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Risk and Return, Source of Risk, Measures of Return, Classification of…
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Source of Risk
Business risk
- Mismanagement of the company’s asset
- Uncertainty of income flows caused by the nature of a firm’s business
- Sales volatility and operating leverage determine the level of business risk
Financial risk
- The improper financing mix used by the company to finance its investment activities
- Uncertainty caused by the use of debt financing
Liquidity risk
- Risk that an asset may not be sold on short notice for its market value
- Not being able to convert the asset into cash at short notice without losing value
Exchange rate risk
- Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor
- Changes in exchange rates affect the investors return when converting an investment back into the “home” currency
Country risk
- Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country
- Individuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return
Measures of Return
Expected return
Calculated by assigning probability to all possible returns from an investment
= Σ P (r) @
= (Ending value – Beginning value) + income/
Beginning value
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Holding period return (HPR)
- Return that captures both the periodic benefits and changes in value. HPR can be -ve or +ve. If any comparison choose the one with the highest return per invested $.
Historical Rates of Return
- Arithmetic Mean
- Geometric Mean
Expected Rates of Return
- Standard Deviation is the square root of the variance. It measures total risk that is the dispersion of returns around an asset’s average or expected return
- Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return. Used to compare the risk of assets with expected return
Classification of Return
Rate of return
- Return that can earn from investing in the various types of assets
Expected return
- Anticipated return from investing in particular investment over a period. Target return that firm may desire to achieve
Realized return
- Actual return
- More or less than the expected return
- Calculated using HPR or HPY
Required return
- minimum rate of return required by investor to compensate for taking a level of risk
Types of Income
- Active Income
Income earned on the job
- Passive income
Derived from real estate, limited partnership, and other forms of tax advantages investment
- Portfolio income
Generated from various types of investments, in form of interest, dividends and capital gains
Risk
- Unfavorable event
- Chance of monetary loss
- Uncertainty that an investment will earn its expected rate of return
- Probability is the likelihood of an outcome
Systematic risk
- It is non diversifiable risk that cannot be eliminating no matter how many securities are held in the investment portfolio.
- These occur outside the company and beyond the financial manager’s direct control.
- The degree of systematic risk are measured by beta coefficient.
Unsystematic risk
- It is diversifiable risk that is unique only to a particular company.
- Occur inside or within the company and thus within the financial manager’s control.
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Portfolio Risk and Return
- A portfolio is simply a collection of assets
- Important to understand the behavior of risk and return
- Evaluation of risk becomes more complex when multiple assets are held
- The portfolio effect is the risk reduction that results from diversification
Portfolio return
- Expected return from a portfolio (Er ) is a weighted average of the expected returns from the individual securities.
E(r) = wi ri + wj rj
- The portfolio effect is the risk reduction that results from diversification.
- Expected return from a portfolio (Erp) is a weighted average of the expected returns from the individual securities.
Portfolio risk
- The std deviation of a portfolio, can be calculated as
σ2P = WI2 σI2 + WJ2 σJ2 + 2 WI WJ CORRIJ σI2 σj2
where, σI2 and σj2 are the variances of returns for securities i and j CORRIJ is the correlation coefficient of their returns.
InvestmentA current commitment of $ for a period of time in order to derive future payments that will compensate for:
- the time the funds are committed
- the expected rate of inflation
- uncertainty of future flow of funds
Return
- Reward of investing
- Consists of periodic cash payment
- Amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss
- Money invested may be referred to as the asset, capital, principle, or the cost basis of the investment
Efficient Portfolio
- An efficient portfolio has the highest possible return for a given standard deviation and has the lowest possible risk for a given expected return
- The efficient frontier is the set of risk-return choices associated with efficient portfolios
Measurement of Systematic Risk
- Beta is the most commonly used measure of systematic risk
- Beta for the market portfolio is equal to 1.0
- A security with a beta equal to 1.0 indicates that it has average systematic risk. A security with a beta greater than 1.0 has systematic risk that is above average, and vice versa