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CHAPTER -4RISK AND RETURN
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RETURN
What we will get back when wesacrifice today after a specified
timeperiod.
Objective of the investment.Motivating force.Concerned with
benefits.
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Factors of Return
Compare the alternative investment. Measurement of historial
return. Helps in estimation of future.
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Types of Return
RealizedReturn
ExpectedReturn
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Determinants of Return
Risk free real rate. The expected rate of return. The risk
associated with the investment.
thus, reqd rate= risk free real rate + inflation
premium + risk premium
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Rate of Return
Income from security in the form of cash flows.
The difference in the price of securitybetween the beginning and
end of theholding period.
Expressed in percentage.
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Measurement of Rate of Return Genral equation for calcualting
R.O.R
K = dt + (Pt Pt-1 )Pt-1
where,Dt = income or cash flow receivables from the security
at time t.K= rate of return.
Pt = price of the security at time t i.e end of holding
period.
Pt-1 = price of the security at time t-1 i.e. Beginning of
theholding period or purchase period
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Example
If the share of ACC is purchased for Rs.3580 in feb 8 of last
year and sold for3800 on feb 9 of this year and thecompany paid a
dividend of Rs 35 forthe year. What is R.O.R.
Ans = 7.12%
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Probability of Rate of Return
K = Pi x Ki
where I = 1 to n
K = expected R.O.R
Pi= probability associated with the ith possible outcome.
Ki = R.O.R from the ith possible outcome.
n= number of possible outcome
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Example
The probability distribution and
corresponding rates of return for alphacompany are shown
below:
Possible Outcomes Probability of occurrence - Pi
Rate of return (%) - Ki
1 .10 50
2 .20 30
3 .40 10
4 .20 -10
5 .10 -30
1.00
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Risk
Difference between actual and expected outcome.
It is a variance.
Expected return from the security may not be materialize.
Uncertainties could be due to the political, economic and
industry factors.
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sources of risksInterest rate risk
Market risk
Inflation risk
Business risk
Financial riskLiquidity risk
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Measurement of total risk
Different ways to calculate risks:
1. range of return = highest possible return
lowest possible return
2. variance = var (k) = Pi (Ki- K)^2
3. S.D = sqrt (var)
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Ques- calculate the standard deviationfor the alpha companys
rate of return Possible outcomes Probability Pi K in %
1 .10 50
2 .20 30
3 .40 10
4 .20 -10
5 .10 -30
Ans- 21.9%
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Risk Return RelationshipReturn
Risk
LowRisk
Averagerisk
High risk
Rf
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