Module -2 Return and Risk Concepts

Concept of return, individual security returns, rate of return, Concept of

Risk, Causes of Risk, Types of Risk - Systematic risk - Market Price Risk,
Interest Rate Risk, Purchasing Power Risk, Unsystematic Risk - Business
risk, Financial Risk, Insolvency Risk, Risk-Return Relationship, Concept of
diversifiable risk and non-diversifiable risk. Calculation of Return and Risk
of Individual Security (Theory & Problems).
Concept of return

Return can be defined as the actual income from a project as well as appreciation in the value
of capital. Thus, there are two components in return—the basic component or the periodic cash flows
from the investment, either in the form of interest or dividends; and the change in the price of the
asset, com-monly called as the capital gain or loss.
The term yield is often used in connection to return, which refers to the income component in
relation to some price for the asset. The total return of an asset for the holding period relates to all the
cash flows received by an investor during any designated time period to the amount of money
invested in the asset.

It is measured as:

Total Return = Cash payments received + Price change in assets over the period /Purchase price of
the asset.
In connection with return we use two terms realized return and expected or predicted return.
Realized return is the return that was earned by the firm, so it is historic. Expected or predicted return
is the return the firm anticipates to earn from an asset over some future period.

Individual security returns

Risk or volatility is really something that is difficult to measure accurately. We can

qualitatively say that a stocks return is volatile, but it is sometimes better to be able to quantify such
a statement. It is common for investors to use variance or, its positive square root, standard deviation
as the measure of risk.

Rate of return

A rate of return (RoR) is the net gain or loss of an investment over a specified time period, expressed
as a percentage of the investment’s initial cost. When calculating the rate of return, you are
determining the percentage change from the beginning of the period until the end.

Rate of return= [(Current Value - Initial value)/ (Initial value)] ×100

Concept of Risk

The concept of risk is intuitively understood by investors. In general, it refers to the

possibility of incurring a loss in a financial transaction. But risk involves much more than that. The
word ‘risk’ has a definite financial meaning.

A person making an investment expects to get some return from the investment in the future.
But, as future is uncertain, so is the future expected return. It is this uncertainty associated with the
returns from an investment that introduces risk into an investment.

The essence of risk in an investment is the variation in its returns. This variation in returns is
caused by a number of factors. These factors which produce variations in the returns from an
investment constitute the elements of risk. Let us consider the risk in holding securities, such as
shares, debentures, etc. The elements of risk may be broadly classified into two groups. The first
group comprises factors that are external to a company and affect a large number of securities
simultaneously. These are mostly uncontrollable in nature. The second group includes those factors
which are internal to companies and affect only those particular companies. These are controllable to
a great extent. The risk produced by the first group of factors is known as systematic risk, and that
produced by the second group is known as unsystematic risk. The total variability in returns of a
security represents the total risk of that security. Systematic risk and unsystematic risk are the two
components of total risk.

Thus, Total risk = Systematic risk + Unsystematic risk

Systematic Risk: As the society is dynamic, changes occur in the economic, political and social
systems constantly. These changes have an influence on the performance of companies and thereby
on their stock prices. But these changes affect all companies and all securities in varying degrees. For
example, economic and political instability adversely affects all industries and companies. When an
economy moves into recession, corporate profits will shift downwards and stock prices of most
companies may decline. Thus, the impact of economic, political and social changes is system-wide
and that portion of total variability in security returns caused by such system-wide factors is referred
to as systematic risk. Systematic risk is further subdivided into interest rate risk, market risk, and
purchasing power risk.

Interest Rate Risk: Interest rate risk is a type of systematic risk that particularly affects debt
securities like bonds and debentures. A bond or debenture normally has a fixed coupon rate of
interest. The issuing company pays interest to the bond holder at this coupon rate. A bond is normally
issued with a coupon rate which is equal to the interest rate prevailing in the market at the time of
issue. Subsequent to the issue, the market interest rate may change but the coupon rate remains
constant till the maturity of the instrument. The change in market interest rate relative to the coupon
rate of a bond causes changes in its market price.

Market Risk: Market risk is a type of systematic risk that affects shares. Market prices of shares
move up or down consistently for some time periods. A general rise in share prices is referred to as
a bullish trend, whereas a general fall in share prices is referred to as a bearish trend. In other words,
the share market alternates between the bullish phase and the bearish phase. The alternating
movements can be easily seen in the movement of share price indices such as the BSE Sensitive
Index, BSE National Index, NSE Index, etc.

Purchasing Power Risk: Another type of systematic risk is the purchasing power risk. It refers
to the variation in investor returns caused by inflation. Inflation results in lowering of the purchasing
power of money. When an investor purchases a security, he foregoes the opportunity to buy some
goods or services. In other words, he is postponing his consumption. Meanwhile, if there is inflation
in the economy, the prices of goods and services would increase and thereby the investor actually
experiences a decline in the purchasing power of his investments and the return from the investment.
Let us consider a simple example. Suppose a person lends ` 100 today at ten per cent interest. He
would get back ` 110 after one year. If during the year, the prices have increased by eight per cent, `
110 received at the end of the year will have a purchasing power of only ` 101.20, i.e. 92 per cent of
` 110. Thus, inflation causes a variation in the purchasing power of the returns from an investment.
This is known as purchasing power risk and its impact is uniformly felt on all securities in the market
and as such, is a systematic risk.

Unsystematic Risk: The returns from a security may sometimes vary because of certain factors
affecting only the company issuing such security. Examples are raw material scarcity, labour strike,
management inefficiency. When variability of returns occurs because of such firm— specific factors,
it is known as unsystematic risk. This risk is unique or peculiar to a company or industry and affects
it in addition to the systematic risk affecting all securities. The unsystematic or unique risk affecting
specific securities arises from two sources: (a) the operating environment of the company, and (b)
the financing pattern adopted by the company. These two types of unsystematic risk are referred to
as business risk and financial risk respectively.
Business Risk: Every company operates within a particular operating environment. This operating
environment comprises both internal environment within the firm and external environment outside
the firm. The impact of these operating conditions is reflected in the operating costs of the company.
The operating costs can be segregated into fixed costs and variable costs. A larger proportion of fixed
costs is disadvantageous to a company. If the total revenue of such a company declines due to some
reason or the other, there would be a more than proportionate decline in its operaing profits because
it would be unable to reduce its fixed costs. Such a firm is said to face a larger business risk. Business
risk is thus a function of the operating conditions faced by a company and is the variability in
operating income caused by the operating conditions of the company.

Financial Risk: Financial risk is a function of financial leverage which is the use of debt in the
capital structure. The presence of debt in the capital structure creates fixed payments in the form of
interest which is a compulsory payment to be made whether the company makes profit or loss. This
fixed interest payment creates more variability in the earnings per share (EPS) available to equity
shareholders. For example, if the rate of return or operating profit ratio is higher than the interest rate
payable on the debt, EPS would increase. On the contrary, if the operating profit ratio is lower than
the interest rate, EPS would be depressed. The increase or decrease in EPS in response to changes in
operating profit would be much wider in the case of a levered firm (a company having debt in its
capital structure) than in the case of an unlevered firm. This variability in EPS due to the presence of
debt in the capital structure of a company is referred to as financial risk. This is specific to each
company and forms part of its unsystematic risk. Financial risk is an avoidable risk in so far as a
company is free to finance its activities without resorting to debt.

Insolvency risk: It is the real possibility that a company may be unable to meet its payment
obligations in a defined period of time generally in a one-year horizon. It is also known as bankruptcy
risk. Business insolvency can originate from various factors such as bad cash flow management,
excessive expenditures and even the failure of clients.

Risk-Return Relationship

The CML shows the risk-return relationship for all efficient portfolios. They would all lie
along the capital market line. All portfolios other than the efficient ones will lie below the capital
market line. The CML does not describe the risk-return relationship of inefficient portfolios or of
individual securities.
Diversifiable Risk, also known as unsystematic risk, is defined as the danger of an event that
would affect an industry and not the market. This type of risk can only be mitigated through
diversifying investments and maintaining a portfolio diversification. You can of this like putting all
of your eggs in one basket.

This concept is best understood by breaking down the requisite elements. The risk element is
defined as a potential risk confined to that company or its market. If a company or investor has a
diversified portfolio, then the risk is mitigated because the company’s other investments will not be
affected. The term diversifiable risk is also synonymous with unsystematic risk. Things that would
be considered unsystematic would be strikes, product malfunctions, boycotts etc.

This term is often used in business when assessing the security of one’s portfolio. The investor
who only owns investments in one company has a high non-systematic risk. By investing in other
company stocks and changing his portfolio mix, the investor can lower the impact of an adverse event
in one industry having a devastating effect on their entire portfolio.

Non-diversifiable risk can be referred to a risk which is common to a whole class of assets or
liabilities. The investment value might decline over a specific period of time only due to economic
changes or other events which affect large sections of the market. However, diversification and asset
allocation can provide prote
ction against non-diversifiable risk as different sections of the market have a tendency to
underperform at different times. Non-diversifiable risk can also be referred as market risk or
systematic risk.

Putting it simple, risk of an investment asset (real estate, bond, stock/share, etc.) which cannot
be mitigated or eliminated by adding that asset to a diversified investment portfolio can be delineated
as non-diversifiable risks. Moreover, this is the risk you are exposed to in an individual investment.
This risk type is involved in almost every investment, i.e., uncertainty of market moving up or down
and the particular movement of the investment.