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Measure Risk And Return

Risk and Return Assignment / Homework Help
Risk:
Risk is the variability of the actual return from the expected return associated with a given investment. The greater the variability, the riskier is the security; the lesser the variability, less risky is the security. If the return from an asset or investment is more certain, the variability would be lesser and thus less risky will the asset be. Risk is a situation wherein the probability distribution of the values a variable can take is known, even though the exact value it takes cannot be known with certainty.

Some of the factors which add to the degree of uncertainty of an investment are:
  • The process or the product becoming obsolete
  • Declining demand for the product
  • Price fluctuations
  • Inflationary tendencies
  • Change in government policy on business and
  • Foreign exchange restrictions.

Types of Risk:

The types of risks the financial managers must consider are:
  • Business risk the risk that the company will have general business problem. This type of risk is mainly dependent upon changes in demand, input prices and technological obsolescence
  • Liquidity risk - this risk arises from the possibility of an asset that may not be sold for its market value, given a short notice. It is said to have a good amount of liquidity risk if an investment must be sold at a high discount
  • Default risk this is the risk that the issuing company is unable to make periodic interest payments or principal repayments on debts. Example: Bonds, debentures and other long-term debts
  • Market risk- this is the risk of changes in stock prices in market, described by volatility and affected by bullish and bearish trends
  • Interest rate risk this is the risk of fluctuations in the value of an asset as the interest rates change. If interest rates rise, the price of fixed income securities like debentures fall and vice versa
  • Purchasing power risk this risk is the possibility of receiving a lesser amount of purchasing power than was originally invested

Return:
The return or rate of return on an investment for a given period is the annual income received adjusted for any change in the market price which is usually expressed as a percentage of the opening market price. Return is the primary motivating force that drives the investment, which represents the reward for undertaking investment. Generally, the return on an investment is measured by the following formula:

Return = Dt + (Pt - Pt - 1)

Pt - 1

Where:
Dt = Annual income or dividend at the end of time period, t
Pt = Closing security price at time period t
Pt - 1 = Opening security price at time period t

The return of an investment consists of two components:
  • Current return:Current return is the periodic income in relation to the beginning price of the investment. The periodic income takes the form of dividend or interest generated by the investment
  • Capital return:Capital return refers to the price change, which is either the price appreciation or depreciation divided by the beginning price of the investment or security

Thus the total return for any security can be said as:

Total return = Current return + Capital return (which are also otherwise called as current yield and capital gains/loss)

Example:

If the price of a stock on Jan 1 is $50, the annual dividend received at the end of the year is $2 and the year end price on Dec 31 is $60, what is the rate of return?

Total return = Current return (yield) + Capital returns (gains/losses)

Current yield = Annual income = $2 = 0.04 or 4%
  Opening price    $50 

Capital gains/losses = (Closing price Opening price) = ($60 - $50) = 0.20 or 20%
Opening price $50

Risk-Return Trade-off

All financial decisions involve some sort of risk-return trade-off. The greater the risk, the greater the return expected. Proper assessment and balance of the various risk-return trade-offs available is part of creating a sound financial and investment plan. The following figure depicts the risk-return trade-off.
Assignment / Homework Help

The above diagram depicts that:
  • More the risk, more is the expected return.
  • Less the risk, less is the expected return.
  • Risk-free rate is the rate of return commonly required on a risk-free security.
  • Risk-return function depends upon the degree of risk and return.

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