Risk Return

Risk and Return
Contents
• Single Period Return from a security
• How to Measure Return from a ‘Variable
Return Security’
• What is Risk and How to Measure it?
• Components of Risk
• What is a Portfolio?
• How to Measure Return and Risk of a Portfolio
Single Period Return from a
Security
Income  Ending Value - Beginning Value
Rate of Return 
Beginning Value
• Also called: Holding Period Return

• 1.Given the following information estimate
the rate of return from the security:
• Price at the beginning of the year : Rs. 120
• Dividend paid at the end of the year: Rs. 5
• Price at the end of the year: Rs. 145
Return from a Variable Return
Security
• Equity shares
• Generate different returns in different periods
• Multiple period & Multiple returns
• Representative returns are calculated using
mean
• Returns may be estimated using historical data
or projected data
Security…
• Estimating Returns from Historical Data:
n
R i
• Arithmetic Mean Return  i 1
n
• 2. Calculate mean return from for the shares

of Alpha Products Ltd. given the following
data:
• 15%, -5%, 5%, 35%, 25%
Security…
• Estimating Returns from Projected Data:
n
• Expected Return E(R)  p R
i 1
i i
• 3.Calculate expected return from the

projected returns from the shares of Lotus
Cosmetics Ltd.
Return (%) -6 12 20 24
Probability(%) 15 50 20 15
Risk of a Variable Return Security
• Risk exists when the returns from a security
are variable
• Risk is measured by variability or dispersion of
returns
• Can be estimated using historical or projected
data
• Measure: Standard Deviation or Variance
Risk of a Variable Return Security…
• Estimating Risk From Historical Returns:
n
 i
(R
• Standard Deviation:σ  i  1
- R ) 2
• Variance = 2 N
σ
• 4.Calculate risk for the shares of Alpha
Products Ltd. given the following data:
• 15%, -5%, 5%, 35%, 25%
• Estimating Risk From Projected Returns:
• Standard Deviation:σ  n p R - E(R) 2

 i i
• Variance = 2 i 1
σ
• 5.Calculate risk from the projected returns
from the shares of Lotus Cosmetics Ltd.
Return (%) -6 12 20 24
Probability(%) 15 50 20 15
• Important Question:
• How can we compare risk-return combination
across multiple investments ?
Components of Risk
• Risk measured in terms of Variance of Returns
is a measure of the Total Risk of the security
• Total risk consists of two components:
• Systematic risk (Market risk)
• Unsystematic risk (Firm specific risk)
• Systematic risk arises out of economy wide
factors which affect every security
• Unsystematic risk arises out of firm specific
factors)
Components of Risk…
• Unsystematic risk can be eliminated by investing in a
portfolio of securities instead of an individual
security. This process is called diversification.
• Systematic risk affects every security. Hence it cannot
be eliminated through diversification.
• Another measure of systematic risk is ‘beta’ (β)
• It measures the sensitivity of the returns from the
security to the variations in market returns
• Hence it can be used to compare systematic risk
between several securities
What is a Portfolio?
• A portfolio refers to a collection of securities.
• Instead of investing all his funds into a single
security the investor distributes his investible
funds among various securities
• A portfolio is also characterized along the two
dimensions of risk and return
• Intelligently chosen, the securities in a
portfolio can reduce its total risk
Measuring Return & Risk of a
Portfolio
• Both return & risk of a portfolio depend on
the following:
• Return & Risk of the individual securities in
the portfolio
• Proportion of the total investible funds
allocated to different securities (weights)
• Interrelationship between returns of different
securities (covariance or correlation of
returns)
Return of a Portfolio
• 2 Security Portfolio:
• E(Rp) = w1E(R1) + w2E(R2)
• w1 + w2 = 1
• n Security Portfolio:
• E(Rp) = w1E(R1) + w2E(R2) + … … + wnE(Rn)
n
  w i E(R i )
i 1
• w1 + w2 + … … + wn = 1
Risk of a Portfolio
• Can be calculated as Variance of portfolio returns
• Simplified formula for 2 Security Portfolio:
σ 2p  w12σ12  w 22σ 22  2w1w 2cov(1,2)
 w12σ12  w 22σ 22  2w1w 2ρ1,2 σ1σ 2
• w1 + w2 = 1
• 6. Calculate the return and risk of a 2 security
• portfolio given the following details:
• w1 = 0.40 σ1 = 10 σ2 = 12 ρ1, 2 = -0.30
• E(R1) = 20% E(R2) = 30%
Capital Asset Pricing Model
• A theory which explains the relationship between
the systematic risk (β) of a security and its expected
return
• Ri = Rf + βi(RM – Rf )
• Expected return consists of two components:
• Risk free rate of return and risk premium
• The graph of CAPM is called Security Market Line
(SML)
• 7. Calculate the expected return for a security with β
of 1.6 given the risk free rate 10% and expected
return on the market 15%
• 8. The stocks of Co. A & Co. B are both selling
for Rs. 100 per share. The projected cash flows
(dividend + share price) from the shares are
given for the next year:
High Growth Low Growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
A: Return (Rs.) 100 110 120 140
B: Return (Rs.) 150 130 90 60
• Calculate the expected cash flow & risk (in

terms of Rupees) for the following
investments: (a) Rs.1000 in shares of Co. A (b)
Rs.1000 in shares of Co. B (c) Rs.500 each in
shares of Cos. A & B
THANK YOU

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Risk and Return

• Also called: Holding Period Return

• 2. Calculate mean return from for the shares

• 3.Calculate expected return from the

• Standard Deviation:σ  n p R - E(R) 2

• Calculate the expected cash flow & risk (in

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