RISK & RETURN

FINANCIAL MANAGEMENT
S.KHATUA
RISK & RETURN
Return--- 2 types
1. Realized Return Ex-Post( after the fact) return, return that
as/could have been earned.
Ex.- A deposit of Rs.1000 in a bank on 1/1, at a stated annual
interest rate of 10% will be worth Rs. 1100 exactly a year later.
2.Expected Return This is the return from an amount that investors
anticipate or expect to earn over some future period.
Components of return 1.periodic cash receipts/income in the form
of dividend/interest etc.
2.Appreciation/depreciation in the price of asset capital gain/loss
Measuring rate of return (k)
D
t
+ ( P
t
-- P
t-1
)
k = --------------------
P
t-1



Examples
Ex.- If a share of ACC is purchased for Rs.3580 on 8
th

feb04 & sold for Rs. 3800 on 9
th
feb05 & the company
paid a dividend for Rs. 35 for year, how do we calculate
rate of return?
rate of return = 35 + (3800 3580)
3580
= 0.713 or 7.13%
Rate of Return of a Bond/ Debenture
Ex.- If a 14%, Rs.1000 ICICI debenture was purchased
for Rs.1350 & the price of this security rises to Rs. 1500
by the end of an year.
rate of return = 140 + 1500--1350 = 21.48%
1350
Expected Rate of Return
A probability is a no. that describes the chances of an
event taking place.
5 rules: 1. A prob. Can never be larger than 1.
2. Sum total of all prob. must be equal to 1.
3. Prob. Cant be a negative no.
4. Its range is 0 to 1.
5. Possible outcomes must be mutually exclusive
Expected rate of return for any asset is weighted
average rate of return using probability of each rate of
return as the weight.
Example
rate of return = k= p
i
k
i

Possible
outcome (i)
Probabilities (p
i
) Rate of return
(k
i
)
p
i
k
i

1 0.1 0.5 or 50% 0.05
2 0.2 0.3 or 30% 0.06
3 0.4 0.1 or 10% 0.04
4 0.2 -.1 or -10% -0.02
5 0.1 -.3 or -30% -0.03
Total 1.0 K= 0.1 or
10 %
RISK
Risk & Return go hand in hand in investment & finance
There is always a trade-off between risk & return
More risk & more return & vice versa
Risk is the chance the actual outcome from an
investment will differ from expected outcome
Broader the range of possible outcome, greater the risk
Variance or Std. Deviation can be a measure of risk
Variance: VAR(K) = p
i
( k
i
k
exp
)2
Std. Deviation = = Sq. root of VAR(k)= [p
i
( k
i
k
exp
)2]1/2

Example
Possible
outcome
K
i
in %
(return)
K
i
-- k
exp
( k
i
k
exp
)2 p
i
p
i
( k
i
k
exp
)2

1 50 40 1600 0.1 160
2 30 20 400 0.2 80
3 10 0 0 0.4 0
4 -10 -20 400 0.2 80
5 -30 -40 1600 0.1 160
total
K
exp
=10%
= p
i
k
i
1.0
VAR(K)=480

Std. Deviation=
= 21.9%
SOURCES OF RISK
Interest Rate Risk

Market Risk

Inflation Risk

Business Risk

Financial Risk

Liquidity Risk
Example Economic Condition
The stock of Alpha Co. performs
well relative to other stocks during
recessionary periods. The stock of
Beta Co., on the other hand, does
well during growth periods. Both the
stocks are currently selling for Rs.
50 per share.
Calculate the exp. Return & Std.
deviation of
1. Rs.1000 in equity stock of Alpha
2. Rs.1000 in equity stock of Beta
3. Rs.500 in each of equity stock
Alpha & Beta
4. Rs.700 in Alpha & Rs.300 in Beta
Which of above 4 options would you
choose? Why?


High
growth
LG stag
nati
on
rece
ssio
n
Prob
0.3 0.3 0.2 0.2
K(alp
ha) %
55 50 60 70
K(Bet
a) %
75 65 50 40