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ISLAMIC INVESTMENT

Mahyuddin Khalidemkay@

salam.uitm

.edu.my

Investment Return and Risk

Topic Contents

The Concept of Return Returns on Investment Risk in Investment The Risk Management Process

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Risk and Return

Risk and Return relationship varies over time.

Investors assumed to be risk averse They will want the same return with less risk.

Assume greater risk only for greater returns.

Fundamental RelationshipThe greater the risk, the greater the expected return (positively related)

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Concept of Return

Return can be defined asRewards from investing

received as current income and increased value

Level of profit from an investment

Total Retur

n

Current income•Periodic cash flow•“Yield” measures relate income return to a price for the security

•Must be in form of cash or readily convertible into cash.

•Dividend from stock, mutual funds or sukuk

Capital gain•Appreciation of value•The change in price of the asset or change of market value in investment

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What Are Investment Returns?

Investment returns measure the financial results of an investment.

Returns can be expressed in: Monetary terms Percentage terms

Typically, investment returns are not known with certainty.

Investment risk pertains to the probability of earning a return less than that expected.

The greater the chance of a return far below the expected return, the greater the risk.

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Measuring Return

Historical Performance

• Past data often provide a meaningful basis for future expectation

Expected (Prospective)

Return• Vital

measurement of performance

Level of Return

• Depend on internal characteristics and external forces

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Types of Returns on Investment

Investment decisions largely based on ex post analysis – modified by ex ante expectations

Types of ReturnsEx Ante Returns• Returns derived from a probability distribution

• Based on expectations about future cash flows

Ex Post Returns• Returns based on a time series of historical data

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Risk and Return

What is risk?

• Uncertainty - the possibility that the actual return may differ from the expected return

• Probability - the chance of something occurring

• Expected Returns - the sum of possible returns times the probability of each returnRisk, from a

finance viewpoint,

refers to the uncertainti

es associated

with returns from an

investment

• These uncertainties would translate into volatility or fluctuation of returns from an investment.

• Measured by standard deviation.• Gains & losses, “upside” potential &

“downside” possibility

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Risk-Return Trade-off

Risk-Return Trade-off

The risk-return trade-off is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to the risk-return trade-off, invested money can render higher profits only if the investor is willing to accept the possibility of losses.For investors, the risk-return trade-off is one of the essential components of each investment decision as well as in the assessment of portfolios as a whole.

Sources of Risk in Investment

• Affects income returnInterest Rate Risk

• Overall market effects (politic, economic and social)Market Risk

• Purchasing power variabilityInflation Risk

• Ability to liquidate investment convenientlyLiquidity Risk

• Investment earning and ability to pay the return (interest, principle, dividend)

Business Risk (non-systematic)

• Payment attributable to the mix of debt and equity to finance business (Default, Liquidity, Marketability, Leverage)

Financial Risk

• Changes in code, treatment, fluctuationExchange Rate/Currency/Tax Risk

• Failure to comply with the Shariah rules and principles in investmentShariah Non-Compliance Risk

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Type of Risk in Investment

Total Risk = General Risk + Specific Risk

Types of RiskSystematic (general) risk• Pervasive, affecting all securities, cannot be avoided

• Interest rate or market or inflation risks

Non-systematic (specific) risk• Unique characteristics specific to issuer

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Risk Aversion

Risk Aversion is: A characteristic of an individual’s preference in risk-taking

situations E.g. By experience and experiment

Rational behavior assumed to be risk-averse A measure of willingness to pay to reducing risk Prefer lower risk given same expected value Decreasing marginal utility of income

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Risk Management

Risk Management is: the process/techniques of reducing the risks faced in an

investment. It generally involves three broad steps;

1. Identifying the source and type of risk.2. Measuring the extent of the risk.3. Determining the appropriate response.

What makes risk management challenging is the fact that risks and returns are generally positively correlated. Thus, the risk-return tradeoff.

The challenge of risk-management is to protect the expected returns while simultaneously reducing or laying-off the risks.

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Speculators and Hedgers Behavior on Risk

Hedgers•Taking positions to reduce their exposures.

Speculators•Taking positions that increase their exposure to certain risks in the hope of increasing their wealth.

The riskiness of an asset or a transaction

cannot be assessed in

isolation or in abstract.

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Risk Management Process

Identifying the source and type

of risk

Figuring out what the most

important risk exposures are for

the unity of analysis.

Measuring the extent of the risk

The quantification of

the costs associated with the risks that

have been identified

Determining the

appropriate response

1.Risk avoidance2.Loss prevention and

control3.Risk retention4.Risk transfer

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Risk Exposure

Risk Exposure is: Particular types of risk one faces due to one’s circumstances.

e.g. job, business, and pattern of consumption, etc. Illustrations of risk exposure:

The risk of a crop failure and the risk of a decline in the price for a farmer.

The risks of fire, theft, storm damage, earthquake damage for a house owner.

The currency risk for a person whose business involves imports or exports of goods.

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Summary

In this chapter

you have learned about:

The Concept of Return

Returns on Investment

Risk in Investment

The Risk Management

Process

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18 Thank you