Subject material for course Islamic Investment

1. ISLAMIC INVESTMENT
Mahyuddin Khalid
emkay@salam.uitm.edu.my
Investment Return and Risk
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2. Topic Contents
 The Concept of Return
 Returns on Investment
 Risk in Investment
 The Risk Management Process
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3. Risk and Return
Risk and Return relationship varies over time.
Investors assumed to be risk averse
They will want the same return
with less risk.
Assume greater risk only for
greater returns.
Fundamental Relationship
The greater the risk, the greater the expected return (positively
related)
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4. Concept of Return
Return can be defined as
Rewards from investing received as
current income and increased value
Level of profit from an investment
Total
Return
Current income
•Periodic cash flow
•“Yield” measures relate income return to a price
for the security
•Must be in form of cash or readily convertible into
cash.
•Dividend from stock, mutual funds or sukuk
Capital gain
•Appreciation of value
•The change in price of the asset or change of market
value in investment
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5. What Are Investment Returns?
 Investment returns measure the financial results of an
investment.
 Returns can be expressed in:
 Monetary terms
 Percentage terms
 Typically, investment returns are not known with certainty.
 Investment risk pertains to the probability of earning a return
less than that expected.
 The greater the chance of a return far below the expected
return, the greater the risk.
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6. Measuring Return
Historical
Performance
• Past data often
provide a
meaningful basis
for future
expectation
Expected
(Prospective)
Return
• Vital
measurement of
performance
Level of Return
• Depend on
internal
characteristics
and external
forces
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7. Types of Returns on Investment
Investment decisions largely based on ex post
analysis – modified by ex ante expectations
Types of Returns
Ex Ante Returns
•Returns derived from a probability
distribution
•Based on expectations about future cash
flows
Ex Post Returns
•Returns based on a time series of historical
data
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8. Risk and Return
What is risk?
• Uncertainty - the possibility that the actual
return may differ from the expected return
• Probability - the chance of something
occurring
• Expected Returns - the sum of possible
returns times the probability of each return
Risk, from a
finance
viewpoint,
refers to the
uncertainties
associated
with returns
from an
investment
• These uncertainties would translate into
volatility or fluctuation of returns from an
investment.
• Measured by standard deviation.
• Gains & losses, “upside” potential &
“downside” possibility
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9. 9
Risk-Return Trade-off
Risk-Return Trade-off
•The risk-return trade-off is the
principle that potential return
rises with an increase in risk.
•Low levels of uncertainty or risk
are associated with low
potential returns, whereas high
levels of uncertainty or risk are
associated with high potential
returns.
•According to the risk-return
trade-off, invested money can
render higher profits only if the
investor is willing to accept the
possibility of losses.
•For investors, the risk-return
trade-off is one of the essential
components of each investment
decision as well as in the
assessment of portfolios as a
whole.

10. Sources of Risk in Investment
•Affects income returnInterest Rate Risk
•Overall market effects (politic, economic and social)Market Risk
•Purchasing power variabilityInflation Risk
•Ability to liquidate investment convenientlyLiquidity Risk
•Investment earning and ability to pay the return (interest,
principle, dividend)
Business Risk (non-systematic)
•Payment attributable to the mix of debt and equity to
finance business (Default, Liquidity, Marketability, Leverage)
Financial Risk
•Changes in code, treatment, fluctuationExchange Rate/Currency/Tax Risk
•Failure to comply with the Shariah rules and principles in
investment
Shariah Non-Compliance Risk
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11. Type of Risk in Investment
Total Risk = General Risk + Specific Risk
Types of Risk
Systematic (general) risk
•Pervasive, affecting all securities, cannot
be avoided
•Interest rate or market or inflation risks
Non-systematic (specific) risk
•Unique characteristics specific to issuer
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12. Risk Aversion
 Risk Aversion is:
 A characteristic of an individual’s preference in risk-taking
situations
 E.g. By experience and experiment
 Rational behavior assumed to be risk-averse
 A measure of willingness to pay to reducing risk
 Prefer lower risk given same expected value
 Decreasing marginal utility of income
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13. Risk Management
 Risk Management is:
 the process/techniques of reducing the risks faced in an investment.
 It generally involves three broad steps;
1. Identifying the source and type of risk.
2. Measuring the extent of the risk.
3. Determining the appropriate response.
 What makes risk management challenging is the fact that risks
and returns are generally positively correlated.
 Thus, the risk-return tradeoff.
 The challenge of risk-management is to protect the expected
returns while simultaneously reducing or laying-off the risks.
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14. Speculators and Hedgers Behavior on Risk
Hedgers
•Taking positions to
reduce their
exposures.
Speculators
•Taking positions
that increase their
exposure to certain
risks in the hope of
increasing their
wealth.
The riskiness of
an asset or a
transaction
cannot be
assessed in
isolation or in
abstract.
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15. Risk Management Process
Identifying the source
and type of risk
Figuring out what
the most important
risk exposures are
for the unity of
analysis.
Measuring the extent
of the risk
The quantification
of the costs
associated with the
risks that have
been identified
Determining
the
appropriate
response
• Risk avoidance
• Loss prevention and
control
• Risk retention
• Risk transfer
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16. Risk Exposure
 Risk Exposure is:
 Particular types of risk one faces due to one’s circumstances.
 e.g. job, business, and pattern of consumption, etc.
 Illustrations of risk exposure:
 The risk of a crop failure and the risk of a decline in the price for a
farmer.
 The risks of fire, theft, storm damage, earthquake damage for a
house owner.
 The currency risk for a person whose business involves imports or
exports of goods.
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17. Summary
In this
chapter
you have
learned
about:
The Concept of
Return
Returns on
Investment
Risk in Investment
The Risk
Management Process
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18. Thank you18