Risk and Return1

Security Analysis
Chapter -1
Dr. Abhay Kumar

Risk and Return: The Basics
 Introduction to Security Analysis

 Basic return concepts
 Basic risk concepts
 Portfolio (market) risk
 Risk and return: CAPM/SML
Investment:
 Investment is a commitment of funds made in the
expectation of some positive rate of return.
Forms of Investments
Real Investments
Financial Investments
Real Investments
 Real estate
• Capital appreciation
• Rental income
• Psychological reasons
• Lesser regulation
• No Proper Market
• Open for all.
 Risk factor: Very risky: property specific risk; low
liquidity, high transaction costs, numerous
taxes/costs during the life of the investment
 Return : depends
Financial Investments
Security Form Financial Investment

Non-Security forms of Financial
Investment
Security Form of Financial Investments
 Equity Stock
 Preferred Stock: Hybrid Security
 Debt instruments
• 1. Coupon bonds: Issued at par; fixed periodic
interest payments; Principal repayment at maturity
or piecemeal payments spread over time
• 2. Discount bonds: Issued at discount to par; no
periodic payments; redeemed at par value at
maturity
• Government debt securities: Different types
depending upon quality (risk), yield, and maturity.
Non-Security forms of Financial
Investment
• Non traded
• Non transferable
• Popular among small investors – typically principal
protection and projection against inflation along with
a small (minimal) real return.
• Tax savings
• Mobilize small private savings for public use
• For a balanced portfolio.
Non-Security forms of Financial
Investment
 National Savings Scheme (NSS )

 Public Provident Fund(PPF)
 Post Office Savings Schemes
 Deposits with Commercial banks
 Corporate FDs – only one with reasonable level of
safety and liquidity issues
Real investor vs. Speculator
 A genuine investor invests to earn a “fair return” on a
rather consistent basis for a relatively long period of time
 How is investment different from Speculation?

• Time horizon: Short; will typically base its decision on news
over the short term irrespective of valuation;
• Risk – Return expectation: Abnormally high-risk for return
expected; decisions often based on rumors, unconfirmed news,
event based; high portfolio churn;
• Are speculators needed: Add depth or liquidity to the market
and wider ownership but cause price instability.
Security
 Fischer: “Pieces of paper representing

indirect claims to real assets held by
someone else”
 “Claims on cash flows of a company or an
asset”
Security Analysis
 Fischer: Process of estimating return (value)

and risk for individual securities.
 The greater the risk, greater is the return
required.
Security Analysis is useful for
Existing Shareholders
Potential Investors
For M&A
Creditors/Financial Institutions
Why are security analysts needed?
 Segregation of ownership and management of

assets/company
 Reduce noise: Analyst reports: Noise cause
price instability, which is due to misinformation.
 Help investors identify stocks with high risk-
adjusted performance by interpreting readily
available but often complex financial data.
Return
Return is the total gain or loss experienced by the

owner of a financial asset or investment over a given
period of time.
 Investment returns measure the financial results of
an investment.
 Returns can be expressed in:
 Rupee terms.
 Percentage terms.
What are investment returns?
If you buy or invest in an asset of any sort, your gain or loss from
that investment is called the return of your investment.
Purpose of return:
a. Time value of Money
b. Inflation
c. Risk Premium
Return can be:

a. High
b. Low
c. Constant
Return
 Realized (Historical) Return

- Ex-post return which was or could have been earned.
 Expected (Ex-Ante) Return
- Return that an investor expects or anticipates to earn
over some future period Subjected to risk
 Components of return
- Periodic cash receipts, interest , dividends etc.
- Appreciation or depreciation in price of the asset
Calculation of Risk and Return
Single security return

Portfolio return
Single period return
Multiple period return
Ex-post / Historical Return
Ex-ante / Expected Return
Types of risks in financial market
 Risk reflects the chance that the actual return on an

investment may be very different than the expected
return. One way to measure risk is to calculate the
variance and standard deviation of the distribution of
returns.
 Variance of return is known as total risk.
Probability distribution
Stock X
Stock Y
Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why?
Types of Risk
Diversifiable Non Diversifiable
Controllable Un Controllable
Unsystematic Systematic
Unique Market
Risk: Systematic and Unsystematic
We can break down the total risk into two components:

systematic risk and unsystematic risk:

Total risk; U
Nonsystematic Risk; 
Systematic Risk; m
n
Systematic risk and Unsystematic risk
 Systematic risks affect the market as a whole and can
not be eliminated totally by any means. Though, it can
be minimized having defensive stocks in the portfolio.
Examples of systematic risk include uncertainty about
general economic conditions, such as GNP, interest
rates or inflation.
 Unsystematic risk affects only a specific firm and can be

eliminated totally by proper diversification.
Some of the Systematic risks are as follows;
 Country Risk: This risks arises in case of all investment in a

single country. Any change in political and economic situation of
the country may impact the return.
 Market risk:-It is the risk of decreasing the capital (or suffering
of loss) because of negative sentiments in the market.
 Interest rate Risk
 Inflation Risk / Purchasing Power Risk
Systematic Risk
•The beta coefficient, , tells us the response of the
stock’s return to a systematic risk.
•In the CAPM,  measured the responsiveness of a
security’s return to a specific risk factor, the return on
the market portfolio.
C o v ( R i, R M )
i 
 (RM )
2
Unsystematic risks
 Financial Risk: This kind of risk arises due to pattern of
financing mix used by the company. More debt financing
will bring more risk. Company with lesser debt or no
debt will have less risk.
 Liquidity Risk: This risk arises when the investors are
unable to exit from the investment at fair value at the
desired date.
 Sector Risk: It is a risk faced by the investors who
invest in sectoral funds or who are more inclined
towards a particular sector.
 Business Risk
 Default Risk
Total risks
Single Stock (Risk &
Return)
Single Stock Risk & Return
 Single Stock
Single Period
Historical
Risk & Return
What is the return on an investment
that costs Rs.1,000 and is sold
after 1 year for Rs.1,100?
Absolute Return:
Amount Received - Amount Invested
Rs.1,100 - Rs.1,000 = Rs.100
Percentage return:
Return/ Invested
Rs.100/Rest.1,000 = 0.10 = 10%.
Realized Return (Single Period)
Realized Return:
K = DT+(PT – PT-1)
 PT-1
K= rate of return (HPY)
Pt = Price of security at time t
Pt-1 = Price of security at time t-1
Dt = Income receivable at time t
Ansh purchased a shares of RIL for Rs.1350 and after one year
sold it Rs.1500. In between Ansh has also received a dividend of
Rs 25. What is the return received by Ansh?
Single stock- Multi period
Historical Return (Single Cash flow)
P0(1+r)n =Pn
or
r0n = (Pn / P0)1/n - 1
Historical Risk
The Standard Deviation Formula

Historical Return (Multiple Cash flow)
r0n = [(1+R1) * (1+R2) * (1+R3)….(1+Rn)]1/n - 1

(By using GM)
Example (Multiple Cash flow)
Calculate annual return and risk from

given data
Year Return
1 15%
2 2%
3 85%
4 -21%
Example
Calculate annual return and risk from

given data
(Rs)
 Year Market Price Dividend

0 100
1 105 2
2 115 2
3 80 2
4 125 5
Single Stock – Expected Risk & Return
Single Stock
Ex-Ante
Risk & Return
Ex-Ante Return( Single Stock-Single
Period)
State of Economy Probability(p) Return(X)
Recession 0.10 -22.0
Below avg. 0.20 -2.0
Average 0.40 20.0
Above avg. 0.20 35.0
Boom 0.10 50.0
Ex-Ante Return
 n
r =  ri Pi .
i =1
rX = Expected returns
ri = rate of return for ith possible outcome
Pi= Probability associated with ith possible outcome
Single stock- single period, Ex-Ante
return
rX = 0.10(-22%) + 0.20(-2%)

 + 0.40(20%) + 0.20(35%)
 + 0.10(50%) = 19.58%.
risk
2
n
  
    i
i 1 
r  r  Pi .

r = Expected returns ; n = Number of years
r i = rate of return for ith possible outcome
Pi= Probability associated with ith possible outcome
risk
 = ((-22 - 19.58)20.10 +
(-2 - 19.58)20.20 +
(20 - 19.58)20.40 +
(35 - 19.58)20.20 +
(50 - 19.58)20.10)1/2
=
Thanks
Any Questions…..

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Security Analysis

Dr. Abhay Kumar

 Introduction to Security Analysis

Security Form Financial Investment

 National Savings Scheme (NSS )

 How is investment different from Speculation?

 Fischer: “Pieces of paper representing

 Fischer: Process of estimating return (value)

 Segregation of ownership and management of

Return is the total gain or loss experienced by the

Return can be:

 Realized (Historical) Return

Single security return

 Risk reflects the chance that the actual return on an

Diversifiable Non Diversifiable

We can break down the total risk into two components:

 Unsystematic risk affects only a specific firm and can be

 Country Risk: This risks arises in case of all investment in a

The Standard Deviation Formula

r0n = [(1+R1) * (1+R2) * (1+R3)….(1+Rn)]1/n - 1

Calculate annual return and risk from

Calculate annual return and risk from

 Year Market Price Dividend

rX = 0.10(-22%) + 0.20(-2%)

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