Financial Management I

5. Introduction to Risk and Return

Dr. Suresh
suresh.suralkar@gmail.com
Phone: 40434399, 25783850

Course Content - Syllabus
*Book preference
Sr Title ICMR Ch. PC Ch. IMP Ch.
1 Introduction to Financial Management 1* 1 1
2 Overview of Financial Markets 2* 2 -
3 Sources of Long-Term Finance 10* 17 20, 21
4 Raising Long-term Finance - 18* 20, 21, 23
5 Introduction to Risk and Return 4* 8, 9 4, 5
6 Time Value of Money
7 Valuation of Securities
8 Cost of Capital
9 Basics of Capital Expenditure Decisions
10 Analysis of Project Cash Flows
11
Risk Analysis and Optimal Capital
Expenditure Decision
2 / 59

3 / 59
Introduction to Risk and Return
Reference Books
1. Financial Management, ICMR Book, Chapter 4
2. Financial Management, Prasanna Chandra, 7th
Edition, Chapter 8, 9
3. Financial Management, I. M. Pandey, 9th Edition,
Chapter 4, 5

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Syllabus Introduction to Risk and Return
1. Risk and Return Concepts
2. Risk in a Portfolio Context
3. Relationship between Risk and Return
4. CAPM

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Introduction

While making the decisions regarding financing and

investment, the finance manager seeks to achieve the
right balance between risk and return, in order to
optimize the value of the firm.

Return and risk go together in investments.

Every investor wants minimum or no risk. Government

bonds are risk-free but offer less returns.

High risk investments e.g. equity can give more returns

Question: How to measure risk and returns?

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1. Risk and Return Concepts

Objective of any investor is to maximize expected returns

from his investments, with minimum risk.

Importance of returns as follows

It enables investors to compare alternative

investments possible

Measurement of historical returns show the past

performance

Measurement of historical returns help in

estimation of future returns

Returns are of two types: Historical returns and expected

returns.

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1. Risk and Return Concepts

Historical Returns (Realized returns): Also called as ex-

post (after the fact) returns.

Expected Returns (Future returns): Also called as ex-

ante or anticipated returns. The expected returns are
subjected to uncertainty or risk hence the component of
probability is attached to it.

Components of Returns

Periodic receipts or income on the investment in the

form of interest , dividend etc. The term yield is
generally used in case of bonds.

The appreciation (depreciation) in the price of an

asset is referred to as capital gain (loss).

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1. Risk and Return Concepts

Historical Returns (Realized returns): Also called as ex-

post (after the fact) returns.
Rate of Return = Dividend yield + Capital Gain Yield

Expected Returns (Future returns): Also called as ex-

ante or anticipated returns.
1 t
1 t t 1
P
) P (P D
k

n
1 i
i i k p k

9 / 59
Illustration 1

The price of ACC share on Feb 8, 2008 was Rs 3580 and

it has increase to Rs 3800 in Feb 9, 2009 and dividend
paid was Rs 35. Calculate the rate of return.

Solution:
1 t
1 t t 1
P
) P (P D
k

3580
) 3580 (3800 35 +

7.12% or 0.0712

10 / 59
Illustration 2

If a14%, Rs 1000 ICICI debenture purchased at 1350

and price is Rs 1500 at the end of the year, what is the
rate of return.

Solution:
1 t
1 t t 1
P
) P (P D
k

1350
) 1350 (1500 140 +

21.48% or 0.2148

11 / 59
Probabilities and Rates of Return
Probability is a number that describes the chances of an
event taking place. Probabilities are governed by five
rules and range from 0 to 1.

The probability can never be larger than 1 (i.e.

maximum probability of an event taking place is 100%)

The sum total of probabilities must be equal to 1.

The probability can never be a negative number.

If an outcome is certain to occur, it is assigned a

probability of 1, while impossible outcomes are assigned
a probability of 0.

The possible outcomes must be mutually exclusive and

collectively exhaustive.

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Illustration 3

The probability distribution and corresponding rates of

return of Alpha Company are shown below

Solution:
= (0.10)(0.50)+(0.20)(0.30)+(0.40)(0.10)+(0.20)
(-0.10)+(0.10)(-0.30)
= 0.05 + 0.06 + 0.04 0.02 -0.03 = 0.1 or 10%
Possible Outcome (i) Probability of Occurrence
(Pi)
Rate of return (%)
(Ki)
1 0.10 50
2 0.20 30
3 0.40 10
4 0.20 -10
5 0.10 -30
Total = 1.00

n
1 i
i i k p k

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Risk

Risk and return go hand in hand in investment and

finance. Investment decisions always involve a trade-off
between risk and return.

Risk can be defined as the chance that the actual

outcome from an investment will differ from the
expected outcome.

This means that, the more variable the outcomes, greater

the risk.

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Risk
Where to invest out of following two stocks ?

Both the stocks have same average returns, but the

returns of stock N fluctuates more, hence it is more
riskier. Therefore prefer stock M.

Investors choice depends on expected returns and

riskiness of returns.
Returns %
Average
Returns %
Standard
Deviation %
Stock M 30 28 34 32 31 31 2.236
Stock N 26 13 48 11 57 31 20.700

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Risk and Expected Rate of Return

Width of a probability distribution of rates of return is a

measure of risk.

The wider the probability distribution, greater is the

risk. Greater the variability of return, greater the
variance.

See the illustrative example of two companies, as below

Illustration
Pi Ki(%)
1 0.05 38
2 0.20 23
3 0.50 8
4 0.20 -7
5 0.05 -22
1.00
Pi Ki(%)
1 0.10 90
2 0.25 50
3 0.30 20
4 0.25 -10
5 0.10 -50
1.00
Beta Company Gamma Company
% 8 K % 20 K
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.1
0.2
0.3
0.4
0.5
Probability
0 0.2 0.4 0.6 0.8 1
0
0.1
0.2
0.3
0.4
0.5
Probability
Return Return
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Illustration

Beta company is the least risky as its probability

distribution is the narrowest.

Gamma company is the riskiest as its probability

distribution is widest.
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.1
0.2
0.3
0.4
0.5
Probability
0 0.2 0.4 0.6 0.8 1
0
0.1
0.2
0.3
0.4
0.5
Probability
Return Return
Beta Company Gamma Company

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Sources of Risk
What are the sources of risk? What are the factors which
make any financial asset risky? They are as follows.

Interest Rate Risk

Market Risk

Inflation Risk

Business Risk

Financial Risk

Liquidity Risk

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Measurement of Total Risk

Risk is associated with the dispersion in the likely

outcome.

Dispersion refers to variability.

If the assets return has no variability, it has no risk.

There are two accepted measures of dispersion or risk.

Variance 2

Standard Deviation

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Variance

The variance of an assets rate of return can be found as

the sum of the squared deviation of each possible rate of
return from the expected rate of return multiplied by the
probability that rate of return occurs.
Where, VAR(k)= Variance of returns
Pi = Probability associated with ith possible
outcome
ki = Rate of return from the ith possible outcome
k = Expected rate of return
n = Number of years
2
n
1 i
i i
) k (k p VAR(k)

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Standard Deviation

The most popular way of measuring variability of return

is standard deviation.

The standard deviation is denoted by is simply square

root of variance.
2

VAR(k)
2
n
1 i
) k - (ki pi

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Risk per unit of Return

The risk per unit of return is calculate using the

coefficient of variance.

Coefficient of Variance =

The coefficient of variance or risk per unit of return is

used while comparing the risk and return involved in two
or more investments.
k

cov

Calculate the variance and standard deviation for Alpha

Companys rates of return.
Illustration
Possible
Outcome
ki(%) pi
1 50 40 1600 0.10 160
2 30 20 400 0.20 80
3 10 0 0 0.40 0
4 -10 -20 400 0.20 80
5 -30 -40 1600 0.10 160
Variance =
k k
i

( )
2
k k
i

2
) ( k k p
i i

480 ) (
2
k k p
i i
2 / 1
2
1
) ( ) (
1
]
1

n
i
i i
k k p k VAR
21.9% 480
23 /59

24 /59
Illustration
Calculate the risk of stocks of following company
Solution:
Variance 2 = p1(r1-E)2 + p2(r2-E)2++pn(rn-E)2 = 73
Standard deviation = 8.54 %. Thus riskiness of this stock is 8.54 %
Scenario Chance pi
Return %
ri
pi x ri
Deviation
(ri - E)
Deviation2
(ri - E)2
pi x Deviation2
i.e. pi(ri - E)2
1 0.25 36 9 11 121 30.25
2 0.5 26 13 1 1 0.50
3 0.25 12 3 -13 169 42.25
E = 25 Sum = 73
Scenario Chance p Returns %
1 0.25 36
2 0.50 26
3 0.25 12

What is portfolio? An investment portfolio refers to

group of assets that owned by the investor.

Generally, investing in a one security is riskier than

investing in portfolio.

In order to reduce the risk, investor hold a diversified

portfolio consisting of equity, bonds, real estate, saving
in banks, and or bullion.

It is possible to construct a portfolio in such a way that

total risk of such portfolio is less than risk of individual
assets.

The saying, dont put all eggs in a single basket.

2. Risk in a Portfolio Context
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Portfolio diversification is the investment in several

different asset classes or sectors

Diversification is not just holding a lot of assets

For example, if you own 50 Internet stocks, you are

not diversified

However, if you own 50 stocks that span 20 different

industries, then you are diversified
Diversification
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27 /59
Risk in a Portfolio Context
Example of investment in two companies
Hence diversion has eliminated the risk. In practice,
diversification can reduce the risk.
Returns %
in summer (hot
season)
Returns % in
winter (cold
season)
Average
Returns %
Risk i.e.
Standard
deviation %
Ice Cream Co. 30 10 20 10
Coffee Co. 10 30 20 10
Investment in both
companies
20 20 20 0

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Diversifiable and Non-diversifiable Risk

Returns on stocks do not move in perfect tandem means

that risk can be reduced by diversification.

There is some positive correlation means that risk can

never be reduced to zero.

So there is a limit on the amount of risk that can be

reduced through diversification.

This can be traced to two major reasons: correlation and

number of stocks in a portfolio

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Correlation Coefficient

Movement of security returns is studied by correlation

coefficient

If two returns move exactly in same direction, then

correlation coefficient is +1

If two returns move exactly opposite to each other, then

correlation coefficient is -1

If two returns are entirely unrelated, then correlation

coefficient is 0

Positive correlation coefficient , up to +1 indicates that

two returns move in same direction but not in same value

Negative correlation coefficient , up to -1 indicates that

two returns move in opposite direction but not in same
value

30 /59
Number of Stocks in the Portfolio

Risk reduction by diversification depends on the number

of stocks in the portfolio.

As the number of stocks increase, the diversifying effect

of each additional stock diminishes as shown in figure
below.
Number of Stocks in
Portfolio
10 20 30 40 200
Diversifiable Risk or
Unsystematic Risk
Non-diversifiable Risk or Market Risk or
Systematic Risk
Total Risk of a
portfolio
R
i
s
k

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Number of Stocks in the Portfolio

Major benefits of diversification are obtained with the

first 10 to 12 stocks, provided they are drawn from
industries that are not closely related.

As the number of securities in a portfolio increases, say

up to 20 or 25, diversification reduces the portfolio risk
rapidly.

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Diversifiable and Non-diversifiable Risk

Risk of any individual stock can be separated into two

components: diversifiable risk and non-diversifiable risk.

Non-diversifiable risk is related to the general economy

or the stock market as a whole and hence can not be
eliminated by diversification. Non-diversifiable risk is
also called as market risk or systematic risk.

Diversifiable risk is specific to the company or industry

and hence can be eliminated by diversification.
Diversifiable risk is also called unsystematic risk or
specific risk.

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Diversifiable and Non-diversifiable Risk

Risks are classified as systematic and unsystematic risks.

Some risk factors may affect an industry as a whole,

while some risk factors affect only a specific firm. For
example monsoon may affect agro industry whereas raw
material cost may affect a specific firm

Systematic risk factors affect the entire market and such

risks can not be diversified or non-diversifiable

Unsystematic risk depends on firm specific risk factors.

This is diversifiable or avoidable risk by investing in a
large portfolio of securities say, 15 or more. They tend to
cancel each other in a portfolio

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Non-diversifiable or Market Risk or
Systematic Risk Factors
They are dependent on an economic environment or
system as a whole

Major changes in the tax rates

War and other calamities

An increase or decrease in inflation rates

A change in economic policy

Industrial recession

An increase in international oil prices, etc.

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Diversifiable or Specific Risk or Unsystematic
Risk Factors
They are dependent on specific company or industry

Company strike

Bankruptcy of a major supplier

Death of a key company officer

Unexpected entry of a new competitor, etc.

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Returns and Risk of a Portfolio

Portfolio is a combination of two or more securities.

Portfolio Returns

Portfolio Risk

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Returns and Risk in Two Asset Portfolio Case

A two asset portfolio is a situation in which the

investment is in only two assets.

Expected Returns from the portfolio:

Risk (variance) in a two asset portfolio case is calculated

as:
or and
2 , 1 2 1
2
2
2
2
2
1
2
1
2
2 w w w w
p
+ +
2 1 2 , 1 2 1
2
2
2
2
2
1
2
1
2
2 w w w w
p
+ +
2 1
1,2
1,2

38/59
Example
Calculate the expected return, variance and standard
deviation for a portfolio containing stocks 1 and 2 with
correlation coefficient 0.75 and following information.
Security Returns % Standard
Deviation %
Proportion of
investments
1 12 10 2/3
2 18 26 1/3

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Solution
Expected portfolio returns:
= W1E1 + W2E2 + W3E3++WnEn
= 2/3 x 0.12 + 1/3 x 0.18
= 0.14 or 14%
Variance of a portfolio:
p2 = W1212 + W2222+ 2W1W21,2
(1)
1,2
Correlation coefficient 1,2 = ------ (2)
12
Therefore p2 = W1212 + W22 22+ 2W1W2 1,2 12
(3)

n
1 i
i i p E W ) E(r

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p2 = W1212 + W22 22+ 2W1W2 1,2 12
= (2/3)2 x 0.12 + (1/3)2 x 0.22 + 2 x 2/3 x 1/3 x 0.75
x0.1x0.2
= 0.0156
Standard Deviation p = 0.1247 or 12.47 %


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Example
A portfolio of two securities x & y is with following
information. Evaluate the impact of diversification on
expected risk and returns for three different values of
correlation coefficients 1, 0.5 and -1.
Security Returns % Standard
Deviation %
Proportion of
investments %
X 20 10 40
y 30 16 60

42 /59
Solution
Expected portfolio returns:
= W1E1 + W2E2 + W3E3++WnEn
= 0.20 x 0.40 + 0.30 x 0.60
= 0.08 + 0.18
= 0.26 or 26%
Case 1: With 1,2 = 1
Variance of a portfolio:
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x 1x 0.1 x
0.16
= 0.018496
p = 0.136 or 13.6 %

n
1 i
i i p E W ) E(r

43 /59
Case 2: With 1,2 = 0.5
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x 0.5 x 0.1 x
0.16
= 0.014656
p = 0.121 or 12.1 %
Case 3: With 1,2 = -1
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x (-1) x 0.1 x
0.16
= 0.003136
p = 0.056 or 5.6 %

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Summary of results
*****
Portfolio
components
x y x & y
1,2 = 1
x & y
1,2 = 0.5
x & y
1,2 = -1
Mean Returns % 20 30 26 26 26
Risk % 10 16 13.6 12.1 5.6

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Risk of Stocks in a Portfolio

In the portfolio context, variance is not the relevant risk

measure

Riskiness of security when held in isolation is not the

same as the riskiness of a portfolio of securities, when
that security is included in the portfolio

It may be useful to regard risk or variability to factors

specific to an industry and a firm.

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3. Relation between Risk and Return
Beta ()

Modern Portfolio Theory defines the riskiness of a

security measured by beta (), the sensitivity of returns
of security w.r.t the market returns.

Beta measures the kind of risk which is non-diversifiable.

Higher the value of beta, higher the riskiness of the
security

47 /59
Estimating the Beta () values

Simple linear regression method

General form of the regression model

y = a + b x +

Particular form of regression model

ri = + rm + (1)
From this = i,m/m2 (2)

Market return is defined as

todays index yesterdays index
= --------------------------------------------
yesterdays index

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Estimating the Beta () values
Regression (Characteristic) line
intercept
slope
S
e
c
u
r
i
t
y

r
e
t
u
r
n
Market return

49 /59
Estimating Beta () values

Beta for a portfolio is a weighted average of the betas of

individual securities

Three methods of estimating betas

1. Based on historical returns data
2. Based on expected probability distribution
3. Estimating betas by adjusting historical betas,
depending on factors causing change in future

50 /59
Historical Betas
Historical betas are calculated based on covariance and
standard deviation values as
= i,m/m2
Adjusted beta are calculated based on historical betas,
adjusting for factors causing change in future for
example earnings, dividends, interest payments etc.

We have seen that the most used measure of risk or

variability in finance is standard deviation.

Unique risk stems from firm specific features, where as

market risk emanates from economy wide features.

Portfolio diversification washes away unique risk but

not market risk.

Hence the risk of a fully diversified portfolio is its

market risk.
4. Capital Asset Pricing Model
51 /59

The contribution of a security to the risk of a fully

diversified portfolio is measured by its Beta, which
reflects the sensitivity to the general market movement.

The question arises what is the rationality between the

risk of the security measured by beta and its expected
return.

The answer is given in a model known as Capital Asset

Pricing Model. (CAPM)
Capital Asset Pricing Model
52 /59

CAPM is represented as
Kj = Rf + j(Km-Rf)
Where
Kj = Expected return on security J.
Rf= Risk Free rate of return.
j= Beta Coefficient of the security j.
Km= Expected Return on Market portfolio.

Required rate of Return = Risk free rate + Risk

Premium
Capital Asset Pricing Model
53 /59

Required rate of Return = Risk free rate + Risk

Premium
Kj = Rf + j(Km-Rf)

The CAPM provides an explicit measure of the

risk premium. It is the product of beta for a
particular security j and the market risk premium.
Capital Asset Pricing Model
Risk free rate Risk Premium
54 /59

Capital Asset Pricing Model

Suppose you have the following information:

Rf = 3.5% Km=8.5% ril=0.75

What should Kril be?

Answer:

Kril = 0.035+ 0.75(0.085-0.035)

= 7.25%
55 /59

Security Market Line

All risky securities are expected to form part of

market portfolio (M) and be properly represented
by SML. Stand alone securities do not provide
diversification.

Investors investing in single security will be

compensated only for the systematic risk borne by
them and not for the unsystematic risk.
56 /59

Security Market Line

Hence the risk premium provided for an

undiversified portfolio is in proportion to the risk
premium provided for completely diversified
market portfolio.
( )

,
_

+
f
m
i f i
R R R R E
_

2
, ,
m
m i
m
m i
i
Var
Cov

57 /59

58 /59
Security Market Line
The SML represents the average or normal, trade-off
between risk and return for a group of securities
SML
A
v
e
r
a
g
e

r
e
t
u
r
n

f
o
r

g
r
o
u
p

o
f

s
e
c
u
r
i
t
i
e
s


r
i
Betas for different securities, risk
Below normal expected returns
Above normal expected returns

59 /59
Applications of Security Market Line
Historical SML:
1. Evaluating performance of portfolio manager
2. Tests asset pricing theories such as CAPM
3. Tests market efficiency
Ex-ante SMLs
1. Identifying undervalued securities
2. Determining consensus, price of risk in current
market prices.
*****