RISK & RETURN

Prepared by:
Nawal surana
Sandeep sharma
Aditya gupta
Anand singh
Ashish pandey
Raaj acharya
 OUTLINE
 Objective
Risk

Return

The Capital Asset Pricing Model

(CAPM)
Attitudes Toward Risk

 Risk
Fear to loose something.
part of every human endeavor.
Risk in investment analysis means
that future returns from an
investment are unpredictable.
It refers to the chance that the actual
outcome (return)from an investment
will differ from an expected outcome.


 CONTD…
Risk is defined as a situation where
the possibility of happening or non
happening of an event can be
quantified and measured.

Ex.:- Investment in Corporate bond
and equity shares
 TYPES OF RISK
 Systematic risk (market risk):-
 Risks within the economy that affect all
businesses.

 It is also called the non-diversifiable risk or
general risk because every security has a built in
tendency to move in line with fluctuations in the
market.


 Unsystematic risk:-
 Risks specific to a particular type of investment,
company, or business.

 It is also called specific risk or diversifiable risk.



 SYSTEMATIC RISK’S TYPES
 Market Risk: It is variability in return
due to change in market price of
investment


 For ex.: Investors’ attitude towards

equities may result in the change in
market price.



 CONTD…
Interest-rate Risk
 It refers to the variability in return
caused by the change in level of
interest rates.
 interest rates on risk free securities
and general interest rate level are
related to each other.


For ex: Prices of bond & debentures have



inverse relationship with the level of interest

rates
 CONTD...
Purchasing power or Inflation
Risk:
 It refers to the uncertainty of
purchasing power of cash flows to be
received out of investment.
 It shows the impact of inflation or
deflation on the investment.
FOR EX: Investor wants an additional

premium for inflation risk (resulting

from decrease in purchasing power) so
interest rates go up.
 UNSYSTEMATIC RISK’S TYPES
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.


 The variation in actual earnings

than the expected earnings refers to
business risk.
 CONTD…
Financial Risk:
 It refers to the degree of leverage
or degree of debt financing used by a
firm in the capital structure.


 Higher the degree of debt

financing, the greater is the degree of
financial risk.
 Total
Total Risk = Systematic
Risk = Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk

Factors such as changes in nation’s

economy, tax reform by the Congress,
STD DEV OF PORTFOLIO RETURN

or a change in the world situation.

Unsystematic risk
Tota
l
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total
Total Risk
Risk ==
Systematic
Systematic Risk
Risk ++
Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
or industry. For example, the death of a
key executive or loss of a governmental
STD DEV OF PORTFOLIO RETURN

defense contract.

Unsystematic risk
Total
Risk

Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of the
beginning market price of the
investment.



Dt + (Pt - Pt-
R 1 )
= Pt-1
 Example for return
The stock price for Stock A was
$10per
$10 share 1 year ago. The stock
is currently trading at $9.50 per
share and shareholders just received
a $1 dividend.
dividend What return was
earned over the past year?


$1.00 + ($9.50 - $10.00 )
R = = 5%
$10.00
 CAPITAL ASSET
PRICING MODEL (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.

 CAPM Assumptions
1 Capital markets are efficient.
2 Homogeneous investor
expectations over a given period.
3. Risk-free asset return is certain

4. Market portfolio contains only



systematic risk

 RISK ATTITUDE
Certainty Equivalent (CE)
CE is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
 CONTD…
 Certainty equivalent > Expected value
 Risk Preference

 Certainty equivalent = Expected value

 Risk Indifference

 Certainty equivalent < Expected value

 Risk Aversion

 Most individuals are Risk Averse.

Averse

 EXAMPLE
 You have the choice between (1) a
guaranteed dollar reward or (2) a coin-flip
gamble of $100,000 (50% chance) or $0
(50% chance). The expected value of the
gamble is $50,000.
 ANAND requires a guaranteed $25,000, or
more, to call off the gamble.
 SUMIT is just as happy to take $50,000 or take
the risky gamble.
 AMIT requires at least $52,000 to call off the
gamble.
 EXAMPLE
What are the Risk Attitude tendencies of


each?

ANAND shows “risk aversion” because her “certainty

equivalent” < the expected value of the gamble.
SUMIT exhibits “risk indifference” because her “certainty
equivalent” equals the expected value of the gamble.
AMIT reveals a “risk preference” because her “certainty
equivalent” > the expected value of the gamble.
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