4.risk and return 2

8/8/2019 4.Risk and Return 2

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Risk and Return


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Risk

Look at the attributes of investments again by

adding 8% GOI Bonds

Compare with government securities orshares


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Evaluation

Return-

current

Return-

Capital returnRisk Liquidity Tax

breaks

Convenie

nce

Equity Low High High High M H H

MF Debt

schemesM L L H H Hh

Bank deposits M 0 Very low H 0,some Hh

PPF 0 M 0 Average/

low

80c Hh

LIC Policies 0 M Very low Averagelo

w

80c Hh

Res.House M M Negligible low H Average

Gold /silver 0 M average average 0 average


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Risk

How can we define risk?


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Risk

In the context of securities market, risk is

Possibility of an outcome which is different from

expected one

Risk = Variability


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Risk

Risk and Uncertainty

Technically different

Risk suggests that a decision maker knows the possible

consequences of a decision and their relative

likelihoods at the time he makes a decision

Uncertainty

Likelihood of future outcome is not known


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Risk

Forces that contribute to variations in return

i.e. in dividends or interest, are the sources of

risk

Some forces sources of risk

Non controllable = Systematic risk

Controllable to a great extent =Unsystematic risk

Total risk = Systematic risk + Unsystematic risk


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Types of risk

Systematic risk Unsystematic risk

Market risk Business risk

Interest rate risk Financial risk

Purchasing power risk


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Risk

Non-controllable risk = Systematic risk

Affects entire market

Market risk

Variability in securities returns due to basicsweeping changes in investors expectation

- Investors reaction to tangible events

- Political, economic, social events

- Investors reaction to intangible events

- Investor psychology, investors over reaction , herdmentality


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Risk

Interest rate risk Fluctuations in interest rates cause uncertainty and affect

market returns

more and quick effect is on bonds returns

Yields on Government securities change, so the yields on

other securities also change

As interest rates go up

Profitability of corporates come down

Cost of margin increases Bond prices come down


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Risk

Purchasing power risk (Inflation risk )

Investors buying power comes down with rise in

inflation


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Risk

Unsystematic risk = Affects a particular

industry / company

Generally controllable


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Business Risk

Related to operations of business External ( result of operating conditions imposed

upon the firm by circumstances beyond its control)

Regulation of industry, local laws ,change in customerspreferences, cut in defense budget, demographic changes

Internal risk ( the efficiency with which a firmconducts operations within broader environmentimposed on it)

Labour relations

Downward trend in sales

Failure of R & D

Dependence on single product


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Risk

Financial risk

Use of leverage or use of debt in capital structure

to increase return

Leverage helps in good times but can be

dangerous in bad times


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Financial leverage

2005-06 2006-7 2007-8

ABC Ltd.

Equity

(Rs.10 face value)

20,00,000 20,00,000 20,00,000

Debt ( cost 10%pa) 10,00,000 10,00,000 10,00,000

Operating income 3,00,000 4,00,000 2,00,000

EPS 1.00 1.5 0.5

XYZ Ltd.

Equity

(Rs.10 face value)

10,00,000 10,00,000 10,00,000

Debt ( cost 10%pa) 20,00,000 20,00,000 20,00,000

Operating income 3,00,000 4,00,000 2,00,000

EPS 1.0 2.0 0.0


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Measuring risk No variability = No risk Historical risk

Variance = Sum of ( Ri-Rm)^2 / n-1

Sum Ri = 60,Rm = 60 / 6 =10, Sum of square of deviations = 536

Variance = 536 / 5 = 10.4 , Std. Deviation = 3.22

Year Return (%)

Ri

Deviation

(Ri-Rm)

Square of

deviation

1 15 5 25

2 12 2 4

3 20 10 100

4 -10 -20 400

5 14 4 16

6 9 -1 1


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Measuring risk

Future risk

A company may give returns of 10,15 and 20%

next year . Probability of these returns is 20 , 30 and 50%

respectively.

How risky is the company? Measure standard

deviation?


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Clue

Variance of probability distribution = sum of

squares of deviations ,weighted by associated

probabilities

Deviations from what? Deviations from

expected rate of return.

How to compute expected rate of return?

Sum of Pi * Ri

Now compute variance, and std. deviation


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Measuring risk

Variance = Sum Pi (Ri E(R))^2

Pi = 0.2,0.3 and 0.5

Ri = 10,15 and 20 %

E(R) = 0.2 *10 + 0.3*15 + 0.5* 20=2.0 + 4.5 + 10 = 16.5

R1-E(r) = 10 - 16.5 = - 6.5, (R1-E(r) )^2 = ( 6.5)^2 = 39

R2 E(r) = 15 16.5 = -1.5, (R2 E(r) ) ^2 = (1.5)^2 = 2.25

R3 E

( r ) = 20 16.5 = 3.5, (R3 E

( r ) ^2 = (3.5)^2 =12.25V = Sum Pi (Ri E(R))^2 = (0.2 *39) + (0.3 * 2.25) + (0.5*12.25) = 14.60

Std. Devn = V^1/2 = 3.8


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Apply your mind

The returns on Securities A and B are given below along with

probabilities.

On the basis of risk and return which one will be your choice

of investment?Probability A Ltd.

(%)

B Lt

(%)

0.5 4 0

0.4 2 3

0.1 0 3


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E(r) = P1r1 + P2r2 +P3r3

E ( Ra) = 2.8

E ( Rb) = 1.5 Std. deviation = (Sum of ( Pi ( Ri E ( r ))^2)^1/2


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Security A

Ri Pi ( Ri- E ( r ) )^2 Pi ( ri E ( r ) )^2

4 0.5 (4 2.8)^2 = 1.44 0.720

2 0.4 ( 2.00- 2.8)^2 =

0.64

0.256

0 0.1 ( 0.00- 2.8)^2 =

7.84

0.784

1.76

Security B

Ri Pi ( Ri- E ( r ) ) 2 Pi ( ri E ( r ) )^2

0 0.5 (0 1.5) ^2 = 2.25 1.125

3 0.4 ( 3- 1.5) ^2 = 2.25 0.9

3 0.1 ( 3-1.5)^2 = 2.25 0.225

2.25


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Security A

Return = 2.8

Std deviation = ( 1.76) ^1/2 = 1.33

Security B

Return = 1.5

Std deviation = ( 1.76) ^1/2 = 1.5

A is better choice.


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Pick your choice

Security

A

Security

A

Security

B

Security

B

Security

C

Security

C

Security

D

Security

D

Return Probability Return Probability Return Probability Return Probability

-30 20 -20 15 -20 20 -10 10

0 40 0 35 10 40 0 25

30 30 20 45 40 30 10 40

70 10 40 5 80 10 20 25


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Pick your choice

Find out expected return for each security.

.1,.08,.2,.08

Find out variance for each security. Make your choice.

4.risk and return 2

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