Risk_and_Return ppt 1 (2)

8/7/2019 Risk_and_Return ppt 1 (2)

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Risk and ReturnRisk and Return

Finance BatchFinance Batch VESIMSRVESIMSR20092009--1111

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Topics CoveredTopics Covered

ReturnReturn

Risk , UncertaintyRisk , Uncertainty

Types of RiskTypes of Risk

Systematic and Unsystematic RiskSystematic and Unsystematic Risk

Introduction to Beta, Risk Premium andIntroduction to Beta, Risk Premium andRisk free rateRisk free rate

Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

Assumptions, Usage, LimitationsAssumptions, Usage, Limitations

Problem SolvingProblem Solving

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What is Return ?What is Return ?

Periodic Cash ReceiptsPeriodic Cash Receipts

Price Change over periodPrice Change over period

Total Return = Income + Price changeTotal Return = Income + Price change

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What is Return ?What is Return ?

Arithmetic ReturnArithmetic Return AverageAverage-- doesdoesnot take into effect the realizednot take into effect the realized

change in wealth over multiplechange in wealth over multipleperiod.period.

Geometric ReturnGeometric Return-- GMGM ReflectsReflectsthe compounding/ cumulative returnthe compounding/ cumulative return

over time. It is given by :over time. It is given by :

[(1+R1)(1+R2)+(1+Rn)]^(1/n)[(1+R1)(1+R2)+(1+Rn)]^(1/n) --11

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Two types ofReturnsTwo types ofReturns

Realized Return:Realized Return: This is exThis is ex post (post (after the fact) return, or return thatafter the fact) return, or return that

was or could have been earned.was or could have been earned. Expected ReturnExpected Return: This is the return: This is the return

from an asset that investorsfrom an asset that investorsanticipate or expect to earn overanticipate or expect to earn over

some future period. This is subject tosome future period. This is subject touncertainty, or risk, and may or mayuncertainty, or risk, and may or maynot occurnot occur

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Brain GymBrain Gym

Q1) If a share of ACC is purchased forQ1) If a share of ACC is purchased forRs 3,580 on Feb 8 of last year, andRs 3,580 on Feb 8 of last year, and

sold for Rs 3,800 on Feb 9 of thissold for Rs 3,800 on Feb 9 of thisyear and the company paid ayear and the company paid adividend of Rs. 35 for the year, whatdividend of Rs. 35 for the year, whatis the rate of return?is the rate of return?

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Solution toBrain GymSolution toBrain Gym

Return (k) = [Div + (Period tReturn (k) = [Div + (Period t PeriodPeriodtt--1) ]/ Period t1) ]/ Period t--11

= [35+(3800= [35+(3800 3580)]/ 35803580)]/ 3580= 7.12%= 7.12%

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Brain GymBrain Gym

Q2) The probability distributions andQ2) The probability distributions andcorresponding rates of return forcorresponding rates of return for

Alpha Company are shown below.Alpha Company are shown below.PossibleOutcomes

Probability ofoccurrence

Rate of Return

1 .10 50

2 .20 30

3 .40 10

4 .20 -10

5 .10 -30

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Solution ofBrain GymSolution ofBrain Gym

KK = (0.10)(0.50) += (0.10)(0.50) +(0.20)(0.30)+(0.40)(0.10)+(0.20)((0.20)(0.30)+(0.40)(0.10)+(0.20)(--

.010)+(0.10)(.010)+(0.10)(--0.30)0.30)= 0.05 +0.06 + 0.04= 0.05 +0.06 + 0.04 --0.020.02 --0.030.03

= .1= .1

or 10%or 10%

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RiskRisk

What is Risk?What is Risk?

Is it same as uncertainty?Is it same as uncertainty?

If no, then what is the differenceIf no, then what is the differencebetween them? Is it same asbetween them? Is it same asUncertainty?Uncertainty?

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Risk vs. UncertaintyRisk vs. Uncertainty

RiskRisk Decision makers alreadyDecision makers alreadyknows the possible consequencesknows the possible consequencesof a decision and their relativeof a decision and their relativelikelihood at the time he is making alikelihood at the time he is making adecision.decision.

UncertaintyUncertainty likelihood of thelikelihood of the

possible outcomes is not knownpossible outcomes is not known

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Formal Definition ofRiskFormal Definition ofRisk

The possibility (likelihood) thatThe possibility (likelihood) thatrealized returns will be less than therealized returns will be less than thereturns that were expected.returns that were expected.

This means that, the more variable theThis means that, the more variable thepossible outcomes that can occur (possible outcomes that can occur (i.ei.ethe broader the range of possiblethe broader the range of possibleoutcomes.), the greater the risk.outcomes.), the greater the risk.

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Risk and Expected Rate ofRisk and Expected Rate of

ReturnReturnThe width of a probability distributionThe width of a probability distribution

of rates of return is a measure ofof rates of return is a measure ofrisk. The wider the probabilityrisk. The wider the probabilitydistribution, the greater is the risk ordistribution, the greater is the risk orgreater the variability of return thegreater the variability of return thegreater is thegreater is the variance.variance.

Hence variance is the measure ofHence variance is the measure ofriskrisk

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Two components ofRiskTwo components ofRisk

NonNon--diversifiable riskdiversifiable risk is that part ofis that part oftotal risk that is related to the generaltotal risk that is related to the generaleconomy or the stock market as a wholeeconomy or the stock market as a whole

and hence cannot be eliminated byand hence cannot be eliminated bydiversification. It is also referred to asdiversification. It is also referred to asmarket risk ormarket risk or systematic risk.systematic risk.

Diversifiable riskDiversifiable risk is that part of totalis that part of totalrisk that is specific to the company orrisk that is specific to the company orindustry and hence can be eliminated byindustry and hence can be eliminated bydiversification. It is also called asdiversification. It is also called asunsystematic risk or specific riskunsystematic risk or specific risk 1515


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Difference between types ofriskDifference between types ofrisk

Systematic RiskSystematic Risk

Unsystematic RiskUnsystematic Risk

Types of Systematic RiskTypes of Systematic Risk

Market riskMarket risk

Interest Rate RiskInterest Rate Risk

Purchasing Power RiskPurchasing Power Risk

Types of Un Systematic RiskTypes of Un Systematic Risk

Business RiskBusiness Risk

Financial RiskFinancial Risk

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Factors that give risk to diffrisksFactors that give risk to diffrisks

NonNon--DiversifiableDiversifiableRiskRisk

Major change in taxMajor change in tax

ratesrates War & other calamitiesWar & other calamities

Increase/ Decrease inIncrease/ Decrease ininflation ratesinflation rates

Change in economicChange in economicpolicypolicy

Industrial recessionIndustrial recession

Diversifiable RiskDiversifiable Risk

Company strikeCompany strike

Bankruptcy of a majorBankruptcy of a major

suppliersupplier Death of a keyDeath of a key

company officercompany officer

Unexpected entry ofUnexpected entry of

new competitor intonew competitor intothe market etc.the market etc.

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IdentifyIdentify

Investor PanicInvestor Panic

Cost of LivingCost of Living

LabourLabour StrikeStrike Increased Debt to Equity RatioIncreased Debt to Equity Ratio

Product ObsolescenceProduct Obsolescence

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Quantitative Description ofRiskQuantitative Description ofRisk

Variability of Return around theVariability of Return around theexpected Average returnexpected Average return RiskRisk

Recall: Calculation of variabilityRecall: Calculation of variability Concepts of Variance / standardConcepts of Variance / standard

DeviationDeviation

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Risk in Contemporary Mode :Risk in Contemporary Mode :

BETABETA statistical measure of systematicstatistical measure of systematicrisk.risk.

It measures the relative risk associated withIt measures the relative risk associated with

any individual portfolio as measured in relation toany individual portfolio as measured in relation tothe risk of the market portfolio. The marketthe risk of the market portfolio. The marketportfolio represents the most diversified portfolioportfolio represents the most diversified portfolioof risk assets an investor could buy since itof risk assets an investor could buy since itincludes all risk assets.includes all risk assets.

= Non = Non diversifiable risk ofasset or a portfolio /diversifiable risk ofasset or a portfolio /

Risk of the market or entire portfolioRisk of the market or entire portfolio

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Beta (Beta ())

Thus , the beta coThus , the beta co--efficient is a measure of the nonefficient is a measure of the nondiversifiable or systematic risk of an assetdiversifiable or systematic risk of an assetrelative to that of the market portfolio. A beta ofrelative to that of the market portfolio. A beta of1.0 indicates an asset of average risk. A beta1.0 indicates an asset of average risk. A betacoefficient greater than 1.0 indicates abovecoefficient greater than 1.0 indicates aboveaverage riskaverage risk-- stocks whose returns tend to bestocks whose returns tend to bemore risky than the market. Stocks with betamore risky than the market. Stocks with betacoefficient less than 1.0 are of below average riskcoefficient less than 1.0 are of below average risk

i.ei.e less riskier than the market portfolio.less riskier than the market portfolio.

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Brain StormBrain Storm

Q) What kind ofQ) What kind of will will Indian stocksIndian stockshave >1, 1,


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Measurement ofMeasurement of, Total risk, Total risk

andS

ystematic RiskandS

ystematic Risk = = CovCov ( stock with market) / Variance of( stock with market) / Variance ofMarket.Market.

We know Total Risk = Variance of theWe know Total Risk = Variance of themarketmarket

Systematic Risk = ^2 * VarianceSystematic Risk = ^2 * VarianceQ) What do you think then UnsystematicQ) What do you think then Unsystematic

Risk will be?Risk will be?

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The Linear relationship ModelThe Linear relationship Model

Now this systematic relationship betweenNow this systematic relationship betweenthe return on the security or a portfoliothe return on the security or a portfolioand the return on the market can beand the return on the market can be

described using a simple linear regressiondescribed using a simple linear regression, identifying the return on a security or, identifying the return on a security orportfolio as the dependent variableportfolio as the dependent variable RrRr andandthe return on market portfolio as thethe return on market portfolio as the

independent variableindependent variable RmRm, in the single, in the singleindex model or market model developedindex model or market model developedby William Sharpe.by William Sharpe.

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C A P MC A P M Developed by William SharpeDeveloped by William Sharpe Mathematical equation to show the risk andMathematical equation to show the risk and

Return tradeoffReturn tradeoff

Risk Free Rate (Risk Free Rate (RfRf))

Market Return (Market Return (RmRm)) Beta (Beta ())

Required rate (Required rate (RrRr))

Required Rate = Risk free rate + risk premiumRequired Rate = Risk free rate + risk premium

RrRr == RfRf ++ ((RmRm RfRf))

Depicts Compensation that investors shouldDepicts Compensation that investors shouldreceive for taking the non diversifiable riskreceive for taking the non diversifiable risk

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Brain GymBrain Gym

Q3) Assuming Savings bank rate asQ3) Assuming Savings bank rate asthe risk free rate, find the requiredthe risk free rate, find the requiredrate of return of Stock ?. When Niftyrate of return of Stock ?. When Niftygoes up by 100%, Stock X goes upgoes up by 100%, Stock X goes upby 127%. Historical point to pointby 127%. Historical point to pointreturn of nifty for past 3 months isreturn of nifty for past 3 months is

14%14% c.a.g.rc.a.g.r

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Security Market Line (SML)Security Market Line (SML)

GraphicalGraphicalrepresentation ofrepresentation ofthe CAPMthe CAPM

Which will be theWhich will be theSML below?SML below?

012345678

9101112

1 2 3 4 5 6 7 8 9 10 11 120

12

34567891 0

1 11 21 31 4

1 5

1 2 3 4 5 6 7 8 9 1 0 1 1 1 2

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Limitations ofCAPMLimitations ofCAPM

Its simplicity and assumptionsIts simplicity and assumptions

Decisions only on risk and returnDecisions only on risk and returnassessmentsassessments

Perfect competitionPerfect competition

No transaction costNo transaction cost

No taxesNo taxes

Borrow and lend any amount at risk lessBorrow and lend any amount at risk lessraterate

Uniform planning horizonsUniform planning horizons

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Home ExerciseHome Exercise

Find out about the following variants ofFind out about the following variants ofCAPMCAPM

. Non Standard forms of CAPM. Non Standard forms of CAPM

. Zero Beta CAPM. Zero Beta CAPM

. Tax adjusted CAPM. Tax adjusted CAPM

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Q) Eva turns to determining a beta for use

in evaluating the offer of an equity stake ina private insurer and rounds her betaestimate of Alleghany, the publiccomparable , to 0.5. As of the valuation

date. Alleghany Corporation has no debt inits capital structure. The private insurer is20 percent insurer is 20 percent funded bydebt.

If a beta of 0.50 is assumed for thecomparable, what is the estimated beta ofthe private insurer?

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Risk_and_Return ppt 1 (2)