Introduction to Finance

Prepared By: Dr. H. M. Mosarof Hossain Professor Department of Finance University of Dhaka mosarof@du.ac.bd

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Chapter 7: Risk and Return

Concept of return and risk Types of return and risk Measures of return and risk Risk-return relationship Risk premium and sources of this

Determinants of required rate of return

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Return
Return: Percentage form of earnings from an investment or asset including normal income and capital gain or loss is called return. Return may be the following three types: 1. Risk-free rate of return rate of return can be earned by making investment in government securities of a country is known as risk-free rate of return.

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Return
2. Nominal rate of return rate of return calculated by ignoring existing level of inflation is known as nominal rate of return. 3. Real rate of return - rate of return determined by considering/adjusting existing level of inflation is known as real rate of return.
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Risk

Risk is the concept of fluctuations. This fluctuations can be (i) a deviation of the actual return from the expected return, or (ii) a deviation of average return from the year to year return. Higher the fluctuations, higher is the risk. Types of risk
i. Systematic risk risk that can not be avoided or minimized and that is out of control of an individual or a business enterprise. ii. Unsystematic risk - risk that can not be avoided but can be minimized by making intellectual decision and that is to some extent under the control of an individual or a business enterprise.
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Risk
iii. Business risk risk related to overall business activities of a particular business enterprise that is mostly out of control of that business enterprise. iv. Financial risk - risk related to using of fund for forming and running business operations or making investments by a particular party that is under the control of that party. Measures of risk i. Standard Deviation absolute measurement of total risk ii. Coefficient of Variation - relative measurement of total risk iii. Beta Coefficient - absolute measurement of systematic risk

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Formula for calculating of Risk-Return

R Expected Return E ( R) R (R * P ) n
i i i

Risk Risk

2 ( R R ) i

n 1
i

( For time series data)

2

( P )( R R )
i

( for probability distribution)

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Calculation of Risk-Return (Historical Data)

Year 2004 2005 2006 2007 2008 Mean Return= Stand.Deviation2 Stand.Deviation=

Return (%) 20 5 -5 15 30 13%

Dev. (Ri-E(R)) 7 -8 -18 2 17 Sum of Dev sq= 730/(5-1)= Square root (182.5)

Dev. Square 49 64 324 4 289 730 182.5 13.5%

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Calculation of Risk-Return (Probability Distribution)

Weather Rain Moderate Dry

Probability (Pi) 0.25 0.5 0.25

Return (Ri) Exp. Value (%) (Pi*Ri) 25 14 0 E(R)= 6.25 7 0 13.25%

Deviation (Ri-E(R))

Deviation Square

Dev sq* Pi

(25-13.25) =11.75
(14-13.25) =0.75 (0-13.25) =-13.25

(11.25)2 =138.0625
(0.75)2 =0.5625 (-13.25)2 =175.5625 Stand Dev2=

(138*.25) =34.52
(.56*.5) =0.28 (175*.25) =43.89 78.69

Risk=

8.87%

Stand Dev

8.87

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Risk-return relationship i.e.

Security Market Line (SML)
Return [E(R)] SML E(Rj) E(Rm) Rf=5% Systematic Risk (Beta) m=1 j=1.9
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Risk premium
The rate of return can be earned by making investment in risk-free asset is called risk free rate of return and the rate of return can be earned by making investment in risky asset is called nominal risky rate of return. Generally the nominal risky rate of return is higher that risk-free rate of return. The increased required rate of return over riskfree rate of return is called risk premium.
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Sources of risk premium

1. Business risk- related to normal business operations. 2. Financial risk- related to capital structure or financing decision. 3. Liquidity risk- related to convert the investment into cash easily and quickly. 4. Foreign exchange rate risk- related to increase or decrease foreign exchange rate. 5. Country risk- related to mainly overall political situation of the country.
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Determinants of required rate of return

1. The real risk-free rate: The rate of return can be earned by making investment in risk-free sector in absence of inflation is known as real risk-free rate. The government sector of any country is considered as risk-free sector. 2. Nominal risk-free rate: The rate of return can be earned by making investment in risk-free sector at presence of inflation is known as nominal risk-free rate.
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Determinants of required rate of return:

3. Expected risk premium: The additional rate of return to be required for compensating additional level of risk for making investment in risky asset or for doing risky business. 4. Conditions in the capital market: The impact of the existing monetary and fiscal policies of the government applicable within the country and the probable change of these.
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