Risk and Return

1. SECURITIES
Types, Risk-Return Relationship and Measures

2. Securities - Types
• STOCK
– Common Stock
– Preferred Stock (Cumulative & Redeemable)
– Convertible Preferred Stock
• LONG TERM DEBT
– Debentures (Sinking Fund/Bullet Payment)
– Convertible Subordinated Debentures
– Secured Notes
– Revolving Credit Notes
– Euro-Currency Credit Notes
• WARRANTS, OPTIONS AND FUTURES
• MUTUAL FUNDS UNITS

3. Sources of Return-Risk
• Return
– Yield (Dividend cash flow or interest cash flow)
– Capital Appreciation
• Risk
– Systematic Risk
• Interest Rate Risk
• Market Risk
• Inflation Risk
– Unsystematic Risk
• Business Risk
• Financial Risk
• Liquidity Risk

4. Measuring Return
• Holding Period Return or Yield
HPR = {CF(t) + P(Closing) }/P(Beginning)
HPY = HPR - 1
• Arithmetic Mean Return
AMR = Sum of yearly return / No of years
• Geometric Mean Return
GMR = {[(1+R1) (1+R2)….(1+R n)] ^ (1/n)} - 1
• Arithmetic versus Geometric Mean Return
• Realized Return versus Expected Return

5. Expected Return and Risk
• Expected Return
E (Ri) = ∑ Pi * Ri
• Expected Risk
Variance (σ2) = ∑ Pi * [Ri – E (Ri)] 2

6. Measuring Adjusted Return
• Inflation Adjusted Return
IAR = {(1+R)/(1+Inflation Rate)} - 1
• Dollar or International Return
IR = {S end/S begin) x ($ begin/$ end)} - 1
S = Stock price at the end and begining
$ = Dollar required to buy Re. 1 or Rs. 100
• Market Adjusted Return
MAR = NR - Market or Index Return during the period

7. Measuring Risk
• Total Risk
– Range, Standard Deviation, Variance of Return
– Co-efficient of variation (SD/Mean)
• Risk from specific source
– Interest Rate Risk; Inflation Risk; Liquidity Risk; etc.
• Systematic Risk
• Unsystematic Risk
• Risk Premium
– Translate Risk into Expected Premium

8. Measuring Systematic Risk (Beta)
• An investment in a single stock exposes the investor
to all sources of risk the stock is exposed.
• Impact of a stock on the risk of portfolio, which an
investor holds, is considerably lower.

9. Beta, Required Rate of Return and SML
• Risk of an individual security is measured by
studying the relationship between the stock and
market portfolio.
• Beta, which is a relative measure, is equal to
covariance between stock’s return and market
portfolio’s return divided by variance of market
portfolio’s return.

10. Beta Computation
• Find weekly or monthly return {compounding
return using ln(Pt/Pt-1)} for a stock and market
portfolio (use a market index as a proxy)
• Find covariance between the two returns(a) and
variance of market portfolio’s return(b); beta = a/b
• Alternatively, run a regression (keeping stock’s
return as dependent variable and market portfolio’s
return as independent variable) between the two;
beta of the stock is equal to beta of the regression.
• Test the reliability of beta

11. Beta of Sensex Stocks (96-2005)

12. Total Risk, Systematic Risk and Unsystematic Risk
• Variance of returns measures total risk
• Beta measures Systematic (common) risk
• Unsystematic or unique risk is difference of total
risk and systematic risk