risk return trade off

1. Risk-Return Trade-off
Introduction: Financial decisions incur different degree
of risk. Investment in government Bonds has less risk, the risk of
default is very less. On the other hand, you would incur more
risk, to invest your money in shares, as return is not certain. In
other words; we can expect low return from government bond
and higher from shares.
Risk Free Securities are Government Securities, IVP, KVP,
Fixed Deposits. Risk Premium Securities are Equity shares,
Mutual Funds etc.
Therefore, the financial manager has to maintain a
balance between Risk and Return the ultimate objective is
maximize the share price as well as value of the firm.

2. Components of Risk
Introduction: Any rational investor, before investing wealth in the stock,
analysis the risk associated with the particular stock. The actual return he
receives from a stock may vary from his expected return and the risk is
expressed in terms of variability. Investor in general would like to analyze the
risk factors and a thorough knowledge of the risk helps him to plan his
portfolio in such a manner so as to minimize the risk associated with the
investment.
Definition: The dictionary meaning of risk is the possibility of loss or injury;
the degree or probability of such loss. In risk, the probable outcomes of all
the possible events are listed. Risk consists of 2 components, the systematic
risk and unsystematic risk. The systematic risk is caused by factors external to
the particular company and uncontrollable by the company. The systematic
risk affects the market as whole. In the case of unsystematic risk the factors
are specific, unique and related to the particular industry or company.

3. Risk Components
Systematic Risk Un-Systematic Risk
Market Risk
Interest Rate Risk
Purchasing Power Risk
Business Risk Financial Risk
Internal Business Risk External Business Risk
-Fluctuations in the sales Social and Regulatory Factors
-Research and Development Political Risk
-Personnel Management Business cycle
-Fixed cost
-Single product

4. Systematic Risk
• The systematic risk affects the entire market.
Often we read in the news papers that the stock
market is in the bear hug or in the bull grip. This
indicates that the entire market is moving in a
particular direction either downward or upward.
The systematic risk is further sub-divided into:
– Market risk
– Interest rate risk
– Purchasing power risk

5. Market risk
• “Jack Clark Francis has defined market risk as that
portion of total variability of return caused by the
alternating forces of bull and bear markets. When
the security index moves upward haltingly for a
significant period of time, it is known as bull
market. In the bull market, the index moves from
a low level to the peak. Bear market is just a
reverse to the bull market; the index declines
haltingly from the peak to a market low point
called bear market. During this period 80 percent
of the securities prices rise or hall along with the
stock market indices.

6. Minimizing the Market Risk
• A) The investor has to study the price behavior of the
stock
• B) The standard deviation and beta indicate the
volatility of the stock. The national stock exchange new
bulletin provides this information. Looking at the beta
value, the investor can gauge the risk factor and make
wise decision according to his risk tolerance
• C) The investor should be careful in the timings of the
purchase and sale of the stock. He should purchase it
at the lower level and should exist at a higher level.

7. Interest rate risk
• Interest rate risk is the variation in the single period rates of
return caused by the fluctuations in the interest rate. It has
affects the price of bonds, debentures and stocks. 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 government
bonds. If higher interest rates were offered by the
government securities, investor would like to switch his
investments from private sector bonds to public sector
bonds to public sector bonds.
• Ex: April 1996 most of the initial public offerings of many
companies remained undersubscribed but IDBI and IFC
bonds oversubscribed because the rate of return attracted
the investors.

8. Protection against interest rate risk
• A) The investor can also buy treasury bills and
bonds of short maturity.
• B) Another suggested solution is to invest in
bonds with different maturity dates. When the
bonds mature in different dates, reinvestment
can be done according to present climate.

9. Purchasing power Risk
• Variation in the returns is caused also by the lost
of purchasing power of currency. Inflation is the
reason behind the loss of purchasing power.
Purchasing power risk is the probable loss in the
purchasing power of the returns to be received.
The rise in price penalizes the returns to the
investor, and every potential rise in price is a risk
to the investor.
• Real Rate of Return= (1+r/1+Q)-1
– R=Nominal future value
– Q=Inflation rate

10. Protection against inflation
• A) The general opinion is that bond yield vary
would provide hedge against the inflation
• B) Another way to avoid the risk is to have
investment in short-term securities and to
avoid long term investment.
• C) Investment diversification can also solve
this problem to a certain extent.

11. Unsystematic Risk
• Unsystematic risk is Unique and peculiar to a
firm or an industry. Unsystematic risk stems
from managerial inefficiency, technological
change in the production process, and non-
availability of raw materials, changes in the
consumer preference and labor problems.
Unsystematic risk broadly classified into a)
Business Risk and b) Financial risk

12. Business risk
• It is the portion of the unsystematic risk cause by
the operating environment of the business. A
variation that occurs in the operating
environment is reflected on the operating income
and expected dividends.
• Protection against business risk:
– A) To guard against the business risk, the investor has
to analyze the SWOT to which the company belongs
– B) Analyzing the profit trend of the company is
essential. The calculation of standard deviation would
yield the variability of the return.

13. Financial Risk
• It refers to the variability of the income to the
equity capital due to the debt capital. It is
associated with the capital structure of the
company fixed interest securities like
debenture and preference shares are the
commitment of the company. Increasing debt
content in the capital structure increasing the
return to the shareholders is known as
financial leverage.

14. Protection against financial risk
• Analyzing the capital structure of the
company. If the debt-equity ration is higher,
the investor should have a sense of caution.
Along with the capital structure analysis, he
should also take into account of the interest
payment. In a boom period, the investor can
select a highly levered company but in a
recession.

15. Problem: (1)
Calculation of Real Rate of Return
• Problem: X expects to earn a nominal rate of 10%
return on his investments next year. If the rate
inflation is expected to be 6% next year what
expected real rate of return would be earn?
• Solution: rr =  1r1Q   1 100
R=Nominal Rate of Return
Q=Inflation Rate
= 1.1010.061100
=3.77%

16. Problem: 2 (Real Rate of Return)
• Problem: Rs.500 debentures earn a coupon
rate of 15% per annum. Inflation rate
expected in the covering one-year period is
12%. Compute the real rate of return.
– Solution: 10.1510.121100
– Answer: 2.7%.

17. Problem: 3 (Risk and Return)
• Problem: Equity share of Rs.10/- promises a dividend
of 20% and it is expected that the price of the share
rise from the current level of Rs.60/- to Rs.80/- in a
year time. Inflation during the next year is estimated
at 14%. What is the real rate of return of the equity?
• Solution:
Nominal Rate=
Expected Price–Current Price+DividendCurrent
Price100
80-60+2/60) X100 = 36.66%
rr = (1+.367/1+.14)-1 X 100 = 19.9%

18. Problem: 4 (Risk and Return)
• Problem: The returns on securities A and B are given below
Probability Security-A Security-B
0.5 4 0
0.4 2 3
0.1 0 3
Give the security of your preference.
The security has to be selected on the basis of Risk and Return.
• Solution:  = R-RP
R = RP
A Security R = 0.5X4 + 0.4X2 + 0.1X0 = 2.8
B Security R = 0.5X0 + 0.4X3 + 0.1X3 = 1.5
A Security  = (4-2.8)² 0.5 + (2-2.8)²0.4 + (0-2.8)²0.1 = 1.33
B Security  =  (0-1.5) ²0.5 + (3-1.5) ²0.4 + (3-1.5) ²0.1 = 1.5
The above problem: A Security will be acceptable because the higher return and lower
risk.

19. Problem: 5 (Risk and Return)
• Problem: The two companies A and B to calculate Risk and Return:
• Company-A Company-B
Probability Return Probability Return
0.10 6 0.10 4
0.25 7 0.20 6
0.30 8 0.40 8
0.25 9 0.20 10
0.10 10 0.10 12
• Answer: A Company Expected Return= 8 R¯
B Company Expected Return= 8 R¯
σA= 1.14
σB = 2.19

20. Problem: 6 (Risk and Return)
Problem: A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell
for at the end of the year with the respective probabilities as follows:
• Price Probability
• 115 0.10
• 120 0.10
• 125 0.20
• 130 0.30
• 135 0.20
• 140 0.10
Calculate the expected return and Standard Deviation.
Solution: (Today’s’ Price-Yesterdays’ price/Yesterdays price) x 100
(115-120/120) x 100= -4.17
(120-120/120) x 100= 0
(125-120/120) x 100=4.17
(130-120/120) x 100=8.33
(135-120/120) x 100=12.50
(140-120/120) x 100=16.67
Rֿ= 7.083 and = 5.91%