risk and return measurement

1. Neelakshi Saini
Assistant professor

2. What is a risk ?

3. According to dictionary meaning : The
existence of volatility in the occurrence of an
expected incident is called risk .Higher the
unpredictability greater is the risk.

4.  Wrong method of investment
 Wrong timing of investment
 Wrong quality of investment
 interest rate risk
 Maturity period or length of investment
 Terms of lending
 National and international factors
 Natural calamities

5. Systematic risk Unsystematic risk
 Market risk
 Interest rate risk
 Purchasing power risk
 Business risk
 Financial risk
 Default credit risk

6. Systematic risk refers to that portion of variation
in return caused by factors that affect the prices
of all securities .This risk cannot be avoided or
ignore .The effect of return causes the prices of
all individual securities to move in the same
directions .systematic risk arises due to the
following factors:

7. a. Market risk : Variations in prices sparked off
due to real social, political and economic events
is referred to as market risk .Market risk arises
out of changes in demand and supply pressures
in the market following the changing flow of
news or expectations .
b. Interest rate risk :Generally price of securities
tend to move inversely with changes in the rate
of interest. The market activity and investor
perceptions are influenced by changes in the
interest rate which turn depend on the nature
of stocks,bonds,loans etc maturity of the
periods and the credits worthiness of the issuer
of the securities.

8.  Purchasing power risk : uncertainty of
purchasing power is referred to as risk due to
inflation. Inflation arouses optimism since all the
prices group and that lead to higher incomes. But
the effect of this hike in incomes increases and
cost of production due to wage rise, rise in prices
of raw material etc. There is a possibility of prices
of desired goods and services going up due to
inflation .

9. Unsystematic risk refers to that portion of the
risk which is caused due to factors unique or
related to a firm or a industry. This risk is
company specific risk and can be controlled if
proper measures are taken. It is caused by
the factors like labors, shortage of power,
recession in particular industry etc.

10.  Business risk : Business risk can be internal as all as
external. Internal risk is caused due to improper
product mix ,non availability of raw materials, absence
of strategic management etc. External risk arises due to
change in operating conditions caused by conditions
thrust upon the firm which are beyond its control
eg;business cycle, government controls, international
market conditions etc.
 Financial risk : This risk is associated with the capital
structure of a company. A company with no debt
financing has no financial risk. The extent of financial
risk depends on the leverage of the firms capital
structure.
 Credit or default risk :The credit risk deals with the
probability of meeting with a default. It is primarily the
probability that a buyer will default. Proper
management can reduce the chances of non payment
of loan .

12.  Standard deviation
 Beta

13. It is a measure of the value of the variables around
its mean or it is the square root of the sum of the
squared deviation from the mean divided by the
number of observances . The arithmetic mean of
the return may be same for two companies but
the return may vary widely.
Or
Standard Deviation as a Measure of Risk. The
standard deviation is often used by investors to
measure the risk of a stock or a stock portfolio.
The basic idea is that the standard deviation is a
measure of volatility: the more a stock's returns
vary from the stock's average return, the more
volatile the stock.

17. Y P(Y) Y* P(Y) Y 2 * P (Y)
7 0.25 1.75 12.25
15 0.50 7.50 112.50
23 0.25 5.75 132.25
Total 1.00 15.00 257
S.D = S Y2 * P(Y) – [S Y*P(Y)]2
S.D = 257 – (15) 2 = 5.66 rupees

18. STOCK A STOCK B
Expected Return 15 rupees 15 rupees
Standard
Deviation
1.41 rupees 5.66 rupees
Comparing the two stocks, we see that both stocks have
the same expected returns. But the SD or risk is different.
The S.D of stock B > S.D of stock A
We can say that the return of stock B is prone to higher

19.  CV is a measure of relative risk.
 It tells us the risk associated with each unit of money
invested.
 Formula:
CV = s(x) / E(X)

22. R = Rf
+ ( Rm
– Rf
)*b

23. Beta describes the relationship between the stock return
and index return. Beta describes the systematic risk
 Beta =+1.0 one percent change in the market index
return causes exactly one percent change in stock return.
It indicates that the stock moves in tandem with the
market .
 Beta =+0.5 one percent change in the market index return
causes exactly 0.5percent change in stock return. It
indicates that the stock is less volatile compared to the
market.
 Beta =+2.0 one percent change in the market index
return causes exactly 2 percent change in stock return. It
indicates that the stock is more volatile. When there is a
decline of 10%in the market return the stock with beta 2
would give a negative return of 20%.

24. Suppose the risk free rate of the security is 6%
The market rate is 12% and the beta is 1.25,
Then the required rate of return for the security would be
R = 6 + (12 – 6) * 1.25
R = 6 + 7.5
R = 13.5%
Reconsider the above example but suppose that the value of B = 1.60. Then the
return would be:
R= 6 + (12 – 6)*1.60
R= 6 + 9.6
R= 15.6%
So, we see that greater the value of beta, the greater the systematic risk and in
turn the greater the required rate of return.