The Basics of Risk and Return

1. Introduction to Risk and Return

  • Focus on fundamental concepts in finance regarding investments, risk, and expected returns.

2. Learning Outcomes

  • Define investment.

  • Describe the return from an investment.

  • Discuss various measures of return.

  • List and contrast sources of risk.

  • Differentiate between standard deviation and beta coefficient as measures of risk.

  • Discuss the relationship between risk and return.

3. What is an Investment?

Definition

  • Investment involves a current commitment of money for a specified period to generate future payments that compensate the investor for:

    • Time the money is committed.

    • Expected inflation rate.

    • Uncertainty of future payments.

4. Fundamental Assumptions in Finance

  • Maximise return for a given level of risk or minimise risk for a given level of return.

  • Investors are inherently risk-averse; higher returns should compensate for higher risks.

5. Measures of Return

Types of Return

  • Return on Equity (ROE): Includes capital gains/losses and dividend yield.

  • ROE (Share) is R = ( P1 - P0 + D0 ) / P0.

  • Holding Period Return: Return from holding an asset for a specified time.

    • Formula: HPR = ( P1 - P0 ) + I1 /P0.

Expected vs. Required Return

  • Expected Return: Anticipated income from an investment, considering risk.

  • Required Return: Return necessary to motivate an investor to accept risk, factoring in:

    1. Alternative investment earnings (risk-free rate).

    2. Risk premium, including inflation and price fluctuation compensation.

6. Sources of Risk

Classification of Risk

  • Diversifiable Risk (Unsystematic Risk): Specific events affecting individual assets can be minimised through diversification, including:

    -business risk

    -financial risk

  • Non-diversifiable risk (systematic risk): Market-wide risks that cannot be minimised by diversification include:

    • Market risk: securities prices fluctuate.

    • Interest rate risk: interest rate changes.

    • Reinvestment rate risk: reinvesting at a lower rate than initially earned.

    • Purchasing power risk: uncertainty that future inflation will erode the
      purchasing power of assets and income

    • Exchange rate risk: -loss from changes in the value of foreign currencies

    • Sovereign risk: gov defaulting on debts

7. Measures of Risk

Standard Deviation

  • Measures the dispersion around realised or expected returns.

  • Higher dispersion indicates greater risk.

Beta Coefficient

  • Indicates how sensitive an asset's return is to market return.

  • A higher beta signifies higher systematic risk (greater sensitivity to market changes).

8. Standard Deviation Example Calculation

  • Calculate standard deviation for Stock A and B using average returns and variances to understand risk dispersion.

9. Risk Reduction Through Diversification

  • Constructing diversified portfolios reduces the firm-specific risks without sacrificing potential returns.

  • Combining assets with low correlation diminishes overall portfolio risk.

10. Portfolio Risk

Components of Portfolio Risk

  • Total portfolio risk consists of both systematic and unsystematic risk, requiring careful consideration in risk management strategies.

11. Beta Coefficients

  • Understand how to compute and interpret beta values for different stocks, conveying the relative risk compared to the market.

12. Capital Asset Pricing Model (CAPM)

CAPM Overview

  • Describes the relationship between risk and expected return, outlining how to calculate required returns based on observed risks.

CAPM Equation

  • ( k = rf + (rm - rf) \ beta )

13. ESG Considerations in Investment

  • Eco-social responsibility is gaining traction; companies can be profitable while maintaining ethical practices, challenging the belief that ethics negatively impact profitability.

14. Conclusion

  • Understanding the principles of risk and return, alongside their measurements, is crucial for effective investment decision-making. The interplay of these concepts influences investor behaviour and market dynamics.