Unit 3

Risk and Return
Learning Outcomes
At the end of this chapter, you should be able to:

 Understand the relationship between risk and return.
 Identify how risk is measured and quantified, and perform
the computations.
 Explain the various types of risk that a finance manager
and an investor face.
 Determine how a portfolio can be used to diversify risks
 Explain the Modern Portfolio Theory
 Explain asset pricing models like the Capital Asset Pricing
model and the Arbitrage Pricing Theory
Financial Management Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 8– 3
Risk and Return
 For a manager of funds, the main job is to be able to invest

money to obtain appropriate rate of return.
 The rate of return on an asset may be defined as follows:
Annual Income + (Ending Price  Beginning Price)/
Beginning Price
 It is also well understood that the possible returns on an
investment is linked to the risk inherent in the investment.
Modern financial theory has enabled us to look at this
relationship in a more systematic manner. It helps us to make
meaningful deductions from the data that is available from the
Stock and Bond Markets.

Risk and Return (cont.)
 We look at comparison of returns between risky and risk free assets in

various countries.
 This graph shows the values of various stock indices in various countries:

 This graph shows the value of Treasury Bill rates of

various countries over time:

 Comparison of returns:
 While the return for the investment in the stock indices were high,
an investment made 2007 would have been at a loss in 2009.

Risk Aversion and Utility
 Risk averse behaviour is the tendency of a person

to reject a bargain with an uncertain payoff and
accept another bargain with a more certain, but
possibly, a lower expected payoff
 Risk loving behaviour of an investor is the
willingness to take on additional risk for an
investment that has a relatively low expected return
 Risk neutral people judge risky investments by
their expected rates of return.

Risk Aversion and Utility (cont.)

The Measurement of Risk
 In the case of risk of investment in shares, the

risk concerned is typically measured by the
standard deviation (σ) of returns of a share,
calculated using either historical returns or the
expected future returns.

Example using probability

Solution
 Mean return of share A

(0.05 x (-10)) + (0.25 x 15) + (0.30 x 20) + (0.35 x 25) + (0.05 x 30)=19.5%
 Mean return of share B
(0.05 x 20) + (0.25 x (-5))+ (0.30 x 26) + (0.35 x 32) + (0.05 x 38)= 20.65%
 Standard deviation of return in share A
√[0.05 x (- 10 -19.5)2] + [0.25 x (- 10 -19.5)2] + [0.30 x (20-19.5)2 ]+[0.35 X (25 -19.5)2 ] + [0.5 X
(30 - 1 9.5)2 ]= 8.05 %
 Standard deviation of return in share B
√[0.05 x (20 - 20.65)2 ] + [0.25 x (-5 - 20.65)2 ] + [0.30 x (26 - 20.65) 2 ]+[0.35 x (32 - 20.65)2 ]+
[0.5 x (38-20.65)2 ]
= √233.23 = 15.27%
 note that while share B has a slightly higher mean return compared with share A, it also has a
correspondingly higher level of risk as evidenced by the higher standard deviation on the return of
share B.

Example using historical data
 Refer pdf file

Managing Risks
Some of the risks faced by any business are:

regulatory and policy risk (These kinds of policies are
not necessarily permanent and can be changed or modified
as per the wishes of the regulator or the government.)
sales risk (The possibility of low sales is known as sales
risk.)
project risk (It usually needs items to be procured from
various vendors, and in a specified period of time for the
timely execution of the project.)

Risks Concerning the Finance
Manager
There are some risks that concern mainly the

finance manager. These risks include:
cash flow risk
capital structure risk
default risk
re-investment risk
interest-rate risk

Manager

Manager

Concept of Portfolio
 An investment in a single asset is subject to all the risks

associated with that, and only that asset.
 Consider an investment that consists of only the stock
issued by one company. If that company's stock suffers a
serious downturn, the investment will sustain the full brunt
of the decline.
 However, by splitting the investment between the stocks
of two different companies, you reduce the potential risk to
your investments, which is now in a portfolio. Thus
diversification is used to create a portfolio that includes
multiple investments in order to reduce risk.

Concept of Portfolio (cont.)
 Decreasing risk via portfolio creation can be simply

described as an application of the old saying ‘do not put
all your eggs in the same basket’.
 Risks can be divided into:
– Systematic risks are market risks that cannot be
reduced by diversification. Recessions and wars are
some examples of systematic risks
– Unsystematic risk is specific to individual security and
can be diversified away as you increase the number
of securities in your portfolio

Modern Portfolio Theory (MPT)
 Modern Portfolio Theory (MPT) is one of the

most important and influential economic
theories dealing with finance and investment. It
was developed by Harry Markowitz and
published under the title "Portfolio Selection" in
the 1952 Journal of Finance.
 MPT quantifies the benefits of diversification.

(cont.)
 If we have data for a collection of securities, we plot a
graph of the return rates and standard deviations for
these securities. We do the plot for all possible
portfolios you can get by allocating among them, we get
a graph as shown below:

(cont.)
 From the graph, you get a region bounded by

an upward-sloping curve, which he called the
efficient frontier.
 Thus, for a given amount of risk, the portfolio
lying on the efficient frontier represents the
combination offering the best possible return.

Ways of Measuring Risks
 In relation to investments, the standard deviation is

used to measure a security or a portfolio’s volatility,
which means the tendency of the returns to rise or fall
in a period of time. A security that is volatile is also
high risk because its performance may change fast.
 The standard deviation of a security or portfolio
measures this risk by measuring the degree to which
the security or portfolio fluctuates in relation to its
average return or the arithmetic mean of the
security/portfolio.

Ways of Measuring Risks (cont.)
 Beta, is another useful measure of risk and it

determines the volatility, or risk, of a stock or fund in
comparison to that of an index or benchmark.
– A stock with a beta very close to 1 means the fund's
performance closely matches the index or benchmark.
– A beta greater than 1 indicates greater volatility than
the overall market.
– A beta less than 1 indicates less volatility than the
benchmark.

Capital Asset Pricing Model
(CAPM)
What it does:
Helps investors identify the asset they should
invest in
Clarifies what risk is rewarded and what is not
Helps ascertain what can be the kind of return
that an investor can expect from an asset

CAPM—Assumptions
 The CAPM model is a ceteris paribus model. It is

only valid within a special set of assumptions.
They are:
o Investors have an identical holding period, which
means all of them contemplate an identical time
horizon for the investment. This feature is also
referred to as a “one period model”.
o Investors are risk-averse individuals who maximize
the expected utility at their end of period.

CAPM—Assumptions (cont.)
 Investors have homogenous expectations (beliefs) about asset

returns, i.e. the way they measure risk and returns is the same
and all of them have the same efficient frontier.
 The conditions of perfect capital market prevail.
 There exists a risk-free asset and investors may borrow or
lend unlimited amounts of this asset at a constant rate: the risk
free rate (kf).
 There are a definite number of assets and their quantities are
fixed within the one period world.
 There is no restriction like regulation and taxes which impede
or hinder trade and make it expensive.

CAPM—Deducing Intuitionally
 If we reflect a little on the assumptions of CAPM, it is

intuitively possible to arrive at the conclusions. The
assumptions imply that everyone has the same assets to
choose from. They also have the same information about
them at any given point of time.
 Further, there is the assumption about all people being risk
averse and also maximizing their utility.
 The availability of the risk-free asset from which anyone can
borrow or invest in unlimited amounts allows the investor a
huge amount of latitude to fulfill their need for investing in
certain securities as and when they want to.

CAPM—Deducing intuitionally
(cont.)
 This means that everyone uses the same

methods to analyze their investments, have the
same thought process to arrive at decisions and
has the similar resources to execute their
desire. The result of the above would be that
everyone holds the same portfolio.
 This portfolio is known as the market portfolio
M.

CAPM—Formula

Arbitrage Pricing Theory (APT)
 The Arbitrage Pricing Theory (APT) was

developed by economist Stephen Ross in 1976.
 The basis of APT is the idea that the price of a
security is driven by a number of factors. These
can be divided into two groups: Macro factors,
and factors specific to that asset.

APT (cont.)
 The formula is derived as the following:
r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅

Where:
r = expected return on the security,
rf = risk free rate
 Each f is a separate factor and each β is a measure of the

relationship between the security price and that factor or
is the β (similar to the beta of CAPM) of each factor.

APT (cont.)
 APT states that the expected risk premium on a

stock should depend on the expected risk
premium associated with each factor and the
stock’s sensitivity to each of these factors.
 The theory does not specify what these factors
are; it could be oil price, price of commodities,
or interest rates.

THANK YOU


Unit 3

Uploaded by

Copyright:

Available Formats

Unit 3

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Unit 3

Uploaded by

Copyright:

Available Formats

Risk and Return

At the end of this chapter, you should be able to:

Financial Management Third Edition All Rights Reserved

 For a manager of funds, the main job is to be able to invest

Financial Management Third Edition All Rights Reserved

 We look at comparison of returns between risky and risk free assets in

Financial Management Third Edition All Rights Reserved

 This graph shows the value of Treasury Bill rates of

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Risk averse behaviour is the tendency of a person

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 In the case of risk of investment in shares, the

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 Mean return of share A

Financial Management Third Edition All Rights Reserved

 Refer pdf file

Financial Management Third Edition All Rights Reserved

Some of the risks faced by any business are:

Financial Management Third Edition All Rights Reserved

There are some risks that concern mainly the

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 An investment in a single asset is subject to all the risks

Financial Management Third Edition All Rights Reserved

 Decreasing risk via portfolio creation can be simply

Financial Management Third Edition All Rights Reserved

 Modern Portfolio Theory (MPT) is one of the

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 From the graph, you get a region bounded by

Financial Management Third Edition All Rights Reserved

 In relation to investments, the standard deviation is

Financial Management Third Edition All Rights Reserved

 Beta, is another useful measure of risk and it

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 The CAPM model is a ceteris paribus model. It is

Financial Management Third Edition All Rights Reserved

 Investors have homogenous expectations (beliefs) about asset

Financial Management Third Edition All Rights Reserved

 If we reflect a little on the assumptions of CAPM, it is

Financial Management Third Edition All Rights Reserved

 This means that everyone uses the same

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

 The Arbitrage Pricing Theory (APT) was

Financial Management Third Edition All Rights Reserved

 The formula is derived as the following:

r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅

 Each f is a separate factor and each β is a measure of the

Financial Management Third Edition All Rights Reserved

 APT states that the expected risk premium on a

Financial Management Third Edition All Rights Reserved

Financial Management Third Edition All Rights Reserved

You might also like