RISK AND RETURN

Risk and Return of the investments are interrelated covenants in the selection any investments, which should be studied through the meaning and definition of risk and return and their classification of themselves in the first part of this chapter and the relationship in between them is illustrated in the second half of the chapter
CONCEPT AND TYPES OF RISK
The variability of the actual return from the expected return which is associated
with the investment /asset known as risk of the investment.
Variability of return means that the Deviation in between actual return and expected
return which is in other words as variance i.e., the measure of statistics.
Greater the variability means that Riskier the security/ investment.
Lesser the variability means that More certain the returns, nothing but Least risky
e.g. Treasury Bills, Savings Deposit.
The risk can be further classified into six different categories
Interest rate risk
Inflation risk
Financial risk
Market risk
Business risk and
Liquidity risk
Interest Rate Risk
It is risk – variability in a security's return resulting from the changes in the level of
interest rates.
Security prices - inverse relationship with
Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50
points to 6 points; change in the rate of interest - change in the prime lending
rate of the banks - Due to Rs. 14,000 cr. amount to be deposited in the
Reserve Bank of India by the Banks - to curtail the Inflation
Impact on the Security Prices
If the rate of interest increases then the price of the existing securities will come
down due to more attraction on the new instruments due to lesser demand on the
existing securities more particularly during the periods of inflationary period
If the rate of interest decreases means that the price of the existing securities will
go up due to lesser attraction on the new investment avenues which are found to
be greater demand for new securities during the periods of deflationary period.
Market Risk
It refers to variability of returns due to fluctuations in the securities market which is
more particularly to equities market due to the effect from the wars, depressions etc.
E.g., Greater/lesser investments by the mutual funds, banks, Foreign institutional
investors and so on due to entry into or out of the market reflects the market -
index is the market risk.
Inflation Risk
Rise in inflation leads to Reduction in the purchasing power which influences only
few people to invest due to
Interest Rate Risk which is nothing but the variability of return of the investment
due to oscillation of interest rates due to deflationary and inflationary pressures.
Business Risk
Risk of doing business in a particular industry / environment is known as business
risk. Business risk is nothing but Operational risk which arises only due to the
presence of the fixed cost of operations. The Higher the fixed cost of operations
requires the firm to have Greater BEP to avoid the firm to incur losses. It is normally
transferred to the investors who invest in the business or company, the major reason
is that EBIT of the firm is subject to the fixed cost of operations.
Financial Risk
Connected with the raising of fixed charge of funds viz Debt finance & Preference
share capital. More the application of fixed charge of financial will lead to Greater the
financial Risk which is nothing but the Trading on Equity.
Liquidity Risk
This is the risk pertaining to the secondary Market, in which the securities can be Bought and sold quickly and without any concession in the price.
Liquidity risk reflects only due to the quality of benefits with reference to certainty of return to receive after some period which is normally revealed in terms of quality of benefits. The more the certainty of benefits leads to lesser the liquidity risk and vice versa.
RISK AND RETURN OF THE PORTFOLIO
Portfolio is the Combination of two or more assets or investments.
Portfolio Expected Return is the weighted average of the expected returns of the
securities or assets in the portfolio.
Weights are the Proportion of total funds in each security which form the portfolio
Wj Kj.
Wj = funds proportion invested in the security.
Kj = expected return for security J.
The risk of the portfolio could be determined what it was in the process of individual
assets?
Benefits of portfolio holdings are bearing certain benefits to single assets.
Including the various type of industry securities - Diversification of assets.
The portfolio construction leads to bring down the risk of the portfolio than the risk
of single assets.
It is not the simple weighted average of individual security.
Risk is studied through the correlation/co-variance of the constituting assets of the
portfolio. The Correlation among the securities should be relatively considered to
maximize the return at the given level of risk or to minimize the risk.
Correlation of the expected returns of the constituent securities in the portfolio.
It is a Statistical expression which reveals the securities earning pattern in the
portfolio as together.
Positive correlation means that Return of the securities in the portfolio are moving
together in same direction.
Negative correlation which illustrates that the Return of the securities are moving
in opposite direction.
Zero correlation reveals that there is - No relationship in between the earnings
pattern among the securities of the portfolio.
The Co-efficient of correlation normally ranges in between –1 and +1.
Diversification of the Risk of Portfolio
Diversification of the portfolio can be done through the selection of the securities which have negative correlation among them which formed the portfolio. The return of the risky and riskless assets are only having the possibilities to bring down the risk of the portfolio.
The following example will certainly facilitate to understand the diversification process of the securities in the portfolio through the correlation co efficient of the returns of the securities which formed the portfolio:
The above table reveals that Portfolio AB is the better one to diversify the risk as minimum
as possible, the reason is that the returns of the respective securities are having negative
correlation among A&B unlike A &C. The negative correlation of the returns between
the A&B only facilitated to reduce the risk to the levels of minimum.
The risk of the portfolio cannot be simply reduced by way adopting the principle of
correlation of returns among the securities in the portfolio. To reduce the risk of the
portfolio, the another classification of the risk has to be studied, which are as follows:
The risk can be further classified into two categories viz Systematic and Unsystematic
risk of the securities
Systematic Risk - which cannot be controlled due to market influences which is known
as Uncontrollable risk, cannot be avoided
Unsystematic Risk-Which can be minimized or reduced this type of risk through diversification of the securities in the portfolio
Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation, political developments
Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation
Systematic Risk: Which only requires the investors to expect additional return/ compensation to bear the
Unsystematic Risk: The investors are not given any such additional compensation to bear unlike the earlier.
The relationship could be obviously understood through the study of Capital Asset Pricing
Model (CAPM).
Developed by William F. Sharpe
Explains the relationship in between the risk and expected / required return
Behaviour of the security prices
Extends the mechanism to assess the dominance of a security on the total risk and
return of a portfolio
Highlights the importance of bearing risk through some premium
Efficiency of the markets
Investors are well informed
No transaction costs - No intermediation cost during the transaction
KEYWORDS
Risk: Deviation in between the actual return and expected return
Return: It is the combination of regular income and capital appreciation income
Yield: Total earnings in terms of market price
Income yield: Earnings in terms of market price
Interest risk: Deviation of return of the security due to fluctuations of interest
Inflation risk: Deviation of return of the security due fluctuations in the purchasing
power with reference to money supply
Operation risk: Risk which is due to fixed cost of operations
Finance risk: Risk due to the application fixed charge of funds
Beta: Co efficient of market responsiveness of the security
Systematic risk: Risk which cannot be diversified
Unsystematic risk: Risk which can be diversified
Risk free return: Return on risk less investments
Risk premium: Return for the undiversifiable risk to bear
CAPM: Capital Asset Pricing Model for the relationship in between Risk and Return

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