Returns

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Simple methods for
determining future
returns.
 
 
Measuring Returns:
•Historical returns
•Single Period
•Multiple Periods
 
 

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Return is the aggregate during a period
•of the dividend and interest payoffs
•along with the capital gain or loss.
 

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 Investors are interested in future
returns or to be more precise they
are interested in expected returns
rather than past returns.
Historical returns are
•good indicators and
•can be useful in providing a base for
future estimates

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But it is the correct or nearly correct
estimates of future returns is what this
subject is all about and which is what
we would be interested in knowing.

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Determining Future
Returns

To anticipate future returns a number of

forecasts come in to play namely for the:
1.     The economy
2.     Stock and bond markets
3.     Sectors of the market
4.     Industries
5.     Individual companies
 

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 Various statistical and
mathematical models may be
created to arrive at such
probability forecasts and the help
of computers may be taken to
crunch a large amount of data to
arrive at plausible estimates

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 Based on these calculations and
considering all the factors:
 we come to a reasonable conclusion
that the chances of an expected rate of
return are say 1 in 100 or 80% or 90%
 this is the probability of an expected
rate of returns materializing according
to a set of circumstances that may
prevail at a particular time in the future.
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 A practical illustration
Supposing elections are to be held in a short
time and an analyst pictures the following
three scenarios

1) Scenario 1 with a probability of 025%

A stable government with majority rule
A rate of return is forecasted to be around
36%

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2) Scenario 2 with a probability of
0.50%
 
A coalition government lasting its
full term.
A rate of return is forecasted to be
around 26%

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 3) Scenario 3 with a probability of
0.25%

Re-elections in the immediate

future.
A rate of return is forecasted to be
around 12%

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 This three scenarios will cover all
possible situations and hence the
total of all the probabilities will be 1
meaning there cannot be another
possible situation.

We put the information in the form of a

table

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Scenario Probabilit Expected
y Return

1 0.25 36%

2 0.50 26%

3 0.25 12%

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 Now an investor will ask a very simple
question considering all the possible
situations and values involved what
would be my average expected
return?

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The expected average return is nothing
but the weighted average return of all
the returns and where the weights are
the respective probabilities.
 

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Scenario Probability Expected Average
Return

1 0.25 36% (.25*36) =9

2 0.50 26% (.50*26)=13

3 0.25 12% (.25*12)=3

9+13+3=25%

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 Expected Return on A
Portfolio of securities:
 
 
A portfolio is nothing but an investment in a number
of individual securities in different proportions.
 
 
 
 
 
 
 

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Stock Price 91 Price92 div Return

X 20 30 2 60

Y 30 40 3 43.33

Z 50 60 5 30

XYZ 100 130 10 40

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 Now the return on a portfolio is the
weighted average of the returns on
individual securities in the
portfolio where the weights are
the proportion of investments in
each security
and can be calculated as follows
 

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 Return Wt * Ret Weighted
Stock Price 91
avg

X 20 60 .20*60 12

Y 30 43.33 .30*43.33 13

Z 50 30 .50*30 15

40

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Which is the same as per our
calculations above

 XYZ 100 130 10 40

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 Returns alone do not form the sole
criteria for investment we have to
also consider risk

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Risk

Suppose we have to evaluate two shares

for which we have collected data for the
past five years as follows
 

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The returns as a percentage
are
Year 1 2 3 4 5

Share A 30 28 34
32 31

Share B 26 13 48
11 57

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Which share would you like to invest
in?
 
You would say the share that gives a
better average return would be the
better share … correct

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Fine but there is one hitch

 
Both the shares have the same
average return of 31%

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Now What
•We have to search for some other
criterion for investment
•We now see which of the two
shares are a more riskier proposal.
•By simple observance it is seen that
returns on B fluctuate more widely
than A

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an hence a prudent investor would prefer
A.
Why?

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Because he perceives A to be less
riskier than B .
Thus an investor would evaluate both
return and risk to arrive at an
investment decision.
 

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How Risky Is Risk

How do we evaluate the riskiness of a

particular return or how do we measure
risk.
 
A common measure is Standard Deviation
and Variance of returns,
 

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 The mean of the squared deviations of
each member of a population from the
population mean. The square of the
population standard deviation.

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We tend to associate investment
risk with the variability of the rate
of returns .
 The standard deviation is one

method by which the variability of

returns may be calculated

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Time Period Return

 1                                           10
 2                                           8
 3                                           -4
 4                                           22
 5                                           8
 6                                           -11
 7                                           14
 8                                           12
 9                                           -9
 10                                      12
 

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 The simple average of the returns
are
 
10+8-4+22+8-11+14+12-9+12
--------------------------------------
10
= 6.20
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 Now standard deviation is the root
of the squares of the deviations
from the mean and is given by the
following formula
 


1
------(x-–Х)2
n -1
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The square of the standard deviation
is called the variance
 
From the information given above
the variance will be

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1/9{(10-6.2)^2 +(8-6.2)^2+(-4-
6.2)^2+(22-6.2)^2+(8-6.2)^2+(-
11-6.2)^2+(14-6.2)^2+(12-
6.2)^2+(-9-6.2)^2+(12-6.2)^2
 
=1/9 (1029.6)
=114.4

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Now the square root of the variance
is the standard deviation
 
Hence

S= (114.4)
= 10.7

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The standard deviation gives us a measure of total
risk
But as we shall see later risk has two components
systematic risk and unsystematic risk
Or
Total risk = systematic risk + unsystematic risk
 or also
 Total Risk = non diversifiable + diversifiable risks
 
 

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Risk in a Traditional Sense

 
Risk in holding securities is generally associated
with the possibility
•that realized returns will be less than the
returns that were expected.
•The source of such disappointment is the
failure of dividends (interest) and/or the
security's price to materialize as
expected.
 

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Forces that contribute to variations
in return-price or dividend
(interest)-constitute elements of
risk.
These forces are categorised into
two parts for the purpose of
ascertaining risk

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•Some influences are external to the
firm, cannot be controlled, and
affect large numbers of securities.
•Other influences are internal to the
firm and are controllable to a large
degree.

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systematic &
unsystematic risk.
In investments, those forces that are
uncontrollable, external, and broad in
their effect are called sources of
systematic risk.
Conversely, controllable, internal factors
somewhat peculiar to industries and/or
firms are referred to as sources of
unsystematic risk.
 
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Systematic risk refers to that portion of total
variability in return caused by factors affecting
the prices of all securities.
Economic,
political,
and sociological changes
are sources of systematic risk.
Their effect is to cause prices of nearly all-
individual common stocks and/or all individual
bonds to move together in the same manner.

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•Unsystematic risk is the portion of total
risk that is unique to a firm or industry.
•Factors such as management capability,
consumer preferences, and labor strikes
cause systematic variability of returns in
a firm.
•Unsystematic factors are largely
independent of factors affecting
securities markets in general.
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A Brief Review of different
types of Risks

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Sources of Risk

The principle sources of risk which concern

Investors and regulators.
 Credit Risk
 Settlement Risk
 Market Risk
 Other Risks
 
 
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 Credit Risk
The risk of a trading partner not fulfilling his obligations in
full on due date or at any time thereafter is a risk that affects
all aspects of business. Among the risks that face financial
institutions, credit risk is the one with which we are most
familiar. It is also the risk to which supervisors of financial
institutions pay the closest attention because it has been the
risk most likely to cause a bank to fail.
credit risk is not equal to the principal amount of the trade,
but rather to the cost of replacing the contract if the
counterparty defaults. This replacement value fluctuates over
time and is made up of current replacement and potential
replacement costs.
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 Market Risk
This
  is the risk to an institution's financial condition resulting from adverse
movements in the level or volatility of market prices of interest rate
instruments, equities, commodities and currencies. Market risk is usually
measured as the potential gain/loss in a position/portfolio that is
associated with a price movement of a given probability over a specified
time horizon. This is typically known as value-at-risk (VAR). An institution
with a 10-day VAR of $100 million at 99% confidence will suffer a loss in
excess of $100 million in one fortnightly period out of 20, and then only if it
is unable to take any action to mitigate its loss

•Finding stock prices falling from time to time while a company's

earnings are rising, and vice versa, is not uncommon.

•Variability in return on most common stocks that is due to basic

sweeping changes in investor expectations is referred to as market
risk.
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 Settlement Risk
Settlement risk is the risk that a settlement in a transfer
system does not take place as expected. Generally, this
happens because one party defaults on its clearing obligations
to one or more counterparties. As such, settlement risk
comprises both credit and liquidity risks. The former arises
when a counterparty cannot meet an obligation for full value
on due date and thereafter because it is insolvent. Liquidity
risk refers to the risk that a counterparty will not settle for full
value at due date but could do so at some unspecified time
thereafter; causing the party which did not receive its
expected payment to finance the shortfall at short notice.
Sometimes a counterparty may withhold payment even if it is
not insolvent (causing the original party to scramble around
for funds), so liquidity risk can be present without being
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 Other Risks
Interest - Rate Risk
 
Interest-rate risk refers to the uncertainty of future market values
and of the size of future income, caused by fluctuations in the general
level of interest rates.
The root cause of interest-rate risk lies in the fact that,
 
as the rate of interest paid on government securities rises or falls, the
rates of return demanded on alternative investment vehicles, such as
stocks and bonds issues in the private sector, rise or fall

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Purchasing-Power Risk (Inflation)
 
. Purchasing-power risk is the uncertainty of the purchasing power of the amounts to
be received.
In more everyday terms, purchasing-power risk refers to the impact of inflation or
deflation on an investment.
 

•Investment is the postponement of consumption,

•If during the holding period, prices on desired goods and services rise, the
investor actually loses purchasing power.

•Rising prices on goods and services are normally associated with what is
referred to a inflation.

•Falling prices on goods and services are termed deflation.

•Both inflation and deflation are covered in the all-encompassing term
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 Business Risk
 
Business risk is a function of
the operating conditions faced by a firm
and the variability these conditions inject into operating income and expected
dividends.
To Illustrate
              if operating earnings could grow as much as 14 percent or as
little as 6 percent than a range of risk say from a high of 11 percent
to a low of 9 percent.
        The degree of variation from the expected trend would measure
business risk.
 
Business risk can be divided into two broad categories: external and internal. Each
firm has its own set of internal risks, and the degree to which it is successful in
coping with them is reflected in operating efficiency.

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 Financial Risk
 
. A firm with no debt financing has no financial risk.
 
        Financial risk is associated with the way in which a company
finances its activities.
        We usually gauge financial risk by looking at the capital
structure of a firm. The presence of borrowed money or debt in the
capital structure creates fixed payments in the form of interest that
must be sustained by the firm.

     

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 Some More Types Of Risk
 
1.    liquidity risk, which comes in two forms. Market
liquidity risk arises when a firm is unable to conclude
a large transaction in a particular instrument at
anything near the current market price. Funding
liquidity risk is defined as the inability to obtain funds
to meet cashflow obligations.
2.    legal risk, which is the risk that a transaction
proves unenforceable in law or because it has been
inadequately documented; and
3.    operational risk, i.e. the risk of unexpected losses
arising from deficiencies in a firm's management
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Unsystematic Risk
An element of price risk that can be largely
eliminated by diversification within an asset class.
In factor models estimated by regression
analysis, it is equal to the standard error. Also
called Security Specific Risk, Idiosyncratic Risk,
Unsystematic Risk.
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