CHAPTER TWO

RISK AND RETURN

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 Concept of Return and Risk
• Investment return and risk are fundamental to
understanding market behavior. The entire scenario of
security analysis is built on two concepts; Risk &
return.

• The risk and return constitute the framework for taking

investment decision.
• There are different motives for investment.
– The most prominent among all is to earn a return on investment. 2
1. Return
• The return is the basic motivating force and the principal reward in
the investment process.
• The return may be defined in terms of
– (i) Realized return, i.e., the return which has been earned, The
realized returns in the past allow an investor to estimate cash
inflows in terms of dividends, interest, bonus, capital gains, etc,
available to the holder of the investment. and
– (ii) Expected return, i.e., the return which the investor anticipates
to earn over some future investment period. The expected return is
a predicted or estimated return and may or may not occur.
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2. Risk:
• Risk in investment analysis means that future returns from an
investment are unpredictable. The concept of risk may be
defined as the possibility that the actual return may not be
same as expected. In other words, risk refers to the chance
that the actual outcome (return) from an investment will differ
from an expected outcome.
• Investments having greater chances of variations are
considered more risky than those with lesser chances of
variations.
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Types of Risk:
1. Systematic Risk/ Non-diversifiable risk
– It refers to that portion of variability in return which is
caused by the factors affecting all the firms.
– It refers to fluctuation in return due to general factors in the
market such as money supply, inflation, economic
recessions, interest rate policy of the government, political
factors, credit policy, tax reforms, etc. these are the factors
which affect almost all firms.
– The systematic risk is also called the general risk.
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Types of Systematic Risk:
a) Market risk: The market risk refers to variability in return due to
change in market price of investment. There are different social,
economic, political and firm specific events which affect the
market price of equity shares.
b) Interest Rate Risk: The interest rate risk refers to the variability
in return caused by the change in level of interest rates.
c) Purchasing-Power Risk/ Inflation Risk: The inflation risk refers
to the uncertainty of purchasing power of cash flows to be
received out of investment.

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2. Unsystematic Risk/ diversifiable risk
• The unsystematic risk represents the fluctuation in return from an
investment due to factors which are specific to the particular firm and
not the market as a whole.
• These factors are largely independent of the factors affecting market
in general.
• Since these factors are unique to a particular firm, these must be
examined separately for each firm and for each industry.
• These factors may also be called firm-specific as these affect one
firm without affecting the other firms.

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Types of Unsystematic Risk:
1) Business Risk: Business risk refers to the variability in incomes of
the firms and expected dividend there from, resulting from the
operating condition in which the firms have to operate.
2) Financial Risk: Refers to how a firm finances its activities.
Investors will look at the firm’s capital structure. It refers to the
degree of leverage or degree of debt financing used by a firm in the
capital structure.
3) Operational risk: Operational risks are the business process risks
failing due to human errors. This risk will change from industry to
industry. It occurs due to breakdowns in the internal procedures,
people, policies and systems.
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The operational risk is further classified into following types.
a) Model risk: Model risk is the risk involved in using
various models to value financial securities.
b) People risk: arises when people do not follow the
organization’s procedures, practices and/or rules.
c) Legal risk: arises when parties are not lawfully
competent to enter an agreement among them.
d) Political risk: is the risk that occurs due to changes in
government policies. Such changes may have an
unfavorable impact on an investor.
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Causes of Risk:
A number of factors which can cause risk in an investment arena
include the following:
– Wrong method of investment
– Wrong timing of investment
– Wrong quantity of investment
– Interest rate risk
– Nature of investment instrument
– Nature of industry in which the company is operating
– Maturity period (length of investment)
– Terms of lending
– National and international factors 10
 Risk and Expected Return
Risk and expected return are the two key determinants of an
investment decision.
Risk, in simple terms, is associated with the variability of the
rates of return from an investment; how much do individual
outcomes deviate from the expected value?
Another major factor determining the investment decision is
the rate of return expected by the investor. The rate of return
expected by the investor consists of the yield and capital
appreciation.
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Determinants of the Rate of Return
The three major determinants of the rate of return expected by
the investor are:
1. The time preference risk-free real rate
2. The expected rate of inflation
3. The risk associated with the investment, which is unique to
the investment.
Hence,
Required return = Risk-free real rate + Inflation premium + Risk premium

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The rate of return from an investment consists of the yield and capital
appreciation:

Where Rt = Rate of return per time period 't'

It = Income for the period ’t’
Pt = Price at the end of time period ’t’
Pt-1 = Initial price, i.e., price at the beginning of the period ’t’

Current yield + Capital gain yield

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Example:
The following information is given for a corporate bond. Price of the
bond at the beginning of the year: Br. 90, Price of the bond at the end of
the year: Br. 95.40, Interest received for the year: Br. 13.50. Compute
the rate of return.
Solution:
The rate of return can be computed as follows:

The return of 21% consists of:

15% current yield and 6% capital gain yield.

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Example 2:
The average market prices and dividend per share of Blue Ltd. for the
past 6 years are given below:
Year Average market Dividend per share
price (Br.) (Br.)
2002 38 1.8
2003 45 2.0
2004 53 2.5
2005 50 2.0
2006 61 2.6
2007 68 3.0

Required: Calculate the average rate of return for past 6 years.

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Solution:
Year Average market Capital gain Dividend/ Div yield ROR
price (Br.) (%) share (%) (%)
(Br.)
A B= C D = C/(A-1) E = B + D
2002 38 - 1.8 - -
2003 45 18.42 2.0 5.26 23.68
2004 53 17.78 2.5 5.55 23.33
2005 50 -5.66 2.0 3.77 -1.89
2006 61 22.00 2.6 5.20 27.2
2007 68 11.48 3.0 4.92 16.4

R = 1/5 (23.68+23.33-1.89+27.2+16.40)
= 1/5(88.72) = 17.75 %
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 Risk measurement
• A useful measure of risk should somehow take into account both the
probability of various possible "bad" outcomes and their associated
magnitudes.
• Instead of measuring the probability of a number of different
possible outcomes, the measure of risk should somehow estimate the
extent to which the actual outcome is likely to diverge from the
expected.
• For this purpose, range, variance, standard deviation and coefficient
of Variation can be used to measure the risk.

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 Example:
• The rate of return of equity shares of Wipro Ltd., for past six years
are given below:

Year 1 2 3 4 5 6
Rate of return (%) 12 18 -6 20 22 24
Required:
Calculate the average rate of return, variance and standard deviation.

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 Calculation of Average Rate of Return ( R )

Year Rate of Return (%) Mean ( ()

2001 12 15 -3 9
2002 18 15 3 9
2003 -6 15 -21 441
2004 20 15 5 25
2005 22 15 7 43
2006 24 15 9 81
=614
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Example 2:
Suppose have collected returns for New Honda Dealership Inc. and for
Harry’s Automotive Repair Inc. for past 4 years.

Return on
Year Dealership Repair
2001 19 14
2002 39 8
2003 15 11
2004 0 19
∑= 73 ∑=52

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 Solution
2 (19 - 18.25)2 + (38 - 18.25)2 + (15 - 18.25)2 + (0 - 18.25)2
σ  193.6875
Dealership 4

σ Dealership  193.6875  13.92%

2 (14 - 13)2 + (8 - 13)2 + (11- 13)2 + (19 - 13)2

σ  16.50
Repairs 4

σ Repairs  16.50  4.01 %

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Example 3:
Mr. Red invested in equity shares of White Ltd., its anticipated returns
and associated probabilities are given below:
Return (%) -15 -10 5 10 15 20 30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05
Required:
Calculate the expected rate of return and risk in terms of standard
deviation.

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Solution: Calculation of expected return and risk in terms of standard deviation
Return(R) Probability (P) (R × P) () xP
-15 0.05 - 0.75 -24.5 600.25 30.0125
-10 0.10 -1.0 -19.5 380.25 38.025
5 0.15 0.75 -4.5 20.25 3.0375
10 0.25 2.50 0.5 0.25 0.0625
15 0.30 4.50 5.5 30.25 9.075
20 0.10 2.00 10.5 110.25 11.025
30 0.05 1.50 20.5 420.25 21.0125
1.00 = 9.5% x P = 112.25

Expected Return = 9.5%

Standard Deviation x P = 10.60
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Example 4:
The probabilities and associated returns of Modern Foods Ltd. are given below:
Calculation of expected return and risk in terms of standard deviation
Return (%) 12 15 18 20 24 26 30
Probability 0.05 0.10 0.24 0.26 0.18 0.12 0.05
Return(R) Probability (P) (P × R) xP
12 0.05 0.60 - 8.56 73.2736 3.664
15 0.10 1.50 - 5.56 30.9136 3.091
18 0.24 4.32 - 2.56 6.5536 1.573
20 0.26 5.20 - 0.56 0.3136 0.082
24 0.18 4.32 3.44 11.8336 2.130
26 0.12 3.12 5.44 29.5936 3.551
30 0.05 1.50 9.44 89.1136 4.456
1.00 = 20.56% x P = 18.547
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• Expected Return = 20.56%
• Standard Deviation x P = = 4.31 %
Example:
Suppose have estimated possible returns for New Honda Dealership Inc. and
Harry’s Automotive Repair for the coming year based on how the economy
does
Return on:
Economy Prob. Dealership Repair
Boom 0.25 40% 6%
Average 0.55 15% 15%
Bust 0.20 -1% 17%
Required:
Calculate the expected rate of return and risk in terms of standard deviation.25
 Solution
For Dealership
Return(R) Probability (P) (P × R) xP
0.40 0.25 0.1 0.2195 0.0482 0.012
0.15 0.55 0.0825 -0.0305 0.0009 0.0005
-0.01 0.2 -0.002 -0.1905 0.0363 0.0073
1.00 = 18.05% x P = 0.0198

Dealership = 14.08%
Repair = 4.20%

Return is more uncertain for the dealership

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 Coefficient of Variation
• Standard Deviation is an absolute measure.
• It is not suitable for comparison, particularly when investment
proposals involve different capital outlay or different monetary
values of probable cash inflows.
• For comparison in such cases, coefficient of variation approach is
the best measure.
• This realization is responsible for the emergence of coefficient of
variation approach in capital risk analysis.
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐝𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧
𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧 =
𝐌𝐞𝐚𝐧
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• Assume you reached at the result of mean of company A and B, were
Br 30,000 and Br 35,000 respectively, and Standard deviation of
17,078 and 25,000 respectively, determine Coefficient of variation:
Answer:

The coefficient of variation suggests that, the more is the coefficient of

variation of a project, the greater is the risk associated with that project.

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 END OF
CHAPTER TWO

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