Basics of Finance series 1- Risk and Return

Finance Series: 1: Risk & Return Analysis:

“It’s always better to be in unison”. It was well said in Geeta by Lord Krsna: Aho Parth! Sanghe sakthi kaliyuge.O Arjun! For unity is the strength in Darkness.

So, as part of this series, I will be discussing, on a regular basis, about basics of Finance then contouring Investment Banking and Security Analysis along with latest happenings in the financial sectors.

As this paper is the very first in the series, I am discussing the very first topic in the financial parlance i.e. Risk and Return Analysis.

In this series we will discuss following:

1. Basic Risk/Return Concepts
2. Portfolio Risk
3. CAPM/SML
4. Portfolio Theory
5. Asset Pricing Model

This topic may seem very primitive in nature and scope but as a start up it might turn up little fruitful and for beginners, it is a must.

I promise to bring you every possible thing in Finance in due course of time as a regular series and we are also committed to deeper and more complex topics as well.

The 1st Year students may take it as an additional rapid go through for their examination preparation and my 2nd year friends may find it useful for their placement brush-ups


So here we go………….

Risk and Return Analysis

There are two kinds of returns in finance
a) Historical returns b) Anticipated returns (future prospective).

We must remember that calculations of risk differ with these two returns. Historical returns are based on the previously recorded data whereas anticipated returns are future projections about “would be realized returns” based on certain assumptions, trends or expectations.

Risk, as it stands, is the quantified value of the uncertainty in the returns (Anticipated return).It pertains to the probability of earning a return less than that expected. So greater is the chance of a return far below the expected return, greater is the risk.

A second school of thought defines risk as the variance (fluctuation, deviation) in the return from a mean, stated, expected or most likely return. Hence, as long as your returns in future (anticipated) are distant from your measurement, you are in a more risky zone.


In the above figure, the Y AXIS SHOWS THE PROBABILITY OF RETURN.

We can see that the stock X represented by red line is more bent towards mean and the height (probability) of return is higher compared to Stock Y with less height. Hence Y is more risky than X even though the return for both is same.

So how do we measure this risk component?

Risk is simply the Standard deviation( square root of variance) of returns.
The formula goes as such:




Here Ki= Return from stock,
= Mean (average) of all such returns

Now this risk can be broken into two halves
a) Part which is company specific (or asset specific)
b) Part which is market specific.

Now the company specific risk is called Diversifiable risk (Unsystematic risk) because this risk can be eliminated by taking a good number of assets (securities) that offsets the effect of one risk by another negatively correlated security (asset).If we take n number of securities or asset that show some kind of negative correlation, than we can have a bucket of securities in which we shall still have optimum profit, even if few of the securities are giving negative return.
This concept is the backbone of Portfolio theory and the bucket of securities from diverse industry or nature that we are talking about is the portfolio.

The second kind of risk is the market related risk which is called Non Diversifiable or Systematic risk. This is the risk associated with the entire market and can not be done away with.


Now Beta (β): β is the alternate measure of Company risk (diversifiable, unsystematic).This is the relationship between a company and the market. It shows how a company performs relative to market.

If market (say, BSE 500) gives a return of 15% and my stock (say RIL) gives a return of 19%, then we relate the returns of RIL with market (BSE 500) as follows:

Ri= α + β(Rm)+ error

This equation means that Return on RIL is β times the return on BSE 500 with a constant term added with some negligible error(negligible because my equation will revert to mean in a little stretched period and this mean error will be zero).
This α = A return realized by the security (RIL) even when market gives zero return.(Remember, this is not the Rf i.e Risk free return.).

This beta can also be termed as such: β = covariance (i,m)/variance(i) i.e. covariance of security with market divided by variance of security.

Security Market Line:

Ki=K(rf)+ β(Km- K(rf))

Here Ki is the return on security (RIL)
K(rf) is the Risk free return(Govt.Security,T bills)(Remember this is not the α of last equation).
Km- K(rf) = Risk Premium .This signifies the extra return(incentive) that investors would ask for investing in a riskier security. Had they invested in T bills, they would not have been into risk. As they are facing risk here, they want an extra incentive for that.

CAPM (Capital Asset Pricing Model):

This model is the mother of portfolio theory and the SML, we just discussed.
Before discussing CAPM, lets first discuss the difference between Expected return and Required return.

Required Rate of return:the return needed by investors for investing in a particular security based on its relative risk profile. In a more explicit term, it is this return which is obtained by SML equation.i.e one obtained with Km, β and K(rf).You simply put values in the right hand side of equation Ki=K(rf)+ β(Km- K(rf)) and obtain Ki.This Ki is your Required rate of return.i.e market forces believe that based on your comparative risk profile ,you would be generating this much return.

But practically, it never so happens that a firm generates this much returns for its shareholders. Because, as we know the return is generated out of profit, that a firm makes based on its hard core business and the return is seldom a captive of market forces(at least financial markets).
Let us assume that investors expect RIL to generate a profit of 19% and the current share prices of RIL say that based on the risk profile and market conditions, after calculating by the equation of CAPM (SML), RIL is supposed to generate a profit of X rupees and hence the return would be A. This A is required rate of return.

Now ,due to his acumen, operational efficiency and better market condition(may be abroad),Mr Mukesh Ambani earned Y rupees as profit and hence gave his shareholders B % return instead of A%.
So,B% is the Expected rate of return.

Now, ideally, in an efficient market, Market forces should have seen this before and the required rate of return should have been B% instead of A%. But it never happen that way.hence, now we are faced with three conditions:

a)Expected ROR> Required ROR: RIL is UNDERVALUED
b) Expected ROR = Required ROR: RIL is FAIRLY VALUED
c) Expected ROR< Required ROR: RIL is OVERVALUED

In first case, the company is better than market perceives it to be. Hence market has undervalued it and placed a lesser price for it. This company is a good investment and in due course of time, market will realize that this is a premium company and hence its share prices would go up.

In second case, the market knows that true worth of company hence no long term correction in prices.

In third case, market has thought that the company is a very good one and demands a premium. But market was wrong. It has actually overvalued the company and the company could not generate enough profit and return as was expected from it. Hence, the prices of its share would go down. . .

All securities above blue line (SML) are UNDERVALUED and all securities below SML are OVERVALUED.
Now at the end of this first session, I would like to discuss two very interesting things which are often neglected in CAPM.The one is effect of inflation and another one is that of Risk profile change.

Impact of Inflation: As we know,SML is the line which originates with Rf(Risk free return) with a slope equal to β.Now, in the linear equation Ki=K(rf)+ β(Km- K(rf)),we observe: K(rf) is the intercept with Y axis i.e Return axis X axis represents Km- K(rf), i.e Risk premium β is the slope. Now if inflation changes (increases),K(rf) i.e Risk free return will be adjusted to new inflation. It means RBI will increase the interest rate to cool off inflation and the yield on T Bills will also increase. In short Interest rate increases. Now as K(rf) increases, the entire SML shifts upward without any change of slope(β).This is justified because β symbolizes security’s relative performance with the market and the impact of higher interest rates will be same both for the RIL and BSE 500( i.e market as well as company).

Impact of change of Risk Appetite: Suppose, the relative appetite of market forces, investors change.i.e the entire market has become more bullish for the economic growth, and the so called India Story has spelt its magic. So what shall happen now? Now , β will change( decrease).This is so because, now market is ready to take bigger risk and is ready to accept Mr Mukesh Ambani with more vigor. The relative performance and riskiness of RIL has gone up compared to rest of the market. A reverse would be expected in a bearish market where β i.e slope becomes more steeper and market starts expecting less to RIL than it used to before.

In a bearish phase, the Risk premium would increase and market would now demand more return for the same risk profile.

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In next issue, I will discuss following:

1. CAPM in detail
2. Efficient frontier Theory
3. Capital Market Line (CML)
4. Security Market Line (SML) in little deeper
5. Arbitrage Pricing Theory
6. Fama French 3 Factor model.

Thank You

Prem Kumar