Invt Chapter 2
Invt Chapter 2
Invt Chapter 2
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Concept of Return and Risk
• Investment return and risk are fundamental to
understanding market behavior. The entire scenario of
security analysis is built on two concepts; Risk &
return.
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Types of Unsystematic Risk:
1) Business Risk: Business risk refers to the variability in incomes of
the firms and expected dividend there from, resulting from the
operating condition in which the firms have to operate.
2) Financial Risk: Refers to how a firm finances its activities.
Investors will look at the firm’s capital structure. It refers to the
degree of leverage or degree of debt financing used by a firm in
the capital structure.
3) Operational risk: inefficient operation, supply chain disruption, or
product quality issues can negatively affect profitability.
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Causes of Risk:
A number of factors which can cause risk in an investment arena
include the following:
– Wrong method of investment
– Wrong timing of investment
– Wrong quantity of investment
– Interest rate risk
– Nature of investment instrument
– Nature of industry in which the company is operating
– Maturity period (length of investment)
– Terms of lending
– National and international factors 9
Risk and Expected Return
Risk and expected return are the two key determinants of an
investment decision.
Risk, in simple terms, is associated with the variability of the
rates of return from an investment; how much do individual
outcomes deviate from the expected value?
Another major factor determining the investment decision is
the rate of return expected by the investor. The rate of return
expected by the investor consists of the yield and capital
appreciation.
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Determinants of the Rate of Return
The three major determinants of the rate of return expected by
the investor are:
1. The time preference risk-free real rate
2. The expected rate of inflation
3. The risk associated with the investment, which is unique to
the investment.
Hence,
Required return = Risk-free real rate + Inflation premium + Risk premium
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The rate of return from an investment consists of the yield and capital
appreciation:
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Example:
The following information is given for a corporate bond. Price of the
bond at the beginning of the year: Br. 90, Price of the bond at the end of
the year: Br. 95.40, Interest received for the year: Br. 13.50. Compute
the rate of return.
Solution:
The rate of return can be computed as follows:
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Example 2:
The average market prices and dividend per share of Blue Ltd. for the
past 6 years are given below:
Year Average market Dividend per share
price (Br.) (Br.)
2002 38 1.8
2003 45 2.0
2004 53 2.5
2005 50 2.0
2006 61 2.6
2007 68 3.0
R = 1/5 (23.68+23.33-1.89+27.2+16.40)
= 1/5(88.72) = 17.75 %
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Risk measurement
• A useful measure of risk should somehow take into account both the
probability of various possible "bad" outcomes and their associated
magnitudes.
• Instead of measuring the probability of a number of different
possible outcomes, the measure of risk should somehow estimate the
extent to which the actual outcome is likely to diverge from the
expected.
• For this purpose, range, variance, standard deviation and coefficient
of Variation can be used to measure the risk.
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Example:
• The rate of return of equity shares of Wipro Ltd., for past six years
are given below:
Year 1 2 3 4 5 6
Rate of return (%) 12 18 -6 20 22 24
Required:
Calculate the average rate of return, variance and standard deviation.
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Calculation of Average Rate of Return ( R )
Return on
Year Dealership Repair
2001 19 14
2002 39 8
2003 15 11
2004 0 19
∑= 73 ∑=52
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Solution
2 (19 - 18.25)2 + (38 - 18.25)2 + (15 - 18.25)2 + (0 - 18.25)2
σ 193.6875
Dealership 4
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Example 3:
Mr. Red invested in equity shares of White Ltd., its anticipated returns
and associated probabilities are given below:
Return (%) -15 -10 5 10 15 20 30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05
Required:
Calculate the expected rate of return and risk in terms of standard
deviation.
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Solution: Calculation of expected return and risk in terms of standard deviation
Return(R) Probability (P) (R × P) () xP
-15 0.05 - 0.75 -24.5 600.25 30.0125
-10 0.10 -1.0 -19.5 380.25 38.025
5 0.15 0.75 -4.5 20.25 3.0375
10 0.25 2.50 0.5 0.25 0.0625
15 0.30 4.50 5.5 30.25 9.075
20 0.10 2.00 10.5 110.25 11.025
30 0.05 1.50 20.5 420.25 21.0125
1.00 = 9.5% x P = 112.25
Dealership = 14.08%
Repair = 4.20%
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END OF
CHAPTER TWO
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