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Module-2
Session-3
Risk and Return I
Outline
Basics of Return
The investors invest in any asset in anticipation of return on the same. In case of financial assets, this
can also be termed as the financial results of the investment or financial asset. As one of the foremost
criteria, an investor can distinguish different financial assets based on return on such financial assets.
Returns can be classified as historical or expected i.e. prospective. Returns can be in absolute value
i.e. in terms of currency and in relative terms i.e. in terms of %. For example, if an investment
purchased one year back at Rs.120 is sold for Rs.132, the absolute return is Rs.12 and the relative
return is 10% (i.e.12 / 120). Return in a way represents total gain or loss on investment. The total
gain/ loss can comprise of periodic return and change in the value of investment at the end of the
holding period.
Hence a basic formula used for calculation of return can be as below:
rt
Pt Pt 1 Ct
Pt 1
Where rt is the actual, required or expected return during period t, Pt is the current price, Pt-1 is the
price during the previous time period, and Ct is any cash flow accruing from the investment.
Suppose one has bought a share of ABC Limited at Rs.300 one year back. Over the last year ABC has
distributed dividend of Rs.5 per share. If the share of ABC sells at Rs.340 today, what is the return?
The total return is Rs.45 that comprises of Rs.5 of dividend and Rs.40 (Rs.340 Rs.300) in terms of
appreciation in the market price of the share. Hence the % return is Rs.45/Rs.300 i.e. 15%.
In case the share of ABC sells at Rs.280 today what is the return?
The absolute return (-ve)Rs.15 (i.e. Rs.5 dividend and loss of Rs.20 in terms of fall in price), which is
-5% on origninal ivestment of Rs.300.
Holding Period Returns
The holding period return is the return that an investor would get when holding an investment over a
period of n years, when the return during year i is given as ri:
Return (%)
12
15
-8
14
16
(1 r1 ) (1 r2 ) (1 r3 ) (1 r4 ) (1 r5 ) 1
(1.12) (1.15) (0.92) (1.14) (1.16) 1
.5670 56.70%
This can be interpreted as 56.70% return over five year holding period. In case an asset does not
provide any periodic return like annual return in the previous example the holding period return
(HPR)can be calculated as below:
HPR
Example: A financial asset was purchased at Rs.300 and it grew to Rs.370 over five year period. The
HPR over three year period is
400
1 0.3333 33.33%
300
This return can be converted to effective annual return which can also be termed as annual holding
period return or yield as below:
Annual HPR = (1+HPR)1/n 1
Where, n is the number of years the investment is held. In the previous example, the annual HPR is:
(1.3333)1/3 1 = 0.1006 = 10.06%
Expected Return
Unlike historical return, in case of expected returns are predicted for the future with relevant values
being predicted. The prediction can be for different expected outcomes. In such case probability is
associated with possible outcomes and expected return from an investment is estimated.
n
E (r ) piri
i 1
Suppose there are two shares A and B and rate of returns in different conditions are expected to be as
below:
State of the
Economy
Probability of
occurrence
Boom
0.50
22
24
Normal
0.30
18
18
Recession
0.20
14
12
change in tax rates can be taxing for the company concerned. Investors residual
income can also be affected by change in personal income tax rules and rates.
Unsystematic vs. Systematic Risk
The risks that can be controlled by diversifying the portfolio of financial assets are known as
unsystematic or diversifiable risk. The risks that cannot be controlled by investors are known as
systematic risk. Market risks are essentially systematic risk where as investor or firm related risks can
be diversified. Systematic risks affect the companies across the system.
Risk Preferences: By default investors are risk averse, the difference among investors is only with
respect to the relative risk averseness. However, based on the preferences for risk, investors can be
classified into three categories as below:
Risk Neutral
Risk Averse
Risk Seeking
Risk of a Single Asset: Please refer Figure 1. Which stock A or B is more risky compared to the
other? Do note that both the stocks have same average rate of return of 15%. The return distribution of
Stock B is more flat than that of Stock A, i.e. the range of possibilities of returns is more compared to
Stock A. From this figure one can conclude that Stock B is more risky than Stock A.
ProbabilityDistribution
StockA
StockB
Rateof
Return(%)
20
15
50
Figure1
Consider the following Assets for which the returns under various conditions of economy are given.
Economy
Prob.
G-sec
Stock 1
Stock 2
Stock 3
Stock 4
Recession
0.10
8.0%
-22.0%
28.0%
10.0%
-13.0%
Below average
0.20
8.0
-2.0
14.7
-10.0
1.0
Average
0.40
8.0
20.0
0.0
7.0
15.0
Above average
0.20
8.0
35.0
-10.0
45.0
29.0
Boom
0.10
8.0
50.0
-20.0
30.0
43.0
8.0%
17.4%
1.7%
13.8%
15.0%
1.00
Expected Return
The G-sec has same return irrespective of the economic outcome. This appears to be risk free.
Stock 1 moves along with the economy (positively correlated) whereas Stock 2 moves in opposite
direction of the economy (negatively correlated).
Measuring Risk: the simplest measure of risk is range which is defined as the difference between the
highest possible return and lowest possible return. In the above table, the range for Stock 1 is 72.0%
whereas for Stock 2 it is 48%. However standard deviation is considered as one of the very well
accepted measure of risk. Standard deviation is the square root of variance.
Variance
ri r Pi .
i 1
n
For Stock 1:
= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10))1/2 =
20.0%.
Similarly for other investments, the standard deviation is given in the following table.
Investment
G-Sec
Stock 1
Stock 2
Stock 3
Stock 4
0%
20.0%
13.4%
18.8%
15.3%
Additional Readings:
Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment,
3rd Edition, Pearson Education.
Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6th Edition, Tata McGraw-Hill.
Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th Edition., PrenticeHall.
Jones, Charles, P., Investment Analysis and Management, 9th Edition, John Wiley and Sons.
Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata McGraw-Hill.
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition,
Thomson South-Western.
Additional Questions:
Q. 1: Suppose one has bought a share of PQR Limited at Rs.224 one year back. Over the last year
PQR has distributed dividend of Rs.8 per share. If the share of PQR sells at Rs.250 today, what is the
return? If the share is trading at Rs.220 today, what is the return earned?
Ans.: The total return is Rs.34 that comprises of Rs.8 of dividend and Rs.26 (Rs.250 Rs.224) in
terms of appreciation in the market price of the share. Hence the % return is Rs.34/Rs.224 i.e.
15.18%. if the share is trading at Rs.220, return earned is: 1.79%.
Q.2: Suppose an investment provides the following periodic return over last four years as below:
Year
Return (%)
10
12
-6
12
Prob.
Stock A
Stock B
Recession
0.10
-18.0
-10.0
Below avg.
0.20
-4.0
2.0
Average
0.40
12.0
8.0
Above avg.
0.20
24.0
12.0
Boom
0.10
30.0
18.0
1.00
Ans.:
Condition of
Economy
Prob.
Return
Prob.*Return
Stock A
Stock B
Stock A
Stock B
Stock A
Stock B
Recession
0.1
18.00
14.00
1.80
1.40
13.92
6.08
Below avg.
0.2
(4.00)
2.00
(0.80)
0.40
41.47
15.49
Average
0.4
12.00
8.00
4.80
3.20
30.98
14.40
Above avg.
0.2
24.00
12.00
4.80
2.40
15.49
9.25
Boom
0.1
30.00
18.00
3.00
1.80
11.24
5.48
13.6
9.2
Variance
(%Square):
113.10
50.70
Standard
Deviation
(%):
10.63
7.12
Exp.
Return
(%):
Business Risk
Financial Risk
Interest rate risk
Liquidity risk
Market risk
Event Risk
Exchange Rate Risk
Purchasing-power risk
Tax risk