Risk and return analysis

TOTAL RISK
The total variability in returns of a security

represents the total risk of that security.

Systematic risk and unsystematic risk are the
two components of total risk. Thus
Total risk
= Systematic risk + Unsystematic risk

Risks associated with investments

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SYSTEMATIC RISK
The portion of the variability of return of a

security that is caused by external factors, is

called systematic risk.
It is also known as market risk or nondiversifiable risk.
Economic and political instability, economic
recession, macro policy of the government, etc.
affect the price of all shares systematically. Thus
the variation of return in shares, which is caused
by these factors, is called systematic risk.

Systematic Risks

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Majorly systematic risk can be

grouped in to
Market risk: it refers to stock variability due to

changes in investors attitudes and expectations.

These are on real and psychological basis. It includes
political, social and economic reasons.
Interest rate risk:- when price of securities rises or
fall due to changes in interest rates. security prices
move inversely to interest rates. This risk affects
bond holders more directly than equity investors.
Purchasing power risk:- this is also known as
inflation risk. With the rise in inflation, there is
reduction in purchasing power and affects all the
securities. This is directly related to interest rate risk.
Interest rate increases with the increase in inflation.

NON - SYSTEMATIC RISK:

The return from a security sometimes
varies because of certain factors affecting
only the company issuing such security.
Examples are raw material scarcity,
Labour strike, management efficiency
etc.
When
variability of returns occurs
because of such firm-specific factors, it is
known as unsystematic risk.

Non Systematic Risks

Majorly unsystematic risk is

divided in to
Business Risk :- it includes
business cycle,
demographic factors,
political policies for industries

Financial risk: it basically includes risk due

to capital structure of companies.

RISK RETURN RELATIONSHIP OF

DIFFERENT STOCKS
Rate of
Return

Market Line E(r)

Risk
Premium
Ordinary
shares
Preference
shares
Subordinate loan
stock
Unsecured loan
Debenture with floating
charge
Mortage loan
Government stock (risk-free)
Degree of Risk
Risk return relationship of different stocks

Measuring Systematic Risk

To be compensated for risk, the risk has to be special.
Unsystematic risk is not special.
Systematic risk is special.

The Beta coefficient () measures the relative

systematic risk of an asset.

Assets with Betas larger than 1.0 have more

systematic risk than average.

Assets with Betas smaller than 1.0 have less
systematic risk than average.
Because assets with larger betas have greater

systematic risks, they will have greater expected

returns.
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Measurement of Risk
Risk refers to dispersion of a variable.
It is measured by variance or SD.
Variance is the sum of squares of the

deviations of actual returns from

average returns .
Variance = (Ri R)2
variance = (SD) 2

Measurement of Return
Return is the motivating force inspiring the investors

in form of rewards for undertaking the investments.

Two types of returns are

Realized return(after the fact return)

Expected return(expected to earn over some future period)

Return on security(single asset) consists of two

parts:
Return = dividend + capital gain rate
R = D1 + (P1 P0)
P0
WHERE R = RATE OF RETURN IN YEAR 1
D1 = DIVIDEND PER SHARE IN YEAR 1
P0 = PRICE OF SHARE IN THE BEGINNING OF THE YEAR
P1 = PRICE OF SHARE IN THE END OF THE YEAR

Portfolio
A portfolio is a bundle of individual

assets or securities.
All
investors hold well diversified
portfolio of assets instead of investing in
a single asset.
If the investor holds well diversified
portfolio of assets, the concern should
be expected rate of return & risk of
portfolio rather than individual assets.

Allocating Capital Between Risky

& Risk Free Assets
Its possible to split investment funds

between safe and risky assets.

Risk free asset: govt securities,T-bills
Risky asset: stock (or a portfolio)

Issues
Examine risk/return tradeoff.
Demonstrate how different degrees of
risk aversion will affect allocations
between risky and risk free assets

Example
rf = 7%

rf = 0%

E(rp) = 15%

p = 22%

w = % in p

(1-w) = % in rf

Expected Returns for

Combinations

E(rc) = wE(rp) + (1 - w)rf

= complete or combined portfolio
For example, w = .75
E(rc) = .75(.15) + .25(.07)
= .13 or 13%

Bond pricing theorems

BOND PRICING THEOREMS

The relationship between bond prices
and changes in interest rates have
been stated by Burton G. Malkiel in
form of some principles. These are
known as bond pricing theorems.
THEOREM 1:

Bond prices move inversely to interest

rate changes.
When y P
When y P
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THEOREM 2:

The longest the maturity of the bond, the more sensitive it is to

changes in interest rates.
THEOREM 3:

The lower a bonds coupon, the more sensitive its price will be to
given changes in interest rates.
THEOREM 4:

A bond s sensitivity to changes in market interest rate increases at

a diminishing rate as time remaining until its maturity increases.

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Bond Duration
Duration is the weighted average measure

f a bond s life. The various time periods in

which the bonds generate cash flows are
weighted according to relative size of
present value of those flows. Formula for
calculating duration is:
d = (t)(Ct)/(1+k)t

(Ct)/(1+k)t

Where Ct=annual cash flows including interest and

repayment of principal
t = time period of each cash flow
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k = discount rate

Capital asset pricing model