CHAP – 4
Risk and Return
Risk and Return
Risk and return are fundamental concepts in finance that are intricately linked and play a
crucial Risk and return are fundamental making. Understanding the relationship between risk
and return is essential for investors seeking to optimize their investment portfolios and
achieve their financial goals
Risk refers to the uncertainty or variability of returns associated with an investment.
encompasses the possibility of losing some or all of the invested capital, as well as the
potential for earning higher-than-expected returns.
Return refers to the gain or loss generated on an investment over a specific period, expressed
as a percentage of the initial investment. It encompasses both capital appreciation and income
received from the investment, such as dividends or interest. Investors expect to be
compensated for the risk they undertake, and returns serve as the reward for bearing that risk.
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 of an original investment.
Quantifiably, risk is usually assessed by considering historical behaviours 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.
Types/Classification of Risk
a) Systematic Risk
b) Unsystematic Risk.
SYSTEMATIC RISK
Systematic risk is that part of the total risk that is caused by factors beyond the control of
specific company of Individual Systematic risk is caused by factors that are external to the
organization. All investments or securities are subjected to systematic risk and therefore, it is a
non – diversifiable risk. Systematic risk cannot be diversified away by holding a large number
of securities.
COMPONENTS OF SYSTEMATIC RISK
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.
Interest Rate Risks: 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
fluctuations in the interest rates are caused by the changes in the government monetary policy
and the changes that occur in the interest rates of treasury bills and the government bonds.
Purchasing power risk: Purchasing power risk is also known as inflation risk. It is so, since it
emanates from the fact that it affects a purchasing power adversely. People have more money in
their hands and they demand more consumable as well as durable goods. Purchasing power risk
is the uncertainty of the purchasing power of the amounts to be received in future due to both
inflation and deflation.
UNSYSTEMATIC RISKS
Unsystematic risk is the risks generated in a particular company or industry and may not apply
to other industries or economies. For example, the telecommunication sector in India is going
through disruption, most of the large players are providing low-cost services, which are
impacting the profitability of small players with small market shares. Small players with low
sector, it requires enormous funding. the business. As telecommunication is a capital-intensive
sector, it requires enormous funding.
TYPES OF UNSYSTEMATIC RISK
Business risk: Business risk refers to the possibility that a company will have lower than
anticipated profits or that it will experience a loss rather than a profit. Business risk is
influenced by numerous factors, including sales volume, per-unit price, input costs, competition
and overall economic climate and government regulations
Every business organization contains various risk elements while doing the business. Business
risks implies uncertainty in profits or danger of loss and the events that could pose a risk due to
some unforeseen events in future, which causes business to fail.
Business risks can be classified into two types:
a) Internal risk: Internal risk arises from the events taking place within the organization.
Internal risks arise from factors which can be controlled such as human factors like talent
management and strikes.
b) External risk: External risks arise from the events taking place outside the organization
External risks arise from factors which cannot be controlled such as economic factors
(market risks, pricing pressure), natural factors (floods, earthquakes), political factors
(compliance and regulations of government
Financial Risk: Financial risk also refers to the possibility of a corporation or government
defaulting on its bonds, which would cause those bondholders to lose money. The probability
of loss is inherent in financing methods which may impair the ability to provide adequate
return.
Financial risk refers to the possibility that a bond issuer will default, by failing to repay
principal and interest in a timely manner.
Financial risk can be divided into,
Credit Risk. Credit risk refers to the risk that a borrower will default on any type of debt by
failing to make required payments. The risk is primarily that of the lender and includes lost
principal and interest, disruption to cash flows, and increased collection costs. The loss may be
complete or partial and can arise in a number of circumstances.
Currency Risk: It is a form of risk that arises from the change in price of one currency
against another. Whenever investors or companies have assets or business operations across
national borders, they face currency risk if their positions are not hedged. Currency risk
involves losses from adverse movements in foreign exchange rates, both short-term and long-
term it affects any company that sells abroad or buys from abroad in foreign currency or that
has foreign subsidiaries.
Country Risk: Country risk arises from an adverse change in the financial conditions of a
country in which a business operates. There are three aspects of country risk.
Country risk can be divided into.,
Political Risk: This is the risk of deteriorating financial conditions from the consequences of
a change of government or political regime, or from continuing uncertainty about what a
government might do. The risk is greatest in countries with political instability, because a
change in government could be sudden and the actions of the incoming government
unpredictable and drastic, e.g., the imposition of exchange controls, nationalization of the
banks etc.
Economic Risk: This is the risk that economic conditions within a country will have harmful
financial consequences, particularly for inflation, interest rates and foreign-exchange rates. If a
government were to decide, e.g., to increase spending by borrowing heavily, business
opportunities would arise for suppliers and contractors to the government, but the financial
consequences of a larger government spending deficit (excess of expenditure over income that
must be financed by government borrowing) might be much higher interest rates for
commercial and private borrowers.
TYPES
OF PORTFOLIO RISKS
Market Risk: This is also known as systematic risk or the risk that an investment will decline in value due to
macroeconomic factors that affect the entire market.
Credit Risk: This risk involves an investment that will decline in value due to a default by the issuer of a bond or
other debt instrument.
Liquidity Risk: This risk involves an investment that cannot be sold or liquidated quickly enough to avoid losses.
Usually, it can occur when there is a lack of buyers in the market or when the investment is illiquid by nature,
such as real estate or private equity
Inflation Risk: This risk pertains to the purchasing power of an invest that will decline due to increases in the
general price level of goods and services.
Interest Rate Risk: The risk involves the value of an investment that will decline due to changes in interest rates
Currency Risk: The risk refers to the value of an investment denominated in a foreign currency that will decline
due to changes in exchange rate
Political Risk: This risk refers to investments that will decline in values due to changes in government policies,
regulations
Reinvestment Risk: This risk may come in the form of future cash flows from an investment that will be
reinvested at a lower rate of return.
MEASURES OF PORTFOLIO RISK
Standard Deviation: Standard deviation is a measure of the dispersion of returns around the
mean of a portfolio. It is a widely used measure of portfolio risk and represents the volatility
of the portfolio
Beta: Beta measures the sensitivity of an investment's returns to changes in the overall
market. A beta of 1 indicates that the investment's returns move in line with the market, while
a beta greater than 1 indicates that the investment is more volatile than the market
Value at Risk (VaR): VaR is a statistical measure of the maximum potential loss that a
portfolio may experience over a given time period with a certain level of confidence.
Conditional Value at Risk (CVaR): CVaR, also known as expected shortfall, is a risk
measure that looks at the expected loss beyond a certain threshold.
Drawdown: A drawdown is a measure of the decline in the value of a portfolio from its peak
value to its lowest point. It is a useful measure of portfolio risk for investors who are
concerned about the potential loss of capital
Sharpe Ratio: Sharpe ratio is a risk-adjusted measure of portfolio performance. It measures
a portfolio's excess return over the risk-free rate relative to its volatility
Sortino Ratio: The Sortino ratio is a risk-adjusted measure of portfolio performance that
takes into account the downside risk
EXPECTED RETURNS OF A PORTFOLIO
The return on an investment can be considered a random variable that can take any values
within a given range. The expected return is based on historical data, which may or may not
provide reliable forecasting of future returns Hence, the outcome is not guaranteed.
Expected return is simply a measure of probabilities intended to show the likelihood that a
given investment will generate a positive return, and what the likely return will be.
The purpose of calculating the expected return on an investment is to provide an investor
with an idea of probable profit vs risk. This gives the investor a basis for comparison with
the risk-free rate of return. The interest rate on 3-month U.S. Treasury
CALCULATING EXPECTED RETURN OF A PORTFOLIO
Calculating expected return is not limited to calculations for a single investment. It can also
be calculated for a portfolio. The expected return for an investment portfolio is the weighted
average of the expected return of each of its components. Components are weighted by the
percentage of the portfolio's total value that each accounts for. Examining the weighted
average of portfolio assets can also help investors assess the diversification of their
investment portfolio
STEPS INVOLVED IN CALCUALTION OF EXPECTED RETURNS OF
A PORTFOLIO
Determine the probability of each return that might occur: Refer to the historical data on
past returns because this information can help to determine appropriate probabilities that a
return can occur for a specific asset
Determine the expected return for each possible return: The expected return for each
probability is also important. This value lets determine how valuable each return is.
Multiply each expected return by its corresponding percentage (weight): This allows to
find the absolute value of each return compared to other returns considering. This is valuable
because can compare returns and determine which ones are the best for.
Add each of the products together to find the weighted average expected return: The
weighted average expected return is the combination of expected returns for each of assets
