FINANCIAL

MANAGEMENT- RISK
AND RETURN
Course Details: Faculty: Prof CA Manasi Gokhale

Semester: I
Course Code: SLFI 501
Credit: 3
Sessions:33
RISK AND RETURN
 Measure of Risk and Return of Single Asset.

 Measure of Risk and Return of a Two Asset Portfolio.

 Discuss the relationship between Risk and Return as per Capital Asset

Pricing Model(CAPM).

 Estimate the beta (β) of a security.

RISK AND RETURN TRADE-
OFF
 Financial Assets are expected to generate cash flows.

 The riskiness of the financial assets is measured in terms of variability of

the cash flows ( returns) from the expected returns ( Cash flows).
 Higher expected variability in cash flows would require a higher expected
return from the assets by the Investors.
 Theoretically, ‘Certainty Equivalent’ (CE) will determine the risk appetite of
the Investors.
 CE < Expected risky return – Risk averse

 CE = Expected risky return – Risk neutral

 CE > Expected risky return – Risk-taker

COMPUTATION OF RETURNS FROM
AN ASSET
 Calculating Historical Returns ( returns already earned) from an asset

I invested in equity stock when the stock price was Rs 60/- . At the end of
the year the price of the stock is Rs 69 and the dividend paid on the stock is
Rs 2.40. Calculate the total return earned on this stock.

 Calculating Expected Return from an asset.

The range of returns from an security under four equally likely possible
states of economic conditions are given. Calculate the Expected Return from
the said security.
MEASURING RISK
 Risk associated with returns from a security can be measured in terms of variability

of returns expected from the security(asset).

 The variability of rates of return may be defined as the extent of the deviations ( or

dispersions) of the individual rates of returns from the average rate of return.

 Two measures of dispersion : Variance and Standard Deviation and Standard

deviation is square root of variance.

 For the earlier example calculate the standard deviation of Returns or expected risk.
EXPECTED RETURN
Economic Rate of Probability Expected
Conditions (1) Return (%) (3) Rate of
(2) Return
Growth 18.5 0.25
Expansion 10.5 0.25
Stagnation 1 0.25
Decline -6 0.25

The expected Rate of return is sum of expected rate of return under

all the possible state of outcomes i.e ( 4.625+2.625+0.25+(-1.5)) =
6%
EXAMPLE EXPECTED
RETURN AND RISK
 The shares of hypothetical company limited has the following anticipated
returns with associated probabilities. Calculate the expected return and
expected risk.
Return
(%) Probability
-20 0.05
-10 0.1
10 0.2
15 0.25
20 0.2
25 0.15
30 0.05
EXAMPLES (PRASANNA
CHANDRA)
 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 1.00. You expect the price per share of MVM stock a year hence to
have a probability distribution as follows
Price a year hence Rs 10 Rs11 Rs 12
Probability 0.4 0.4 0.2
a) What is the expected price per share a year hence?
b) What is the expected rate of return?
CALCULATING EXPECTED RETURN
FOR 2- ASSET PORTFOLIO
 The return of a portfolio is equal to weighted average of the returns of
individual assets ( or securities) in the portfolio. Weights are taken as equal
to the proportion of investment value in each asset.
 Suppose you have opportunity of investing your wealth in assets X and Y
and you decide to invest 50% of your wealth in X and 50% in Y . What is
the expected rate of return on a portfolio consisting of both X and Y? How
can I increase my expected Return from this portfolio?
Returns ( R ) %
State of Probability
Economy X Y
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20
2-ASSET PORTFOLIO-
EXPECTED RETURN
 Consider returns from following 2 assets:
 Calculate expected return and expected risk for each of the asset.
 Calculate the expected return from the portfolio if you are investing equally
in A and B.

Returns ( R ) %
Economic
condition
Probability A B
Good 0.5 40 0
Bad 0.5 0 40
MEASURING RISK FOR 2- ASSET
PORTFOLIO
 The portfolio variance or standard deviation depends on the co-movement
of returns on two assets.
 Covariance of returns on two assets measures their co-movement.
 Variance of 2-Asset portfolio includes the proportionate variances of
individual security and the covariance of the securities
 Formula for Covariance = SD X * SD Y * CorrelationXY
 Correlation is a measure of linear relationship between two variables.
 Variance of Portfolio

 σ2 P = (σ 2X *W2X) + (σ2 Y* W2 Y) + 2*WX* WY* COV

xy

 COV = σX* σY* Corr

xy XY
MEASURING RISK FOR 2-
ASSET PORTFOLIO
 Securities M and N are equally risky, but they have different expected
returns. From the information given below calculate the expected return on
the portfolio. Also calculate the portfolio risk if Corrmn is
 a) + 1.0 b) -1.0 c) 0.0 d) + 0.10 e) -0.10

Particulars M N
Expected Returns
(%) 16 24

Weight 50% 50%

Standard
Deviation(%) 20 20
EXAMPLES (PRASANNA
CHANDRA)
 The stock of Alpha company performs well relative to other stocks during
recessionary periods. The stock of Beta Company on the other hand does
well during the growth periods. Both the stocks are currently selling for Rs
50 per share. The rupee return (dividend plus price change) of these stocks
for the next period would be as follows:

Economic Condition
High Low Stagnatio
growth growth n Recession

Probability 0.3 0.3 0.2 0.2

Return on Alpha
Stock 55 50 60 70
Return on Beta
Stock 75 65 50 40
EXAMPLES (PRASANNA
CHANDRA)
 Calculate the expected return and standard deviation of:

a) Rs 1000 in the equity stock of Alpha

b) Rs 1000 in the equity stock of Beta
c) Rs 500 in the equity stock of Alpha and Rs 500 in the equity stock of Beta
( home-work)
d) Rs 700 in the equity stock of Alpha and Rs 300 in the equity stock of Beta
CAPM MODEL TO CALCULATE THE REQUIRED
RETURN
 The CAPM model provides a framework to determine the required rate of return on
an asset and indicates the relationship between the return and risk of the asset.
 It helps in determining whether the asset is fairly valued
 Required Rate of return on security = Rf + β(Rm-Rf)
 ( Using CAPM method)
 Where
 Where Rf = Risk-free rate

 Β = Beta of the particular security

 (Rm-Rf) = compensation per unit of risk

 Beta * (Rm-Rf) = Risk premium

CAPM ASSUMPTIONS
 Investors are risk-averse

 Perfect markets: there are no taxes, no transaction costs, securities are

completely divisible, and the market is competitive.

 Investors can borrow and lend freely at a riskless rate of interest.

 Investors are risk-averse and prefer the highest expected returns for a

given level of risk.

 All investors have the same expectations about the expected returns and

risks of the securities.

MEASUREMENT OF BETA
 Market risk vs Unique Risk

 Total Risk = Unique Risk + Market Risk

 Unique Risk is firm specific and its diversifiable or unsystematic risk

 Market Risk is risk attributable to economy wide factors- Inflation, money supply, interest rate

structure and affects all the firms. It is referred to as systematic or non diversifiable risk.

 Contribution of Individual stock to the risk of well diversified portfolio is measured in terms of

its market risk

 Market risk of a security reflects its sensitivity to market movements.

MEASUREMENT OF BETA
 Market risk is measured in terms of Beta (β)
 Beta (β) measures the contribution of the security to the risk of the portfolio
 It reflects the sensitivity of the security to the market movements.
 The beta for the market portfolio is 1

 Beta (β) = Cov ( Rj Rm)/ σ 2m

 From the following data compute beta of security j

 Std deviation of J = 12%; Std deviation of m =9%; and Corr of j and m =+0.72
CAPM MODEL - EXAMPLES
 The risk free rate of return is 8% and the market rate of return is 17%. Betas for
four securities P,Q,R and S are respectively 0.60, 1.00,1.20 and -0.20. What are
the required rate of return on these four shares?
 If the risk free rate is 10%, the beta of security A is 1.25, return on market
portfolio is 14% and the expected rate of return on security A is 14.2%. Please
comment whether you should invest in security A?
 The risk-free return is 10% and the return on market portfolio is 15%. Stock A’s
beta is 1.5; its dividends and 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? ( Problem no 8.4, Prasanna Chandra).
 The risk-free return is 8%; and the expected return on market portfolio is 12%. If
the required rate of return on a stock is 15%. Calculate the Beta.( Problem no
8.5 Prasanna Chandra)
CAPM MODEL EXAMPLES
 The required return on market portfolio is 12%. The beta of stock X is 2.The
required return on stock is 18%.The expected dividend growth on stock X is
5%.The price per share of Stock X is Rs 30. What is the expected dividend
per share of stock X next year? What will be the combined effect of
following on the price per share of stock X?
 a) The inflation premium increases by 2%
 b) The decrease in the degree of risk aversion reduces the differential
between the return on market portfolio and the risk free return by 1/3rd
 c) The expected growth rate of dividend on the stock X decreases to 4%
 d) The beta of stock X falls to 1.8

( Problem 8.7 Prasanna Chandra)

SECURITY MARKET LINE
 It shows the relationship between Beta and the required rate of return from
the security.
 Higher the beta; higher the required rate of return

Stock Rate of Return Beta

A 12.50% 0.5

B 15.00% 1

C 17.50% 1.5
SECURITY MARKET LINE
Y
20.00%

18.00%
C
16.00%

14.00% B

12.00% A

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0.4 0.6 0.8 1 1.2 1.4 1.6