sector has relative to
    the whole stock market. The market has a beta of 1, and it can be used to
    gauge the risk of a security. If a security's beta is equal to 1, the security's
    price moves in time step with the market. A security with a beta greater
    than 1 indicates that it is more volatile than the market.

    Conversely, if a security's beta is less than 1, it indicates that the security is


    less volatile than the market. For example, suppose a security's beta is 1.5.
    In theory, the security is 50 percent more volatile than the market.

    Value at Risk (VAR)


    Value at risk is a statistical measure used to assess the level of risk
    associated with a portfolio or company. The VAR measures the maximum
    potential loss with a degree of confidence for a specified period. For
    example, suppose a portfolio of investments has a one-year 10 percent
    VAR of $5 million. Therefore, the portfolio has a 10 percent chance of
    losing more than $5 million over a one-year period.

    Conditional Value at Risk (CVAR)


    Conditional value risk is another risk measure used to assess the tail risk of
    an investment. Used as an extension to the VAR, the CVAR assesses the
    likelihood, with a certain degree of confidence, that there will be a break in
    the VAR; it seeks to assess what happens to investment beyond its
    maximum loss threshold. This measure is more sensitive to events that
    happen in the tail end of a distribution—the tail risk. For example, suppose
    a risk manager believes the average loss on an investment is $10 million
    for the worst one percent of possible outcomes for a portfolio. Therefore,
    the CVAR, or expected short fall, is $10 million for the one percent tail.

    Categories of Risk Management


    Beyond the particular measures, risk management is divided into two broad
    categories: systematic and unsystematic risk.

    Systematic Risk
    Systematic risk is associated with the market. This risk affects the overall
    market of the security. It is unpredictable and undiversifiable; however, the
    risk can be mitigated through hedging. For example, political upheaval is a
    systematic risk that can affect multiple financial markets, such as the bond,
    stock, and currency markets. An investor can hedge against this sort of risk
    by buying put options in the market itself.

    Unsystematic Risk
    The second category of risk, unsystematic risk, is associated with a
    company or sector. It is also known as diversifiable risk and can be
    mitigated through asset diversification. This risk is only inherent to a
    specific stock or industry. If an investor buys an oil stock, he assumes the
    risk associated with both the oil industry and the company itself.

    For example, suppose an investor is invested in an oil company, and he


    believes the falling price of oil affects the company. The investor may look
    to take the opposite side of, or hedge, his position by buying a put option
    on crude oil or on the company, or he may look to mitigate the risk through
    diversification by buying stock in retail or airline companies. He mitigates
    some of the risk if he takes these routes to protect his exposure to the oil
    industry. If he is not concerned with risk management, the company's stock
    and oil price could drop significantly, and he could lose his entire
    investment, severely impacting his portfolio.

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