This document discusses key concepts related to investment risk and returns. It explains that return allows investors to measure investment performance and build wealth over time. Both internal factors like management and external forces like economic environment impact investment returns. The document also distinguishes between market risk, which is outside an investor's control, and business risk, which depends on management decisions. Finally, it defines concepts like required rate of return, real rate of return, and risk premium that investors use to evaluate investments.

1. PRINCIPLES
OF
INVESTMEN
T
Tutorial 2- Risk and Returns

2. 1. EXPLAIN THE IMPORTANCE OF
RETURN.
• Return is the profit from an investment or the rewarding for
investing.
• The rate of return indicates how rapidly an investor can build
wealth.
• It allows us to ‘keep score’ on how our investments performance are
doing compared to our competitors.
• It also helps us to predict for future expectations but does not
guarantee for future performance.

3. 2. EXPLAIN WHY INTERNAL
CHARACTERISTICS AND EXTERNAL FORCES
ARE THE KEY FACTOR IN RETURN
a) Internal Characteristics
• Type or risk of investment- The higher the risk, the higher the
return
• Issuer’s management- If a company management is well organized,
it can help the company to improve return in future.
• Issuer’s Financing - e.g. debt level (stability of company), High debt
level will affect a company’s return in future.

4. CONT’ D
b) External Forces
• Political Environment – gov policy, tax policy
• Business Environment
• Economic Environment – GDP, unemployment rate
• Inflation
• Deflation

5. 3. DISTINGUISH BETWEEN MARKET RISK
AND BUSINESS RISK. HOW IS INTEREST
RATE RISK RELATED TO INFLATION RISK?
• Market risk (external) is the risk of decline in investment returns because of
market factors independent of the given investment.
• Type of investments affected: All types of investments
• Uncontrollable (can be influenced by other market, can be changed by economic)
• Examples of market risk:
- Stock market decline on bad news
-Politician upheaval
-Changes in economic conditions

6. • Business risk (internal) is the degree of uncertainty associated with an investment’s
earnings and the investment’s ability to pay the returns owed to investors.
• Type of Investments affected: common stock, preferred stock
• Controllable (based on manager’s decision)
• Examples of business risk :
- Decline in company profits or market share
-Bad management decisions
• The distinction between market risk and business risk parallels the distinction
between market-value accounting and book-value accounting.
CONT’ D

7. Relationship between interest rate risk and inflation risk:
• Negative relationship
• When there is a high interest rate, money supply will decrease, leading
to a lower market inflation and the present value of items will be low.
• When the interest rate is decreased to boost up the money supply, it
will lead to an increase in inflation and higher present value.
• Inflation high > High interest rate > More saving > Less borrowing(cost
of borrowing high) >Less Money Supply > Low inflation
CONT’ D

8. CONT’ D
• Interest rate risk and inflation risk are clearly directly related.
• Positive Relationship in short run
• Negative Relationship in long run
• Interest rates and inflation generally rise and fall together as interest
rate is one of the tools to tackle inflation by policy maker.

9. Required rate of return:
• The rate of return an investor must earn on an investment to be fully compensated for its
risk.
• Required return on investment = Real rate of return + Expected inflation premium + Risk
premium for investment
• Required return on investment = Risk-free rate + Risk premium for investment
Real rate of return (after deducting inflation):
• Equals the nominal rate (before deducting inflation) of return minus the inflation rate
• Measures the change in purchasing power provided by an investment
4. BRIEFLY EXPLAIN THE REQUIRED RATE OF
RETURN, REAL RATE OF RETURN, EXPECTED
INFLATION PREMIUM, AND RISK PREMIUM.

10. Expected inflation premium:
• The average rate of inflation expected in the future
Risk premium:
• Additional return an investor requires on a risky investment to compensate for risks
based upon issue and issuer characteristics (High risk requires high premium in order
to compensate the risk taken by the investor)
• Issue characteristics are the type, maturity and features
• Issuer characteristics are industry and company factors
• Equity risk premium is the difference between stock and risk-free return
CONT’ D

11. 5. EXPLAIN WHY HOLDING
PERIOD RETURN IS
USUALLY MEASURE THE
RETURN FOR ONE YEAR OR
LESS.
• Holding period return is the total return earned from holding
an investment for a specified holding period.
• Holding period return usually measures the return for one year
or less because it does not consider the time value of money.
• In another word, it does not discount back the value to their
present value.
• Hence, this might cause inaccuracy when measuring investment
returns if the time period measured is longer than one year.

12. EXPLAIN TWO (2) TYPES OF RETURN THAT INVESTORS CAN GET FROM AN
INVESTMENT.
6. EXPLAIN TWO (2) TYPES OF
RETURN THAT INVESTORS CAN GET
FROM AN INVESTMENT.
a) Income
• Cash or near-cash that is received as a result of owning an investment.
• Example: Stock Dividends, Interest earned from bank accounts, Rent received from
property/real estate investments.
b) Capital gains (or losses)
• The difference between the proceeds from the sale of an investment and its original
purchase price
• Example: Gains/Losses from sales of a share, Gains/Losses from sales of property/real
estate

13. a) Real estate
• Liquidity Risk is the risk of not being able to liquidate an investment
conveniently and at a reasonable price. It brings negative effect on real
estate.
• e.g. The price of a house has to be lowered for a quick sale.
b) Stocks
• Stock is influenced by Business Risk. It is the degree of uncertainty associated
with an investment’s earnings and the investment’s ability to pay the returns
owed to investors.
• e.g. Bad management decisions cause decline in share price of a company.
7. DISCUSS A RISK THAT ASSOCIATED
WITH THE FOLLOWING INVESTMENT

14. c) Bonds
• Interest Rate Risk is the chance that changes in interest rates will adversely
affect a security’s value like bonds.
• e.g. Market values of existing bonds decrease as market interest rates increase.
d) Certificates of deposit
• It is affected by purchasing power risk and it is the chance that changing price
levels (inflation or deflation) will adversely affect investment returns.
• e.g. When CD rates lower than the rate of inflation, money will lose its
purchasing power over time if interest gains are outdone by inflation rates.
CONT’ D

15. • Exchange rate risk is the possibility that the value of an investment will
change when the currency is exchanged.
• This occurs when there is movement in the exchange rate between
placing an order and the transaction being completed.
• An exchange rate depreciation (appreciation) stimulates (dampens)
investment by enhancing demands in both the domestic and export
markets, but it reduces (increases) investment because of the increasing
cost of imported intermediate goods and the user cost of capital.
8. DISCUSS THE EXCHANGE RATE
RISK AND HOW DOES IT AFFECT YOUR
INVESTMENT POSITION.

16. • The idea behind the use of standard deviation is that standard deviation
can help to determine the market volatility.
• In other words, standard deviation is used to measure how much an
investment's returns can vary from its average return.
• The higher standard deviation is, the riskier the investment is whereby
lower standard deviation indicates the investments are lower risk.
9. STANDARD DEVIATION CAN BE USED AS ONE
OF THE MEASURES OF RISK. EXPLAIN THE
IDEA BEHIND THE USE OF STANDARD
DEVIATION.

17. a) Risk-indifferent
• It refers to an investor who does not require a change in return as
compensation for greater risk.
• For example, there are two investment opportunities , Investment A that is to
invest RM500 with 100% certainty which will increase to RM 550 (10% return)
in one year where Investment B is to invest RM100 with a 50% certainty that
will increase to RM 150 (50% return) or it might decline to RM50 in one year.
• For risk-indifferent investors, they will not mind choosing any one of it as both
investments offer a return of RM50 although there will be a loss of RM50 when
choosing for Investment B.
10. EXPLAIN THE FOLLOWING TERMS
WITH EXAMPLE:

18. b) Risk-averse
• A risk averse investor is an investor who prefers greater return in
exchange for greater risk.
• For example, based on the example above, a risk averse investor will
choose investment A as they know that once they invest RM500 now , it
will increase to RM 550 in a year.
CONT’ D

19. c) Risk-seeking
• It refers to an investor who will accept a lower return in exchange for
greater risk.
• For example, a risk-seeking investor would prefer Investment B ( high risk,
high return).
CONT’ D