Investment and Portfolio Management

UNIT-III – Measurement of Risk and Return

Return can be defined as the actual income from a project as well as appreciation
in the value of capital. Thus, there are two components in return—the basic
component or the periodic cash flows from the investment, either in the form of
interest or dividends; and the change in the price of the asset, commonly called as
the capital gain or loss.

The term yield is often used in connection to return, which refers to the income
component in relation to some price for the asset. The total return of an asset for
the holding period relates to all the cash flows received by an investor during any
designated time to the amount of money invested in the asset.

Computation of Return

Expected rate of Return

The expected return is the profit or loss that an investor anticipates on an

investment that has known historical rates of return (RoR). It is calculated
by multiplying potential outcomes by the chances of them occurring and

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then totaling these results. Expected returns cannot be guaranteed. The
expected return for a portfolio containing multiple investments is the
weighted average of the expected return of each of the investments.
Expected return calculations are a key piece of both business operations and
financial theory, including in the well-known models of the modern
portfolio theory (MPT)

For example, if an investment has a 50% chance of gaining 20% and a 50%
chance of losing 10%, the expected return would be 5% = (50% x 20% +
50% x -10% = 5%).

What is Expected Return?

The expected return on an investment is the expected value of the

probability distribution of possible returns it can provide to investors. The
return on the investment is an unknown variable that has different values
associated with different probabilities. Expected return is calculated by
multiplying potential outcomes (returns) by the chances of each outcome
occurring, and then calculating the sum of those results (as shown below).

Computation of Expected Return.

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 RISK

Risk is defined in financial terms as the chance that an outcome or

investment's actual gains will differ from an expected outcome or return.
Risk includes the possibility of losing some or all an original investment.

Investing money in the markets has a high degree of risk and you should
be compensated if you're going to take that risk. If somebody you
marginally trust asks for a Rs.500 loan and offers to pay you Rs.600 in
two weeks, it might not be worth the risk, but what if they offered to pay
you Rs.1000? The risk of losing Rs.500 for the chance to make Rs.1000
might be appealing.

Calculation of Risk

For problems on Return and Risk calculation, Standard Deviation, Variance, Beta Co-efficient

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Refer Notes
Investors invest in anticipated future returns, but these returns can rarely be predicted.
The difference between the expected return and the realized return and latter may deviate
from the former. This deviation is defined as risk. All investors generally prefer
investment with higher returns, he must pay the price in terms of accepting higher risk
too. Investors usually prefer less risky investments than riskier investments. Government
bonds are known as risk-free investments, while other investments are risky investments.

Classification of Risk

Systematic Unsystematic

Or Or

Uncontrollable controllable

1. Market risk 1. Business risk

2. Interest rate risk 2. Financial risk

3. Purchasing power risk

SYSTEMATIC RISK

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It affects the entire market. It indicates that the entire market is moving in a direction.
It affects economic, political, sociological changes. This risk is further subdivided
into:

1. Market risk

2. Interest rate risk

3. Purchasing power risk

1. Market risk:
Jack Clark Francis defined market risk as “portion of total variability in return caused
by the alternating forces of bull and bear markets. When the security index moves
upward for a significant period, it is bull market and if the index declines from the
peak to market low point is called troughs i.e., bearish for significant period. The
forces that affect the stock market are tangible and intangible events. Tangible events
such as earthquake, war, political uncertainty and fall in the value of currency.
Intangible events are related to market psychology. For example – In 1996, the
political turmoil and recession in the economy resulted in the fall of share prices and
the small investors lost faith in the market. There was a rush to sell the shares and
stocks that were floating in the primary market were not received well.

2.Interest rate risk:

It is the variation in single period rates of return caused by the fluctuations in the
market interest rate. Mostly it affects the price of the bonds, debentures, and stocks.
The fluctuations in the interest rates are caused by the changes in the government
monetary policy and changes in treasury bills and the government bonds.
Interest rates not only affect the security traders but also the corporate bodies who carry.
their business with borrowed funds. The cost of borrowing would increase, and a
heavy outflow of profit would take place in the form of interest on the capital borrowed.
This would lead to a reduction in earnings per share and a consequent fall in the price

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of shares.

EXAMPLE –In April 1996, most of the initial public offerings of many companies
remained undersubscribed, but IDBI & IFC bonds were oversubscribed. The assured rate
of return attracted the investors from the stock market to the bond market.

3.Purchasing power risk:

Variations in returns are due to loss of purchasing power of currency. Inflation is the
reason behind the loss of purchasing power. The inflation may be, “demand-pull or
cost-push “.

Demand pulls inflation, the demand for goods and services is in excess of
their supply. The supply cannot be increased unless there is an expansion of
labour force or machinery for production. The equilibrium between demand
and supply is attained at a higher price level.
Cost-push inflation, the rise in price is caused by the increase in the cost. The
increase in the cost of raw material, labour, etc makes the cost of production
high and ends in high price level. The working force tries to make the
corporation share the increase in the cost of living by demanding higher
wages. Hence, Cost-push inflation has a spiraling effect on price level.

UNSYSTEMATIC RISK
Unsystematic risk stems from managerial inefficiency, technological change in
the production process, availability of raw materials, change in consumer preference
and labour problems. They must be analyzed by each firm separately. All these factors
form Unsystematic risk. They are.

1. Business risk

2. Financial risk

1. BUISNESS RISK:

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 It is caused by the operating environment of the business. It arises from the
inability of a firm to maintain its competitive edge and the growth or stability
of the earnings. The variation in the expected operating income indicates the
business risk. It is concerned with the difference between revenue and earnings
before interest and tax. It can be further divided into:

Internal business risk

External business risk

Internal business risk - it is associated with the operational efficiency of the

firm. The efficiency of operation is reflected in the company’s achievement of
its goals and their promises to its investors. The internal business risks are:

Fluctuation in sales

Research and development

Personal management

Fixed cost

Single product

External business risk –It is the result of operating conditions imposed on

the firm by circumstances beyond its control. The external business risk is,
Social and regulatory factors

Political risk

Business cycle.

2. FINANCIAL RISK:
It is the variability of the income to the equity capital due to the debt capital. Financial
risk is associated with the capital structure of the firm. Capital structure of firm consists

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of equity bonds and borrowed funds. The interest payment affects the payments that are
due to the equity investors. The use of debt with the owned funds to increase the return
to the shareholders is known as financial leverage.

The financial risk considers the difference between EBIT and EBT. The
business risk causes the variation between revenue and EBIT. The financial risk is
an avoidable risk because it is the management which has to decide how much has
to be funded with equity capital and borrowed capital.