Risk and Return Measurement

RISK & RETURN
MEASUREMENT
RUBY SHARMA

What is a risk ?
RUBY SHARMARUBY SHARMA

RISK IS…..
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 of an
original investment.
The existence of volatility in the occurrence of an expected incident is
called risk .Higher the unpredictability greater is the risk.
In finance, risk is the probability that actual results will differ from
expected results.

RISK….
Risk is defined as the volatility of returns.
Quantifiably, risk is usually assessed by considering historical
behaviors and outcomes. In finance, standard deviation is a common
metric associated with risk. Standard deviation provides a measure of
the volatility of asset prices in comparison to their historical averages in
a given time frame.

RISK….
Each investor has a unique risk profile that determines their willingness
and ability to withstand risk. In general, as investment risks rise,
investors expect higher returns to compensate for taking those risks.
Risk can be reduced using diversification and hedging strategies.

CAUSES OF RISK
 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

TYPES OF RISKS

Systematic and unsystematic
risk
Systematic risk is uncontrollable by an organization and
macro in nature.
Unsystematic risk is controllable by an organization and
micro in nature.

SYSTEMATIC RISK
Systematic risk is due to the influence of external factors on an
organization. Such factors are normally uncontrollable from an
organization's point of view.
It is a macro in nature as it affects a large number of organizations
operating under a similar stream or same domain. It cannot be planned
by the organization.

The types of systematic risk are
depicted and listed below.

Interest rate risk
Interest-rate risk arises due to variability in the interest rates from time
to time. It particularly affects debt securities as they carry the fixed rate
of interest.
The types of interest-rate risk are depicted and listed below.
Price risk and
Reinvestment rate risk.

Price risk arises due to the possibility that the price of the shares,
commodity, investment, etc. may decline or fall in the future.
Reinvestment rate risk results from fact that the interest or dividend
earned from an investment can't be reinvested with the same rate of
return as it was acquiring earlier.

Market risk
Market risk is associated with consistent fluctuations seen in the trading
price of any particular shares or securities. That is, it arises due to rise
or fall in the trading price of listed shares or securities in the stock
market.

Purchasing power or
inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it
originates from the fact that it affects a purchasing power adversely. It
is not desirable to invest in securities during an inflationary period.
The types of power or inflationary risk are:
Demand inflation risk and
Cost inflation risk.

Demand inflation risk and
Cost inflation risk.
Demand inflation risk arises due to increase in price, which result from
an excess of demand over supply. It occurs when supply fails to cope
with the demand and hence cannot expand anymore.
Cost inflation risk arises due to sustained increase in the prices of goods
and services. It is actually caused by higher production cost. A high cost
of production inflates the final price of finished goods consumed by
people.

Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing
within an organization. Such factors are normally controllable from an
organization's point of view.
It is a micro in nature as it affects only a particular organization. It can
be planned, so that necessary actions can be taken by the organization to
mitigate (reduce the effect of) the risk.
The types of unsystematic risk are depicted and listed below.
Business or liquidity risk,
Financial risk
credit risk and
Operational risk.

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 .

TOOLS FOR MEASURING
RISK
 Standard deviation
 Beta

Standard deviation
Standard deviation. The investment industry’s primary measure of risk
is standard deviation. Standard deviation really tells you how much an
investment will fluctuate from the average return.
The return of any investment has an average, which is also the expected
return, but most returns will be different from the average: some will
be more, others will be less. The more individual returns deviate from
the expected return, the greater the risk and the greater the potential
reward.
The degree to which all returns for a particular investment or asset
deviate from the expected return of the investment is a measure of its
risk.

EXAMPLE
OUTCOME RETURN
FROM STOCK
(A ) X
PROB. (X) RETURN
FROM STOCK
(B) Y
PROB.(Y)
1 13 .25 7 .25
2 15 .50 15 .50
3 17 .25 23 .25

SOLUTION
STOCK X STOCK Y
EXPECTED RETURN 15 RUPEES 15 RUPEES
S.D. 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 fluctuation as
compared to stock A

Limitations of Using Standard Deviation
as a Risk Measurement Metric
Standard deviation as a risk measurement metric only shows how the
annual returns of an investment are spread out, and it does not
necessarily mean that the outcomes will be consistent in the future. The
investments may be affected by other non-related factors such as
interest rate changes and market competition, and the annual return may
fall outside the predicted range. It means that standard deviation should
not be used as the final risk measurement tool, but should be used
alongside other risk measurement functions.

Limitations of Using Standard Deviation
as a Risk Measurement Metric
Another weakness of deviation risk measurement is that it assumes a
normal distribution of data values. It means that there is a uniform
probability for achieving values above or below the mean. For example,
68% of the time, all individual values will fall one standard deviation
away from the mean. The assumption may not apply to all types of
investments.

Coefficient of variation
Coefficient of variation is a measure used to assess the total risk per unit
of return of an investment.
It is calculated by dividing the standard deviation of an investment by
its expected rate of return.
Since most investors are risk-averse, they want to minimize their risk
per unit of return. Coefficient of variation provides a standardized
measure of comparing risk and return of different investments. A
rational investor would select an investment with lowest coefficient of
variation.
RUBY SHARMA

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

RUBY SHARMA

Beta
A coefficient, that describes how the expected return of a stock or
portfolio is correlated to the return of the financial market as a whole.
Essentially, beta measures the systematic risk of a security or a
portfolio, demonstrating how volatile it is in relation to the entire
market or a particular benchmark.
Beta is calculated using regression analysis. Numerically, it represents
the tendency for a security's returns to respond to swings in the
market. Formula to calculate required rate of return with beta is:
R = Rf + ( Rm – Rf)*

BETA
 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 is considered to be ‘defensive’ and 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 is considered to be ‘aggressive’ and more volatile
than the market.
RUBY SHARMA

Suppose the risk free rate of return for security is 6%. Market rate is
12% and beta is 1.25. Then the required rate of return for the security
would be :
R = 6 +(12-6)*1.25
R= 13.5%
Reconsider the above example but suppose that the value of Beta =
1.60. Then the return would be:
R = 6 +(12-6)*1.60
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.
RUBY SHARMA

Risk and Return Measurement

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