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Risk & Return BBA 2313

This document discusses risk and return in financial management. It defines key concepts like return, risk, probability distributions, expected rate of return, standard deviation, and coefficient of variation. It also covers portfolio risk and return, including expected portfolio return and how risk is broken down. The capital asset pricing model and its use of beta to relate risk and return is explained. Security market line is also defined.

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seyam kaiser
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12 views

Risk & Return BBA 2313

This document discusses risk and return in financial management. It defines key concepts like return, risk, probability distributions, expected rate of return, standard deviation, and coefficient of variation. It also covers portfolio risk and return, including expected portfolio return and how risk is broken down. The capital asset pricing model and its use of beta to relate risk and return is explained. Security market line is also defined.

Uploaded by

seyam kaiser
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Risk and Return

Course Title: Financial Management


Course Code: BBA 2313

Benazir Rahman
Lecturer, Business Administration
Northern University Bangladesh
Return
Return represents the total gain or loss
on an investment.
Income received on an investment plus
any change in the market price.
Risk
Risk is defined as the chance of suffering
a financial loss.
Variabilityin the return from those that
are expected.
Probability Distribution
 A listingof all possible outcomes or events with a
probability assigned to each outcome.
Measurement of Risk & Return
Expected Rate of Return
The rate of return expected to be realized from an
investment; the mean value of the probability
distribution of possible result.
^
k  expected rate of return

^ n
k   k i Pi
i 1
Standard Deviation
A measure of the tightness or variability/dispersion of
return/outcome around its mean value.
Variance

The standard deviation squared.

  Standard deviation

 Variance  2
n
  i
(k
i1
 k̂ ) 2
Pi
Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of return.
Shows relative dispersion of risk or a measure of
risk per unit of expected return (Relative risk).

Std dev 
CV   ^
Mean k
Portfolio Risk and Return
 Portfolio
Combination of two or more
securities/assets.
Portfolio Expected Return
 For a portfolio, the expected return
calculation is straightforward. It is
simply a weighted average of the
expected returns of the individual
securities: N
E k P    i E ki 
i 1

 Where i is the proportion (weight) of


security i in the portfolio.
Portfolio Expected Return (cont.)
 Suppose that we have three securities in the
portfolio. Security 1 has an expected return of
10% and a weight of 25%. Security 2 has an
expected return of 15% and a weight of 40%.
Security 3 has an expected return of 7% and a
weight of 35%. (Note that the weights add up
to 100%.)
 The expected return of this portfolio is:

E k P   0.250.10  0.400.15  0.350.07  0.1095  10.95%


Investor attitude towards risk
Risk aversion – assumes investors dislike risk and
require higher rates of return to encourage them
to hold riskier securities.
Risk lover/Risk Preference- Those investors who
want to take risk at a lower rate o return.
Risk premium – the difference between the return
on a risky asset and less risky asset, which serves
as compensation for investors to hold riskier
securities.
Breaking down sources of risk
Breaking down sources of risk

Stand-alone risk = Market risk + Firm-specific risk


Market risk – portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Also known as Systematic Risk.
Firm-specific risk – portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.
Also known as Unsystematic Risk.
Risk and Return: The Capital Asset
Pricing Model (CAPM)
A model that describes the relationship between
risk & expected return;
In this model expected return is risk-free rate
plus a premium based on the systematic risk of
security.
Risk and Return: The Capital Asset
Pricing Model (CAPM)
ki = kRF + (kM – kRF) βi
Assume kRF = 8% and kM = 15% and
market risk or beta is 1.30.
ki = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
Risk and Return: The Capital Asset
Pricing Model (CAPM)
The required return for all assets is
composed of two parts: the risk-free rate
and a risk premium.
The risk premium is a function of
both market conditions and the asset
itself.
The risk-free rate (RF) is usually
estimated from the return on T-bills
Risk and Return: The Capital Asset
Pricing Model (CAPM)
The risk premium for a stock is
composed of two parts:
The Market Risk Premium which is the
return required for investing in any risky
asset rather than the risk-free rate
Beta, a risk coefficient which measures
the sensitivity of the particular stock’s
return to changes in market conditions.
Beta
Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
Denoted by βi or β p

Indicates how risky a stock is if the stock


is held in a well-diversified portfolio.
Expected vs. Required returns

^
k k
^
HT 17.4% 17.1% Undervalue d (k  k)
^
Market 15.0 15.0 Fairly val ued (k  k)
^
USR 13.8 14.2 Overvalued (k  k)
^
T - bills 8.0 8.0 Fairly val ued (k  k)
^
Coll. 1.7 1.9 Overvalued (k  k)
Comments on beta
If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Security Market Line (SML)
SML is a line that shows the linear
relationship between expected returns for
individual securities & systematic risk(βi).
Risk and Return Graphically

The security Market Line


Rate of Return

Slope or βi

RFR

Risk
THANK YOU……….

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