CHAPTER 3- RISK AND RETURN

Chapter 3: Risk and Return

Table of Contents
Chapter 3: Risk and Return ............................................................................................................ 1
Types of Risks in Investments ................................................................................................... 2
Detailed Types of Investment Risks ...................................................................................... 4
Measurement of Risk and Return .............................................................................................. 9
I. Measurement of Return ..................................................................................................... 10
II. Measurement of Risk ........................................................................................................ 12
III. Risk-Adjusted Return Measures ..................................................................................... 15
IV. Capital Asset Pricing Model (CAPM) ............................................................................. 16
I. Calculation of Return .............................................................................................................. 17
III. Calculation of Risk-Adjusted Return Measures ........................................................... 24

Risk is an inherent and unavoidable part of life, affecting everyone from individuals to
large organizations on a daily basis. For effective management and mitigation of potential
losses, it's crucial to understand the various types of risks and how they can impact
you or your organization. Risks can broadly include financial, operational, strategic, and
reputational risks, among others.

By understanding each type of risk and its potential effects, one can take proactive and
actionable steps to prevent negative consequences. Thoughtful planning and preventative
measures empower businesses to be prepared for the diverse range of risks that may
emerge. Let's delve into the various categories of risk.

What is Risk?

In finance and investment, risk is fundamentally linked to uncertainty and potential

outcomes.

• Definition 1: Risk is any activity or investment that offers the potential for gain
but also carries the possibility of loss.

• Definition 2: More specifically in investments, risk can be defined as the

probability or likelihood that the expected return from a security or investment
will not actually materialize (i.e., you might get less than you anticipated, or even
lose money).

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• Definition 3: Investment risk is the likelihood of incurring losses relative to the

expected return on any particular investment.

Risk is broadly associated with various aspects of life, including business operations,
financial investments, and even personal decisions. Generally, risks are categorized into:

• Economic Activities: Risks related to financial markets, business ventures, and

investments (e.g., stock market investments).

• Physical Activities: Risks associated with tangible actions or events (e.g., driving,
natural disasters).

By understanding what risk is and how to effectively manage or minimize potential

losses, individuals and organizations can make better, more informed decisions when
facing uncertain situations. Careful planning and preparation are key to mitigating adverse
impacts.

Types of Risks in Investments

[If they ask types of portfolio risk, Write the same]

The risks associated with investments are diverse. They can be broadly classified and
understood in terms of their impact and whether they can be diversified away.

Total Risk = General Risk + Specific Risk

Total Risk = Market Risk + Issuer Risk

Total Risk = Systematic Risk + Unsystematic Risk

This breakdown highlights that the total risk of an investment is a sum of its systematic
and unsystematic components.

Systematic Risk & Unsystematic Risk

These are the two fundamental categories of investment risk:

1. Systematic Risk (Non-Diversifiable Risk / Market Risk)

• Nature: Systematic risk represents the uncertainty that affects a large number
of investments across the entire market or a broad sector. It is inherent to
the overall market and economy.

• Diversification: A crucial characteristic is that it cannot be eliminated or

significantly reduced through diversification. This means no matter how many
different stocks or assets you combine in your portfolio, you will still be exposed
to systematic risk.

• Causes: It is typically caused by macroeconomic factors that influence all or

most businesses and industries. Examples include:

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o Inflation: Changes in the general price level of goods and services.

o Exchange Rates: Fluctuations in currency values.

o Political Instability: Uncertainty arising from government policies or

political events.

o Natural Disasters: Widespread catastrophic events.

o Recessions/Depressions: Broad economic downturns.

o Wars, Structural Economic Changes, Tax Law Changes: Factors that affect
the entire economic landscape.

• Impact: The effect of these factors is to put pressure on all securities, causing
their prices to generally move in the same direction. For instance, during a boom
period, prices of most securities tend to rise, indicating overall economic
prosperity.

• Control: Systematic risk is largely uncontrollable from an individual investor's

or company's perspective, as it originates from external, broad market forces. It
can be reduced (e.g., by choosing less volatile assets) but never completely
eliminated.

2. Unsystematic Risk (Diversifiable Risk / Specific Risk / Issuer Risk)

• Nature: Unsystematic risk is unique or specific to an individual investment, a

particular company, or a specific industry sector. It does not affect the average
investor holding a well-diversified portfolio.

• Diversification: A key characteristic is that it can be reduced or largely

eliminated through diversification. By combining various assets that are not
perfectly correlated (i.e., their movements are independent or move in opposite
directions), the specific risks of individual assets tend to cancel each other out.

• Causes: It is caused by factors specific to the firm or industry. Examples include:

o Changes in Management Structure: Decisions or instability within a company's

leadership.

o Asset Mispricing: A specific asset being over- or undervalued due to unique

circumstances.

o Legal Issues: Lawsuits or regulatory fines specific to a company.

o Technological Disruptions: A new technology making a specific company's

product or process obsolete.

o Labor Strikes: Work stoppages within a particular company or industry.

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o Irregular or Disorganized Management Policies: Poor decision-making or

execution within a firm.

o Consumer Preferences (specific to a product/brand): Shifts in consumer taste

affecting only certain companies.

• Impact: These factors are independent of the broader market's price mechanisms.

• Control: While unavoidable for any single investment, unsystematic risk can be
managed through effective diversification strategies.

The key to investing wisely is understanding both systematic and unsystematic

risks and how they can affect your investments.

Detailed Types of Investment Risks

A. Systematic Risks (Non-Diversifiable)

These risks generally affect the entire market or broad sectors and cannot be diversified
away.

1. Market Risk:

o Definition: Market risk refers to the variability in stock prices (or overall security
returns) due to changes in investors' collective attitudes, sentiments, and
expectations. It's often synonymous with systematic risk.

o Causes: It's primarily driven by investor reactions to tangible events (real economic,
political, social reasons) and intangible events (psychological factors, expectations,
or fear/overconfidence).

▪ Tangible Events: Political changes, economic shifts (recessions, depressions,

changes in consumption patterns), social developments.

▪ Intangible Events: Emotional instability among investors, fear of loss, or undue

confidence leading to excessive buying or selling.

o Impact: A decline or rise in market prices triggers emotional instability. Fear of

loss can lead to excessive selling, pushing prices down. Hope of gain can lead to
active buying, pushing prices up. Investors tend to react more strongly to price
declines than increases.

o Diversification: Market risk cannot be eliminated through diversification because

prices of all stocks generally tend to move together with the overall market. While
combining stocks wisely can reduce its impact on a portfolio (by combining stocks
that react differently to market changes), it won't fully eliminate it. All equity
investors face the risk of a downward market.

o Mitigation (limited): Investors can try to reduce market risk by being conservative
in their portfolio construction, timing their stock purchases, or choosing only "growth

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stocks" (though even these are susceptible to market downturns). However, falling
markets will still bring down prices across the board, though the decline in some
stocks will be less than others.

2. Interest Rate Risk:

o Definition: This is the variability in a security's return resulting from changes in

the general level of interest rates in the economy.

o Impact on Security Prices: Interest rate changes generally affect security prices
inversely. This means that when interest rates rise, security prices (especially bond
prices) tend to fall, and vice versa. This inverse relationship is due to the valuation
of securities, as future cash flows are discounted at a higher rate when interest
rates rise.

o Primary Impact: Interest rate risk affects bonds more directly and significantly
than common stocks. It is a major risk for all bondholders.

o Example: If you hold a portfolio of long-term bonds with fixed interest rates and
prevailing interest rates suddenly rise, newly issued bonds will offer higher yields.
This makes your existing bonds, which offer lower fixed yields, less attractive.
Consequently, their market value will decrease, potentially leading to a capital loss
if you sell them before maturity.

o Maturity and Yield: Generally, the longer the maturity period of a security, the
higher its potential yield, but also the higher its sensitivity to interest rate changes
(and thus greater price fluctuations). Short-term interest rates tend to fluctuate
more rapidly than long-term rates.

3. Purchasing Power Risk (Inflation Risk):

o Definition: This is the possibility that the purchasing power of your invested money
will decline over time, even if the nominal return is stable. It arises from changes
in the prices of goods and services, covering both inflation (rising prices) and
deflation (falling prices).

o Impact: With uncertain inflation, the real return (inflation-adjusted return) of an

investment involves risk, even if the nominal return (stated return) is guaranteed
(e.g., a Treasury bond). If inflation outpaces your investment returns, your money
buys less in the future.

o Relationship with Interest Rate Risk: This risk is closely related to interest rate
risk because interest rates generally rise as inflation increases. Lenders demand
additional "inflation premiums" to compensate for the anticipated loss of purchasing
power.

o Indian Context: In India, purchasing power risk is typically associated with inflation
and rising prices, often driven by "cost-push" (rising production costs) or "demand-

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pull" (excess demand over supply) inflation. Rising Wholesale Price Index (WPI) and
Consumer Price Index (CPI) reflect this price spiral. Consumers who save for future
consumption find their budgets affected by rising prices and reduced purchasing
power.

4. Regulation Risk (Legislative/Political Risk - Type 1):

o Definition: The risk that changes in government regulations, tax laws, or policies
could adversely affect the attractiveness, value, or fundamental nature of an
investment.

o Impact: Certain investments might be attractive due to specific regulatory or tax

advantages (e.g., municipal bonds with tax-exempt interest). A change in these laws
can eliminate that advantage, making the investment less desirable and causing its
price to tumble.

o Example (1987 Tax Law Changes): In 1987, changes in US tax laws reduced the
attractiveness of many existing limited partnerships that relied on special tax
considerations. This led to a dramatic fall in their prices, leaving investors with
"different securities" than what they originally bought. Due to a lack of a robust
secondary market, many investors couldn't sell these illiquid securities except at
"firesale" prices.

5. Bull-Bear Market Risk:

o Definition: This risk specifically refers to the variability in market returns that
results from the alternating forces of bull (rising) and bear (falling) markets.

o Bull Market: An upward trend where the market index rises fairly consistently
from a low point (trough) over a period of time.

o Bear Market: A downward trend that begins when the market index reaches a
peak and declines to the next trough.

o Impact: Investors face the risk of purchasing assets at the peak of a bull market
and seeing their value decline significantly during a subsequent bear market, or
missing out on gains during a bull market.

B. Unsystematic Risks (Diversifiable)

These risks are specific to a particular company or industry and can be reduced through
diversification.

1. Business Risk (Operating Risk):

o Definition: The risk of doing business in a particular industry or environment.

It's a function of the operating conditions a company faces and the variability in
its operating income.

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o Causes: Fluctuations in operating revenue and expenses (both variable and fixed).
A higher proportion of fixed operating expenses in a firm's total expenses means
greater operating risk (higher operating leverage).

o Impact: High fluctuations in operating income over time lead to uncertainty and
increased business risk. Conversely, an increase in stable operating income lowers
business risk.

o Measurement: Business risk is measured with the Degree of Operating Leverage

(DOL).

▪ Degree of Operating Leverage (DOL) = Percentage Change in Operating

Income / Percentage Change in Sales

▪ If DOL > 1, it indicates the existence of operating risk, meaning a small change
in sales leads to a larger change in operating income due to fixed costs.

o Examples: U.S. Steel faces unique problems as a large steel producer (e.g.,
commodity price volatility). General Motors faces challenges related to global oil
prices and competition from imports.

2. Financial Risk:

o Definition: This risk is specifically associated with the financing activities of a

firm, particularly the use of debt in its capital structure.

o Causes: As the proportion of debt securities in a company's total capital increases,

its fixed financial charges (interest payments) also increase. Since interest payments
are mandatory regardless of profits, a higher debt burden increases the risk of
not being able to meet these obligations.

o Impact: A higher financial risk means that the amount of profit remaining for
equity shareholders (and thus Earnings Per Share - EPS) becomes more volatile
and can significantly decrease if the company's operating income is not sufficient
to cover fixed interest charges.

o Measurement: Financial risk is measured with the Degree of Financial Leverage

(DFL).

▪ Degree of Financial Leverage (DFL) = Percentage Change in EPS /

Percentage Change in EBIT (Earnings Before Interest and Taxes)

▪ If DFL > 1, it indicates the existence of financial risk, meaning a small change
in EBIT leads to a larger change in EPS due to fixed interest costs.

3. Management Risk:

o Definition: The risk that poor decisions, errors, or ethical lapses by a company's
management can harm investors.

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o Causes: Managers are fallible and can make mistakes (e.g., forecasting errors, poor
strategic choices, inefficient operations) or engage in unethical behavior.

o Agency-Principal Relationship: This risk is often highlighted by the "agent-

principal theory," which suggests that hired managers (agents) might not always
act perfectly in the best interests of the shareholder-owners (principals). Owners,
having a direct stake, are often more incentivized to maximize company value.

o Mitigation: Research suggests investors can reduce losses from management errors
by investing in companies where executives have significant equity investments,
aligning their interests more closely with shareholders. Examples like Enron,
WorldCom, and Arthur Andersen demonstrate how "creative accounting" practices
by management can erode net worth while maintaining false stock prices, leading
to significant investor losses.

4. Default Risk (Credit Risk):

o Definition: The portion of an investment's total risk that results from changes in
the financial integrity or creditworthiness of the issuer. It is the risk that the
issuer of a debt security (bond) will fail to make timely interest payments or
repay the principal.

o Impact: When a company's financial health deteriorates (moves closer to

bankruptcy), the market price of its securities will typically decline, reflecting the
increased risk of default. Conversely, an improvement in financial health can lead
to higher security prices.

o Actual vs. Perceived Loss: Most losses suffered by investors due to default risk
are not from actual bankruptcy, but rather from the decline in security prices
as the firm's financial integrity weakens. By the time a company actually defaults
or goes bankrupt, its security prices will have often already fallen to near zero.

5. Liquidity Risk:

o Definition: The risk associated with the ease and speed at which a security can
be bought or sold in its secondary market without significantly affecting its price.

o Impact: A liquid investment can be traded quickly without a significant price

concession. The more uncertainty about the time it takes to sell an asset, or the
size of the price discount needed to sell it quickly, the greater the liquidity risk.

o Examples: A Treasury bill has very low liquidity risk because it can be easily
traded with minimal price impact. A small Over-The-Counter (OTC) stock, however,
might have substantial liquidity risk due to limited buyers and sellers.

o Liquid Assets Risk: This refers specifically to the risk of needing to accept price
discounts or pay high sales commissions to sell an asset without delay. Perfectly
liquid assets are highly marketable with no liquidation costs. Illiquid assets are

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not readily marketable and incur larger price discounts or commissions to find a
buyer.

6. International Risk: This is a broad category encompassing risks specific to

international investments. It includes:

o Exchange Rate Risk (Currency Risk):

▪ Definition: The variability in returns on international securities caused by

fluctuations in currency exchange rates.

▪ Impact: Investors who invest internationally face the prospect that even if
their foreign investment performs well in the local currency, their returns
might be significantly reduced (or even turn into losses) when converted back
to their home currency due to unfavorable exchange rate movements.

o Country Risk (Political Risk - Type 2):

▪ Definition: The risk associated with the political, and by extension, the
economic stability and viability of a specific country's economy. This is crucial
for investors investing directly or indirectly in foreign countries.

▪ Impact: Political instability, changes in government policies, expropriation of

assets, social unrest, or other country-specific events can adversely affect the
value of investments within that country.

7. Industry Risk:

o Definition: That portion of an investment's total variability of return caused by

events that specifically affect the products and firms within a particular industry.
An industry is viewed as a group of companies competing with each other to
market a homogeneous product.

o Impact: Events unique to an industry (e.g., changes in consumer taste for a

specific product category, new technology disrupting that industry, increased
competition within the industry, changes in input costs specific to that industry)
can impact all companies within that industry, regardless of their individual
performance.

Measurement of Risk and Return

*(some of the Formulas and tables are not typed/ converted properly so refer old notes)
In finance, for effective decision-making, it's not enough to just understand what risk
and return are; you also need to be able to quantify them. This chapter will delve into
the various methods used to measure both the return generated by an investment and
the risk associated with it.

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I. Measurement of Return

Return on an investment represents the gain or loss generated over a specific period,
typically expressed as a percentage of the initial investment. Returns can come from
various sources, including capital gains (change in price) and income (dividends or
interest).

Components of Return:

1. Yield (Income Component): This refers to the periodic cash flows generated by
the investment.

o For stocks: Dividends received.

o For bonds: Interest payments (coupon payments).

o For real estate: Rental income.

2. Capital Gain or Loss (Price Appreciation Component): This is the change in

the market price of the asset over the holding period.

o If the selling price is higher than the purchase price, it's a capital gain.

o If the selling price is lower than the purchase price, it's a capital loss.

Methods of Measuring Return:

1. Holding Period Return (HPR) / Absolute Return:

o Definition: This measures the total return earned from holding an asset for
a specific period, regardless of whether it's one day, one month, or multiple
years. It does not annualize the return.

o Formula:

HPR=Beginning Value(Ending Value - Beginning Value) + Income Received

Where:

▪ Ending Value = Selling Price (or Current Market Price)

▪ Beginning Value = Purchase Price

▪ Income Received = Dividends, Interest, or other cash distributions

during the holding period.

o Example: If you buy a stock for ₹100, receive ₹5 in dividends, and sell it for
₹110 after one year:

$HPR = \frac{(₹110 - ₹100) + ₹5}{₹100} = \frac{₹10 + ₹5}{₹100} = \frac{₹15}{₹100} =

0.15 \text{ or } 15% $

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o Usefulness: Primarily used for short-term periods (less than a year) or when
simply showing the total gain/loss over a specific, non-annualized period.

2. Expected Return:

o Definition: This is the anticipated future return on an investment, calculated

as the weighted average of all possible returns, with the weights being the
probabilities of each return occurring. It's a forward-looking measure.

o Formula:

E(R)=i=1∑n(Pi×Ri)

Where:

▪ E(R) = Expected Return

▪ Pi = Probability of the i-th possible return

▪ Ri = The i-th possible return

▪ n = Number of possible outcomes

o Example:

| Economic Condition | Probability (Pi) | Return (Ri) | Pi×Ri |

| :----------------- | :------------------ | :------------- | :--------------- |

| Boom | 0.30 | 20% | 6% |

| Normal | 0.40 | 10% | 4% |

| Recession | 0.30 | -5% | -1.5% |

| | Sum = 1.00 | | Sum = 8.5% |

Expected Return = 8.5%

3. Realized Return (Historical Return):

o Definition: This is the actual return an investor has obtained from their
investment at the end of the holding period. It is based on past performance.

o Calculation: Uses historical price data and income received over past periods
to calculate actual returns.

4. Annualized Return / Compound Annual Growth Rate (CAGR):

o Definition: When an investment is held for more than one year, simply using
the HPR doesn't account for the compounding effect. Annualized return or
CAGR provides an average annual rate of return over a multi-year period,

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assuming returns are compounded. It makes returns comparable across

different holding periods.

o Formula (for CAGR):

CAGR=(Beginning ValueEnding Value)(Number of Years1)−1

o Example: If an investment of ₹1,00,000 grew to ₹1,50,000 in 3 years:

CAGR=(₹1,00,000₹1,50,000)(31)−1=(1.5)0.3333−1≈1.1447−1=0.1447 or 14.47%

o Usefulness: Essential for comparing investments held for different durations,

as it normalizes returns to an annual basis, reflecting the compound growth.

II. Measurement of Risk

Risk, in the context of investments, is the uncertainty or variability of returns. It

quantifies how much the actual returns might deviate from the expected returns.

Key Concepts for Risk Measurement:

• Variability of Returns: The essence of risk. An investment whose returns fluctuate

significantly is considered high-risk, while one with stable returns is low-risk.

• Probability Distribution: The set of all possible returns and their associated
probabilities.

Methods of Measuring Risk:

1. Range:

o Definition: The simplest measure of risk. It is the difference between the highest
possible return and the lowest possible return from an investment.

o Formula:

Range=Maximum Return−Minimum Return

o Example: If an investment can yield returns of 25% (best case), 10% (most likely),
and -10% (worst case):

Range=25%−(−10%)=35%

o Limitations: It only considers the extreme values and ignores the distribution of
returns in between. It doesn't tell us about the likelihood of those extremes.

2. Standard Deviation (σ):

o Definition: The most common and statistically robust measure of total risk or
total variability of an investment's returns. It quantifies the dispersion of actual
returns around the expected (or average) return. A higher standard deviation

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indicates greater risk (more volatile returns), while a lower standard deviation
indicates lower risk (more stable returns).

o Formula (for historical returns):

σ=n−1∑i=1n(Ri−Rˉ)2

Where:

▪ σ = Standard Deviation
▪ Ri = Individual historical return for period i
▪ Rˉ = Average (Mean) of historical returns
▪ n = Number of historical periods

o Formula (for expected returns based on probability distribution):

σ=i=1∑nPi(Ri−E(R))2

Where:

▪ Pi = Probability of the i-th possible return

▪ Ri = The i-th possible return
▪ E(R) = Expected Return (calculated earlier)
▪ n = Number of possible outcomes

o Interpretation: In a normal distribution, approximately:

▪ 68% of returns fall within ±1 standard deviation of the mean.

▪ 95% of returns fall within ±2 standard deviations of the mean.

▪ 99.7% of returns fall within ±3 standard deviations of the mean.

o Usefulness: It provides a quantitative measure of total risk and is widely used

in portfolio theory.

3. Variance (σ2):

o Definition: The square of the standard deviation. It measures the average squared
deviation of individual returns from the mean return. While mathematically
important, it's less intuitive than standard deviation because its units are squared
(e.g., % squared).

o Formula: Variance=σ2 (Just square the standard deviation calculation).

4. Coefficient of Variation (CV):

o Definition: A relative measure of risk. It is used to compare the risk of

investments that have different expected returns. It measures the risk per unit
of return.

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o Formula:

CV=Expected ReturnStandard Deviation (Risk)

o Usefulness: A lower CV indicates a better risk-return trade-off, meaning less risk

for each unit of expected return. It's particularly useful when comparing
investments with vastly different expected returns where standard deviation alone
might be misleading.

5. Beta (β):

o Definition: A measure of an investment's systematic risk (market risk). It

quantifies the sensitivity of an individual stock's (or portfolio's) returns to changes
in the overall market's returns.

o Interpretation:

▪ β=1.0: The security's price moves exactly in line with the market. If the
market goes up by 10%, the security is expected to go up by 10%.

▪ β>1.0: The security is more volatile than the market (aggressive). If the
market goes up by 10%, a stock with β=1.5 is expected to go up by 15%.

▪ β<1.0: The security is less volatile than the market (defensive). If the market
goes up by 10%, a stock with β=0.8 is expected to go up by 8%.

▪ β<0 (Negative Beta): The security moves inversely to the market (very rare
for common stocks). If the market goes up, the security is expected to go
down.

o Formula:

β=Variance (Market Return)Covariance (Security Return, Market Return)

Or, more simply:

β=Correlation (Security Return, Market Return)×Standard Deviation (Market Return)Standar

d Deviation (Security Return)

o Usefulness: Beta is a crucial input in the Capital Asset Pricing Model (CAPM)
for determining the expected return for an asset given its systematic risk. It
helps investors understand how a particular stock will behave relative to the
overall market.

6. Correlation Coefficient (r):

o Definition: Measures the degree to which two assets' returns move in relation
to each other. It ranges from -1 to +1.

o Interpretation:

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▪ r=+1 (Perfect Positive Correlation): The returns of two assets move in

the exact same direction and proportion.

▪ r=−1 (Perfect Negative Correlation): The returns of two assets move in

perfectly opposite directions.

▪ r=0 (No Correlation): The returns of two assets move independently of

each other.

o Usefulness: Crucial for diversification. Combining assets with low or negative

correlation helps reduce portfolio risk without sacrificing much return.

III. Risk-Adjusted Return Measures

These measures evaluate investment performance by considering the amount of risk

taken to achieve a certain level of return. They help investors compare investments with
different risk profiles.

1. Sharpe Ratio:

o Definition: Measures the excess return (return above the risk-free rate)
per unit of total risk (standard deviation).

o Formula:

Sharpe Ratio=Portfolio Standard DeviationPortfolio Return−Risk-Free Rate

Where:

▪ Risk-Free Rate: The return on a risk-free investment (e.g., government

bonds).

o Interpretation: A higher Sharpe Ratio indicates a better risk-adjusted

return, meaning the investment provided more return for the total risk
borne.

2. Treynor Ratio:

o Definition: Measures the excess return per unit of systematic risk (Beta).
It is similar to the Sharpe ratio but uses beta in the denominator, making
it suitable for evaluating diversified portfolios (where unsystematic risk has
been largely eliminated).

o Formula:

Treynor Ratio=Portfolio BetaPortfolio Return−Risk-Free Rate

o Interpretation: A higher Treynor Ratio indicates a better risk-adjusted

return, considering only the market risk.

3. Alpha (α):

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o Definition: Measures the excess return of an investment relative to what

would be predicted by a benchmark or a model like the Capital Asset
Pricing Model (CAPM). It represents the value added by a fund manager's
active investment decisions, above and beyond the return for the risk taken.

o Formula (based on CAPM):

Alpha=Actual Return−Expected Return (as per CAPM)

Where Expected Return (as per CAPM) = Risk-Free Rate + β * (Market Return - Risk-
Free Rate)

o Interpretation:

▪ Positive Alpha: The investment outperformed its expected return for

the level of risk taken. (Good performance)

▪ Negative Alpha: The investment underperformed its expected return.

(Poor performance)

▪ Zero Alpha: The investment performed exactly as expected given its

systematic risk.

o Usefulness: Used to evaluate the skill of an investment manager.

IV. Capital Asset Pricing Model (CAPM)

• Developed By: William Sharpe (1970).

• Purpose: A widely used model to determine the expected return of an asset or

portfolio, given its systematic risk (Beta). It distinguishes between systematic risk
(which investors are compensated for) and unsystematic risk (which can be
diversified away).

• Core Principle: Investors are compensated for taking on systematic risk, not
unsystematic risk. Therefore, the expected return of an asset should be linearly
related to its beta.

• Formula:

E(Ri)=Rf+βi×(Rm−Rf)

Where:

o E(Ri) = Expected Return of Security i

o Rf = Risk-Free Rate of Return (e.g., return on Treasury bonds)

o βi = Beta of Security i (Systematic Risk)

o (Rm−Rf) = Market Risk Premium (The additional return investors expect

for investing in the overall market compared to a risk-free asset).

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o Rm = Expected Return of the Market Portfolio (e.g., Nifty 50, Sensex).

• Security Market Line (SML): The CAPM formula can be graphically represented
by the Security Market Line. The SML plots the expected return against beta. It
shows the relationship between risk (beta) and expected return for all assets in
the market. Assets that plot above the SML are considered undervalued (offering
higher return for their risk), while those below are overvalued.

Conclusion

Measuring risk and return is fundamental to financial decision-making. By understanding

and applying these various statistical and financial tools, investors and financial managers
can quantify past performance, forecast future expectations, and make informed choices
to build diversified portfolios that align with their risk tolerance and financial goals.
While return aims to be maximized, risk needs to be managed and understood to
achieve sustainable long-term wealth creation.

I. Calculation of Return
Return calculations quantify the income and capital appreciation (or depreciation) of an
investment.1 We'll look at historical (realized) and expected returns.

A. Calculation of Historical / Realized Return

When we have past data, we can calculate the actual return achieved.2

1. Holding Period Return (HPR):

o Concept: Measures the total return over a specific period, including both price
changes and any income received.3 It's a simple, direct measure for any length
of holding period.4

o Formula:

HPR=Beginning Price(Ending Price - Beginning Price) + Income Received

o Example 1: Stock with Dividend

You bought a share of XYZ Ltd. for ₹250. After one year, you received a dividend of
₹15, and the share's market price is now ₹280.

▪ Beginning Price = ₹250

▪ Ending Price = ₹280

▪ Income Received (Dividend) = ₹15

HPR=₹250(₹280−₹250)+₹15=₹250₹30+₹15=₹250₹45=0.18 or 18%

Your holding period return for XYZ Ltd. is 18%.

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o Example 2: Bond with Interest

You purchased a bond for ₹980. Over the year, it paid ₹70 in interest. At the end of
the year, the bond's market value is ₹995.

▪ Beginning Price = ₹980

▪ Ending Price = ₹995

▪ Income Received (Interest) = ₹70

HPR=₹980(₹995−₹980)+₹70=₹980₹15+₹70=₹980₹85≈0.0867 or 8.67%

Your holding period return for the bond is approximately 8.67%.

2. Annualized Return / Compound Annual Growth Rate (CAGR):

o Concept: Used when an investment is held for more than one year to calculate
the average annual growth rate, assuming compounding. It provides a
standardized measure for comparing investments of different durations.5

o Formula:

CAGR=(Beginning ValueEnding Value)(Number of Years1)−1

(Note: This formula assumes all intermediate income is reinvested to contribute to the
Ending Value. If income is taken out, more complex Time-Weighted Rate of Return
calculations are needed, but for basic [Link], CAGR as presented is usually sufficient for
multi-year price appreciation)

o Example:

An investment grew from ₹50,000 to ₹75,000 over a period of 4 years.

▪ Beginning Value = ₹50,000

▪ Ending Value = ₹75,000

▪ Number of Years = 4

CAGR=(₹50,000₹75,000)(41)−1CAGR=(1.5)0.25−1CAGR≈1.10668−1≈0.10668 or 10.67%

The investment grew at an average annual compound rate of approximately 10.67%.

B. Calculation of Expected Return

This is a forward-looking calculation, based on different possible future scenarios and

their probabilities.

1. Expected Return (E(R)):

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o Concept: A weighted average of all possible returns, where the weights are
the probabilities of those returns occurring. It's the most likely return an
investor anticipates.

o Formula:

E(R)=i=1∑n(Pi×Ri)

Where:

▪ Pi = Probability of the i-th possible return6

▪ Ri = The i-th possible return

▪ n = Number of possible outcomes

o Example:

Consider an investment with the following possible returns and probabilities:

| Economic Condition | Probability (Pi) | Return (Ri) | Calculation (Pi×Ri) |

| :----------------- | :------------------ | :------------- | :----------------------------- |

| Boom | 0.25 | 25% (0.25) | 0.25×0.25=0.0625 |

| Normal Growth | 0.50 | 12% (0.12) | 0.50×0.12=0.0600 |

| Recession | 0.25 | -8% (-0.08) | 0.25×−0.08=−0.0200 |

| Total | 1.00 | | Sum = 0.1025 |

E(R)=0.1025 or 10.25%

The expected return for this investment is 10.25%.

II. Calculation of Risk

Risk measures the variability or uncertainty of returns. We'll cover several key measures.

A. Calculation of Absolute Risk Measures

These measures quantify the total variability of an investment's returns.

1. Range:

o Concept: The simplest measure of risk, indicating the spread between the
best and worst possible outcomes.

o Formula:

Range=Maximum Return−Minimum Return

o Example:

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Using the previous expected return example:

▪ Maximum Return = 25%

▪ Minimum Return = -8%

Range=25%−(−8%)=25%+8%=33%

The range of possible returns for this investment is 33%.

2. Standard Deviation (σ):

o Concept: The most widely used measure of total risk. It quantifies how
much the returns typically deviate from the average or expected return. A
higher standard deviation means higher risk.7

o Formula (for Expected Returns with Probabilities):

σ=i=1∑nPi(Ri−E(R))2

(We use this formula when given probabilities for different outcomes.)

o Example (Continuing from Expected Return Example):

We know E(R)=10.25%.

| Economic Condition | Probability (Pi) | Return (Ri) | (Ri−E(R)) | (Ri−E(R))2 | Pi(Ri

−E(R))2 |
| :----------------- | :------------------ | :------------- | :-------------- | :--------------- | :---------------
------ |

| Boom | 0.25 | 0.25 | 0.25−0.1025=0.1475 | 0.02175625 | 0.25×0.02175625=0.0054390625

|

| Normal Growth | 0.50 | 0.12 | 0.12−0.1025=0.0175 | 0.00030625 |

0.50×0.00030625=0.000153125 |

| Recession | 0.25 | -0.08 | −0.08−0.1025=−0.1825 | 0.03330625 |

0.25×0.03330625=0.0083265625 |

| | | | | Sum = | 0.01391875 |

σ=0.01391875 ≈0.11797 or 11.80%

The standard deviation (risk) of this investment is approximately 11.80%.

o Formula (for Historical Returns - Sample Standard Deviation):

σ=n−1∑i=1n(Ri−Rˉ)2

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(We use this formula when given a series of past returns and need to calculate historical
risk. Using n−1 in the denominator provides an unbiased estimate for a sample.)

o Example (Historical Standard Deviation):

Suppose a stock had the following returns over the last 5 years: 10%, 15%, 5%, 20%,
8%.

▪ First, calculate the average historical return (Rˉ):

Rˉ=(10%+15%+5%+20%+8%)/5=58%/5=11.6% (0.116)

▪ Now, calculate the sum of squared deviations:

| Year | Return (Ri) | (Ri−Rˉ) | (Ri−Rˉ)2 |

| :--- | :------------- | :---------------- | :---------------- |
| 1 | 0.10 | 0.10−0.116=−0.016 | 0.000256 |
| 2 | 0.15 | 0.15−0.116=0.034 | 0.001156 |
| 3 | 0.05 | 0.05−0.116=−0.066 | 0.004356 |
| 4 | 0.20 | 0.20−0.116=0.084 | 0.007056 |
| 5 | 0.08 | 0.08−0.116=−0.036 | 0.001296 |

| | | Sum = | 0.014120 |

▪ Finally, calculate standard deviation:

σ=5−10.014120 =40.014120 =0.00353 ≈0.05941 or 5.94%

The historical standard deviation of this stock's returns is approximately 5.94%.

B. Calculation of Relative Risk Measures

These measures help compare the risk of investments with different characteristics.

1. Coefficient of Variation (CV):

o Concept: Measures risk per unit of expected return. It's useful for
comparing investments when their expected returns are significantly
different. A lower CV indicates a more favorable risk-return trade-off.8

o Formula:

CV=Expected ReturnStandard Deviation (Risk)

o Example:

Consider two investments:

▪ Investment A: Expected Return = 10%, Standard Deviation = 5%

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 CHAPTER 3- RISK AND RETURN

▪ Investment B: Expected Return = 15%, Standard Deviation = 8%

▪ For Investment A:

CVA=10%5%=0.50

▪ For Investment B:

CVB=15%8%≈0.533

Even though Investment B has a higher standard deviation (higher absolute risk), its
Coefficient of Variation (0.533) is slightly higher than Investment A's (0.50). This suggests
that Investment A offers a slightly better return for each unit of risk taken compared
to Investment B.

C. Calculation of Systematic Risk and Portfolio Diversification

1. Beta (β):

o Concept: Measures systematic risk, indicating how sensitive an investment's

returns are to changes in the overall market returns. It's the slope of the
regression line of the asset's returns against the market's returns.

o Formula (Practical): Beta is typically calculated using regression analysis on

historical data.9 However, for conceptual understanding and simple
calculations, it can be approximated or provided.

Beta=Variance(Rmarket)Covariance(Rasset,Rmarket)

Alternatively:

Beta=Correlation(Rasset,Rmarket)×Standard Deviation(Rmarket)Standard Deviation(Rasset)

o Example (Conceptual Calculation / Interpretation):

Suppose for Stock X:

▪ Standard Deviation of Stock X's returns (σstock) = 18%

▪ Standard Deviation of Market returns (σmarket) = 12%

▪ Correlation between Stock X and Market returns (rstock,market) =

0.8

βstock=0.8×0.120.18=0.8×1.5=1.2

Stock X has a Beta of 1.2, meaning it is 20% more volatile than the market.10 If the
market moves up/down by 10%, Stock X is expected to move up/down by 12%.

2. Portfolio Beta:

o Concept: The weighted average of the betas of the individual assets in a

portfolio.11 It represents the overall systematic risk of the portfolio.

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o Formula:

βPortfolio=j=1∑m(wj×βj)

Where:

▪ wj = Weight (proportion) of asset j in the portfolio

▪ βj = Beta of asset j

▪ m = Number of assets in the portfolio

o Example:

A portfolio consists of:

▪ Stock A: 40% weight, Beta = 1.1

▪ Stock B: 30% weight, Beta = 0.9

▪ Stock C: 30% weight, Beta = 1.4

βPortfolio=(0.40×1.1)+(0.30×0.9)+(0.30×1.4)βPortfolio=0.44+0.27+0.42βPortfolio=1.13

The portfolio's overall Beta is 1.13, indicating it's slightly more volatile than the market.

3. Correlation Coefficient (r):

o Concept: Measures the strength and direction of the linear relationship

between the returns of two assets.

o Formula (Simplified for interpretation, actual calculation is complex):

rXY=σX×σYCovariance(RX,RY)

Where:

▪ Covariance(RX,RY) measures how returns of X and Y move together.

▪ σX,σY are standard deviations of X and Y.12

o Interpretation:

▪ r=+1: Perfect positive correlation (move in same direction

proportionally)13

▪ r=−1: Perfect negative correlation (move in opposite direction

proportionally)14

▪ r=0: No linear correlation (move independently)15

o Use in Diversification:

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▪ To reduce risk, combine assets with low or negative correlation.16

For example, if Asset X and Asset Y have a correlation of -0.5, when
X performs poorly, Y might perform well, balancing the portfolio.

▪ Combining assets with a correlation of less than +1 will always

reduce portfolio standard deviation (risk) compared to the weighted
average of individual standard deviations.17

III. Calculation of Risk-Adjusted Return Measures

These ratios help evaluate how much return is generated for the level of risk taken.18

1. Sharpe Ratio:

o Concept: Measures excess return (return above the risk-free rate) per unit
of total risk (standard deviation). Useful for comparing investments where
total risk is relevant.

o Formula:

Sharpe Ratio=Portfolio Standard DeviationPortfolio Return−Risk-Free Rate

o Example:

▪ Portfolio P: Return = 15%, Standard Deviation = 12%

▪ Portfolio Q: Return = 12%, Standard Deviation = 8%

▪ Risk-Free Rate = 5%

▪ Sharpe Ratio for P:

SharpeP=0.120.15−0.05=0.120.10≈0.833

▪ Sharpe Ratio for Q:

SharpeQ=0.080.12−0.05=0.080.07=0.875

Portfolio Q has a higher Sharpe Ratio (0.875 vs. 0.833), indicating it provides a better
return per unit of total risk.

2. Treynor Ratio:

o Concept: Measures excess return per unit of systematic risk (Beta). More
appropriate for well-diversified portfolios where unsystematic risk is
negligible.

o Formula:

Treynor Ratio=Portfolio BetaPortfolio Return−Risk-Free Rate

o Example:

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 CHAPTER 3- RISK AND RETURN

▪ Portfolio X: Return = 18%, Beta = 1.3

▪ Portfolio Y: Return = 14%, Beta = 0.9

▪ Risk-Free Rate = 6%

▪ Treynor Ratio for X:

TreynorX=1.30.18−0.06=1.30.12≈0.0923

▪ Treynor Ratio for Y:

TreynorY=0.90.14−0.06=0.90.08≈0.0889

Portfolio X has a higher Treynor Ratio (0.0923 vs. 0.0889), indicating it provides a better
return for each unit of systematic risk.

3. Alpha (α):

o Concept: Measures the investment's actual return compared to the return

predicted by the Capital Asset Pricing Model (CAPM) for its level of
systematic risk. It reflects the "active return" or value added by
management.

o Formula:

Alpha=Actual Return−[Rf+β×(Rm−Rf)]

(The term in the square brackets is the Expected Return according to CAPM)

o Example:

▪ Actual Return of Stock Z = 16%

▪ Risk-Free Rate (Rf) = 4%

▪ Beta of Stock Z (βZ) = 1.2

▪ Market Return (Rm) = 10%

▪ First, calculate Expected Return via CAPM:

E(RZ)=0.04+1.2×(0.10−0.04)E(RZ)=0.04+1.2×0.06E(RZ)=0.04+0.072=0.112 or 11.2%

▪ Now, calculate Alpha:

AlphaZ=0.16−0.112=0.048 or 4.8%

Stock Z generated a positive alpha of 4.8%, meaning it outperformed its expected return
(given its systematic risk) by 4.8%.

IV. Capital Asset Pricing Model (CAPM) Calculation

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 CHAPTER 3- RISK AND RETURN

• Concept: Used to calculate the required or expected rate of return for an

investment, given its systematic risk.

• Formula:

E(Ri)=Rf+βi×(Rm−Rf)

Where:

o E(Ri) = Expected Return of Security i

19

o Rf = Risk-Free Rate of Return20

o βi = Beta of Security 21
i

o (Rm−Rf) = Market Risk Premium22

• Example:

Consider a stock with a Beta of 0.9. The current risk-free rate is 5%, and the expected
market return is 13%.

o Rf=0.05
o β=0.9

o Rm=0.13

E(Rstock)=0.05+0.9×(0.13−0.05)E(Rstock)=0.05+0.9×0.08E(Rstock)=0.05+0.072E(Rstock
)=0.122 or 12.2%

Based on CAPM, the expected (or required) return for this stock is 12.2%. This is the
minimum return an investor should expect for taking on the systematic risk associated
with this stock.

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