Risk and Return

Learning objectives:
1. Understand and measure the risk and return on financial asset.
2. Understand and measure the risk and return on a portfolio.
3. Distinguish between Market risk and unique risk (Systematic and Unsystematic
risk)
4. Understand and calculate the Beta of a security and factors affecting Beta.
2 Important Terminology and its
 meaning
Financial Risk
 Financial Portfolio
 Diversification
 Market risk(Systematic Risk)
 Diversifiable risk(Unsystematic Risk)
 Risk Aversion
 Beta
3 Risk and Return of a Portfolio
 1. A portfolio consists of two securities A and B. The expected return on these two
securities are 10% and 18% respectively. The expected return on the portfolio,
when the proportions invested in A and B are 0.4 and 0.6. Calculate the return on
the portfolio.
 2. Calculate the expected return and the standard deviation from the data given

State of the Probability Return on Return on Return on

economy stock A stock B Portfolio
1 0.20 15 -5

2 0.20 -5 15

3 0.20 5 25

4 0.20 35 5

5 0.20 25 35
 Risk associated with investment in
4
security Unique Market Risk/Systematic
Risk/Unsystematic Risk Risk
Meaning: Risk due to firm specific Risk which affects the
factors overall market due to
economic factors
Factors responsible: Labour strike, new Growth rate, Inflation rate,
competitor, change in Govt spending, change in
management the interest rate structure
Impact on portfolio: Can be reduced through Cannot be reduced
diversification through diversification(It
is also called as non-
diversifiable risk)
Tools for measuring: Variance and Standard Beta
deviation
Total Risk = Unique Risk + Market Risk
 Beta: β
5  The sensitivity of a security to market movements is called Beta.
 The beta for the market portfolio is 1.
 Stocks having a beta of higher than 1 will have greater fluctuation than the
market portfolio
 Stocks having a beta of lower than 1 will have lower fluctuation than the market
portfolio
 Formula for Beta = Covariance(R i,Rm)/Varaiance(Rm)

Security Market Line

The relation ship between risk and return which is linear in nature .
CAPM formula
Intercept: It represents the nominal rate of return on the risk free security.
Risk free real rate + Inflation rate
Slope: It represents the price per unit of risk. The slope changes when the risk
aversion of investors changes.
 Security market equilibrium
6
 When the expected rate of return is equal to the required rate of
return- Equilibrium
 When the expected rate of return is more than the required rate of
return- Security is undervalued : BUY
 When the expected rate of return is less than the required rate of
return- Security is overvalued :SELL
Example:
a) The Beta of Stock A is 1.25 and the treasury bill return is 10%. The market
portfolio return is 14%. Calculate the required return for stock A as per CAPM.
b) Investors expect that the earnings, dividends and price of the stock will continue
to grow at 6% per annum. The previous dividend paid was Rs. 1.70. The current
market price of the stock is Rs. 22.
What will you do as an investor if you are holding the stock? Why?
c) Find out the equilibrium price for stock A.
 Practice Questions:

7 1. The stock of Box Ltd. Performs well relative to other stocks during recessionary
periods. The stock of Cox Ltd. On the other hand, does well during growth periods. Both
the stocks are currently selling for Rs. 100 per share. You assess the rupee
return(dividend plus price) of these stocks for the next year as follows:
High growth Low growth stagnation Recession

Probabability 0.3 0.4 0.2 0.1

Return on Box’s 100 110 120 140

stock
1. k
Return on Cox’s 150 130 90 60
stock

Calculate the expected return and standard deviation of investing:

a) Rs. 1000 in the equity stock of Box ltd.
b) Rs. 1000 in the equity stock of Cox ltd.
c) Rs. 500 each in the equity stock of Box ltd. and Cox ltd.
8

2.Following information is provided:

Returns of T- Bill is 20% and return of Sensex is 28%. Calculate the return as per CAPM
for each of the company’s stock. Plot them on SML. Identify whether they are underpriced,
overpriced or correctly priced and advise accordingly.
Stock A B

Expected return 32% 27%

Beta 1.5 0.7

 3. The risk free rate of return is 9%. The expected rate of return on the market
9 portfolio is 13%. The expected rate of growth for the dividend of firm A is 7%. The
last dividend paid on the equity stock of firm A was Rs 2.00. The beta of firm A’s
equity stock is 1.2.
a) What is the equilibrium price of the equity stock of firm A?
b) How would the equilibrium price change when
(i) the inflation premium increases by 2%
(ii) the expected growth rate increases by 3% and
(iii) the beta of A’s equity rises to 1.3

4. You are considering purchasing the equity stock of MVM company. The current
price per share is Rs. 10. You expect the dividend a year hence to be Rs. 1 . You
expect eh price per share of MVM stock a year hence to have the following
probability distribution. What is the expected price per share a year hence?
Price after a Rs. 10 11 12
year
Probability 0.4 0.4 0.2
 5. The risk free return is 10% and the return on market portfolio is 15%.
10
Stock A’s beta is 1.5, its dividends an earnings are expected to grow at the
constant rate of 8%. If the previous dividend per share of stock A was Rs.
2, what should be the intrinsic value per share of stock A?

6. The risk free rate of return is 8% and the expected return on a market
portfolio is 12%. If the required return on a stock is 15%, what is its beta?

7. The risk free return is 9%. The required return on a stock whose beta is
1.5 is 15%. What is the expected return on the market portfolio?