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Risk & Return

Here are the steps to solve this problem: 1) Given returns over past 5 years: 14%, 12%, -8%, 25%, 2% 2) Convert returns to return relatives: 1.14, 1.12, 0.92, 1.25, 1.02 3) Calculate Cumulative Wealth Index: WI0 = 1 WI1 = 1.14 WI2 = 1.14 * 1.12 = 1.2768 WI3 = 1.2768 * 0.92 = 1.173936 WI4 = 1.173936 * 1.25 = 1.467920 WI5 = 1.4

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Rahul Kukreja
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82 views34 pages

Risk & Return

Here are the steps to solve this problem: 1) Given returns over past 5 years: 14%, 12%, -8%, 25%, 2% 2) Convert returns to return relatives: 1.14, 1.12, 0.92, 1.25, 1.02 3) Calculate Cumulative Wealth Index: WI0 = 1 WI1 = 1.14 WI2 = 1.14 * 1.12 = 1.2768 WI3 = 1.2768 * 0.92 = 1.173936 WI4 = 1.173936 * 1.25 = 1.467920 WI5 = 1.4

Uploaded by

Rahul Kukreja
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Risk and Return

SAPM
Module I
MBA SEM III
Dr. Mayur Rao
Return
 Primary motivating force that drives investment
 It represents reward for undertaking investment
 Current Return
 Is the periodic cash flow, such as dividends or interest
generated by investment
 Capital Return
 Is reflected in price change, appreciation or depreciation in
price
 Total return = Current Return + Capital Return

2
Risk
 Risk refers to the possibility that the actual
outcome of an investment will differ from its
expected outcome
 Sources of risk:-
 Business risk: risk of poor business performance due
to competition, technological changes, substitute
products, consumer preferences, supply changes etc
 Interest rate risk: As interest rate goes up, the
market prices of existing fixed income securities
will go down and vice versa.
 Market risk: Prices of equity shares fluctuate widely
majorly due to change in sentiment.

3
Sources of Risk

 Business Risk
 Interest Rate Risk
 Market Risk
Types of Risk
 Total Risk = Unique Risk + Market Risk
(As per Modern portfolio Theory)

[A] Systematic Risk


1. Market Risk
2. Interest rate Risk
3. Purchasing Power Risk

[B] Unsystematic Risk


1. Business Risk
 Internal Business Risk like Sales fluctuation, H.R., Cost etc
 External Business Risk like Social, Regulatory, Political etc
2. Financial Risk
 Associated with capital structure
Risk Cont…
 Types of Risk:
Total risk = Unique Risk + Market Risk
Or
Total Risk = Unsystematic Risk + Systematic Risk
 Unique Risk:
 It represents that portion of total risk which stems from
firm-specific factors like development of new product,
labour strike, emergence of competitor etc
 Unique risk can be compensated by combination of other
stocks called diversification
 Market Risk:
 It is that portion of risk which is attributable to economy-
wide factors like growth rate of GDP, level of government
spending, money supply, interest rate structure, inflation
etc.
6
 These factors affect all the firms in an economy to
certain degree, this risk cannot be avoided
Managing Risk
 The ways to manage the risk include attempt
to control potential damage , diffuse,
diversify and transfer risk to those willing to
accept it.
 One can manage the risk by transferring it to
another party who is willing to assume risk.
Insurance company does not do anything to
contain the risk per se but assume risk on
your behalf.
 Management of risk through derivatives
commonly referred as hedging which enable
offsetting of risk emerging from one
situation.
Risk Measurement
 Measurements cannot be cent percent
accurate because risk is caused by
numerous macro factors Measurement
provides an approximate quantification of
risk.
 Ex- post Risk (Past Returns)
 Ex- ante Risk (Future Returns)
 Standard Deviation
 Characteristic Regression Line (CRL)
Characteristic Regression Line
 Measures diversifiable and undiversifiable
risk. CRL is a simple linear regression model
estimated for a particular stock against the
market index return.
Ri= αi +βi Rm + ei

 Ri= Return of the ith stocks


 αi =Intercept
 βi =Slope of the ith stock
 Rm =Return of the market
index
 ei =the Error term
 The security return is
 Today’s security return=
(Todays’ Price – Yesterday’s Price) x 100
Yesterday’s Price

 Today’s market return=


(Todays’ Index – Yesterday’s Index) x 100
Yesterday’s Index
Measuring Historical Return

 Example: Price at the beginning of the


year, Rs. 60, Dividend paid at the end of
the year Rs. 2.40, Price at the end of the
year Rs. 69

Chapter 4 Prassana Chandra 11


Historical return cont…
 Return Relative:
 This is used when we want to measure
Cumulative Wealth Index or Geometric Mean,
because negative value cannot be used in
calculation of these
 Put differently, RR = 1+ total return in decimals
 So, return relative will not be negative, it least
can be zero

Chapter 4 Prassana Chandra 12


Historical return cont…

 Cumulative Wealth Index


 It is more useful in measuring level of wealth, rather
than change in level of wealth
 It captures cumulative effect of total returns

 WI0 is taken as 1 and R1,R2,Rn etc are taken in decimals


 If a stock has given returns like, 14%, 12%, -8%, 25% and
2% over the period of 5 years, then

13
Historical Return Cont…

 Summary Statistics:
 Arithmetic Mean gives the central tendency of a series
of data (here series of returns). It represents the typical
performance of a single period
 Geometric Mean gives average compound rate of growth
that has actually occurred over multiple period

14
Historical Return Cont…

 CAGR:
 Compounded Annual Growth Rate

Chapter 4 Prassana Chandra 15


Historical Return Cont…

 Arithmetic Mean Vs Geometric Mean


 In real world, focus is more on central
tendency, hence AM is used more

Chapter 4 Prassana Chandra 16


Measuring Historical Risk

 Risk refers to the possibility that the actual outcome


of an investment will differ from the expected
outcome
 Variance and Standard Deviation are common
measures of risk
 They are defined as follows:

17
Measuring Historical Risk…

 Criticism of Variance (and Std. Dev.) as a


measure of risk:
 All deviations are considered, positive as well as
negative. However investors do not view positive
deviation as risk. If the assumption of symmetric
distribution of return is valid, then it is okay
 If probability distribution is not symmetrical, then
skewness of the distribution should also be used.

Chapter 4 Prassana Chandra 18


Measuring Historical Risk…

 Rationale for Standard Deviation


 For normally distributed variable, its
mean and std. dev. contain all the
information
 Its analysis is very easy
Probability Distribution

Chapter 4 Prassana Chandra 19


Measuring Mean:
Scenario or Subjective Returns

Subjective returns
E(r) = ∑ p(s ) r(s )
s
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states
Measuring Variance or
Dispersion of Returns
Subjective or Scenario
Variance = ∑ p(s ) [rs - E(r)]2
s
Standard deviation = [variance]1/2
Rates of Return: Single Period

HPR  P P D
1 0 1

P 0

HPR = Holding Period Return


P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one
Q1.
Compute expected Return and Standard
Deviation
State Prob. of State r in State
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
Solution- Q1

E(r) = (.1)(-.05) + (.2)(.05)...+


(.1)(.35)

E(r) = .15

Irwin/Mc
Graw-Hill
P(s) r(s) [r(s) – E (r ) ] [r(s) – E (r ∑P(s) [r(s) – E (r )]2
)]2

0.1 -0.05 -0.2 0.04 0.004


0.2 0.05 -0.1 0.01 0.002
0.4 0.15 0 0 0
0.2 0.25 0.1 0.01 0.002
0.1 0.35 0.2 0.04 0.004

Variance Total 0.012


0.1095
Q2 – Find Return

Ending Price = 48
Beginning Price = 40
Dividend = 2
Solution- Q2

 HPR = (48 - 40 + 2 )/ (40) = 25%

Irwin/Mc
Graw-Hill
Q3. Find out E(r) and б
(Po= 100 Rs.)
State of Probability Ending Dividend
Economy price
Boom 0.25 140 4
Normal 0.50 100 NIL
Growth
Recession 0.25 80 NIL
Q4. Find out E(r) and б

State of Beginni Ending Probabilit Dividen


Economy ng price Price y d (Rs)

Boom 250 310 1/3 4


Normal 250 250 1/3 4
Growth
Recession 250 175 1/3 4
(Extra Sums from Chandra)- 1A
 Calculate the Total Return as well as the
Return Relative for the three stocks

Stock Beginning Dividend Ending


Price Price Price

A 30 3.40 34

B 72 4.70 69

C 140 4.80 146


(Extra Sums from Chandra)- 1B
 During the Past five years, the returns of a stock
were as follows:
 Compute the following: (a)Cumulative Wealth
Index (b) Arithmetic Mean (c) Geometric Mean (d)
Variance (e) standard Deviation

Year Return
1 0.07
2 0.03
3 -0.09
4 0.06
5 0.10
(Extra Sums from Chandra)- 1C
 You are thinking of acquiring some shares of ABC
ltd. The rates of return expectations are as
follows:

Possible rate of Probability


return

0.05 0.20

0.10 0.40

0.08 0.10

0.11 0.30
(Extra Sums from Chandra)- 1D
 The total return of stock A over five year is as
follows: Calculate Arithmetic Mean, Geometric
Mean and

Year Total Return (%)


1 19

2 14

3 22

4 -12

5 5
Excess Returns, Risk Premiums &
Risk Aversion
 Risk Premium is the difference between expected
HPR on the index stock and the risk free rate.
 The difference in any particular period between the
actual rate of return on a risky asset and the risk
free rate is called excess return.
 The degree to which investors are willing to commit
funds to stocks depends on risk aversion. If the risk
premium were 0, people would not willing to invest
any money in stocks, then they are risk averse
investors

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