P2 sec B TOPIC 3

RISK AND
RETURN
Presented by: muhammad sanooh
 Risk and return

Risk and return are two interrelated concepts that are central to investing.
Risk refers to the possibility of losing some or all of the investment, while
return refers to the profit or gain that an investor can potentially earn on an
investment. Generally speaking, investments with higher risk have the
potential for higher returns, while lower-risk investments have the potential
for lower returns.
 return

return refers to the profit or gain that an investor earns from their investment.
It represents the financial benefit that an investor receives as a result of
committing money or resources toward a particular investment.

Returns can come in various forms, including interest, dividends, capital

appreciation (the increase in the value of the investment), or any combination
of these. The type and amount of return that an investor receives depend on a
number of factors, such as the risk associated with the investment, the time
horizon of the investment, and the economic conditions in the market.
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annual rate of return n pra

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Annual rate of return is the percentage gain or loss that an investment earns
over the course of a single year. It shows how much an investment has grown
or declined in value over a year, and is expressed as a percentage of the
amount invested.

RETURN RECEIVED FOR THE INVESTMENT

ANNUAL RATE OF RETURN =
AVARAGE INVESTMENT
 Risk

Risk in investment refers to the possibility of losing some or all of the money
invested in an asset or security. All investments carry some level of risk,
regardless of their type or the underlying asset. The potential for loss is
commonly associated with the potential for gain, meaning higher risk
investments generally have the potential for greater returns.

Investors must understand the level of risk associated with a particular

investment before committing funds. The risk level depends on various factors,
such as the type of asset or security, the economic and market conditions, the
performance of the issuer or company, and the investor's expectations.
 Systematic risk

Systematic risk refers to the risk that is inherent in the entire market or the
entire economy and affects all businesses and assets to some degree. It is also
known as market risk or non-diversifiable risk. Systematic risk events cannot
be avoided or mitigated through diversification, as they are related to the
market itself and its specific conditions. Some examples of systematic risk
include a recession, inflation, natural disasters, political instability, and
changes in interest rates or tax policies. As a result of such events, all
businesses, stocks, and assets in the market tend to move in the same
direction. Investors cannot eliminate systematic risk entirely,
 unsystematic risk

unsystematic risk, also known as company-specific risk, is the risk that is

specific to an individual company or industry. Unsystematic risk can be
minimized through diversification, as it is related to a specific business or
industry and can be mitigated or avoided by spreading investments across
various sectors or companies. Unsystematic risk factors can include variables
such as labor strikes, legal disputes, issues with management, or supply chain
interruptions. By diversifying across different companies, industries, and
geographic regions, investors can minimize the risk associated with a single
company or industry.
 Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is used to determine the expected
return on an investment based on its level of risk, factoring in both firm-
specific risk and systematic (market) risk
The theory behind the CAPM is that investors will price investments so that the
expected return on a security will be equal to the risk-free rate plus a risk
premium that is proportional to the security’s risk.
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R= Rf + β[Rm − Rf ]

Where:

R = Required rate of return on common equity

Rf = Risk-free rate of return
Β = Beta of the security
Rm = Market return
 Risk-free rate is the theoretical rate of return on an investment with zero (or
very low) risk. (usually a U.S. Treasury bill)
MARKET risk premium is the difference between the expected return for the
market portfolio and the risk-free rate (RM – RF).
The market risk premium measures the excess return over and above the risk
free rate that investors demand in order to move investments into the stock
market in general
risk premium (β[RM – RF]). This is the risk premium that investors require to
purchase that specific stock. The risk premium required by investors to invest in
a particular stock is proportional to that investment’s beta.
 Beta

“Beta,” the letter in the Greek alphabet “β,” measures how the security’s
returns compare to the returns of the market as a whole
A security’s beta is a measurement of the security’s systematic risk. . Beta is a
measure of a stock’s historical volatility compared with the volatility of the
market as a whole
individual securities respond differently to these risks. A security’s beta
represents how much, historically, the returns for that security have increased
or decreased in response to these systematic risks relative to how much the
returns for the market as a whole have increased or decreased in response to
the same risks
 Beta = 1.0: An individual security with a beta of 1.0 has the same systematic
risk as the market as a whole. This means that the returns for an individual
security with a beta of exactly 1.0 have historically moved in exactly the same
direction and in exactly the same amount as the market has moved. That
stock’s returns have historically been perfectly correlated with the returns of
the market
Beta > 1.0: The stock or portfolio is more volatile (riskier) than the market.
More volatility requires a higher return.
Beta < 1.0: The stock or portfolio is less volatile than the market. Less
volatility requires a lower return.
 A negative beta means that the investment has moved in the opposite
direction of the overall market. In other words, when the market goes up, the
investment tends to go down, and vice versa. It is important to note that a
negative beta does not indicate that an investment is necessarily more or less
risky than the overall market.

Negative beta is relatively rare, but it can provide diversification benefits to an

investor's portfolio, as it has the potential to reduce overall risk.
 The Security Market Line (SML)

The Security Market Line is the graphical representation of the Capital Asset
Pricing Model. It would represent the predicted required return to an average
security in the market at each level of beta according to the Capital Asset
Pricing Model theory. Beta, or risk, is on the x-axis (the horizontal axis), while
one-year return is shown on the y-axis
muhammad sanooh
 Portfolio Risk and Return

A portfolio is a collection of assets that are managed as a group.

a portfolio would probably consist of a group of stocks and other marketable
securities
a portfolio could consist of different marketable securities, shares of other
companies and/or debt of other companies.

Portfolio theory, also called modern portfolio theory, is an investment

philosophy that seeks to construct an optimal portfolio of securities according
to the investor’s preferences with respect to risk and return. According to
portfolio theory, a particular security should not be evaluated as a
standalone investment. Instead, each individual security should be evaluated
according to how its market value is expected to vary in relation to the market
values of the other securities in the portfolio
The key to constructing a portfolio is diversification. The idea of diversification
is to combine securities in such a way so as to reduce risk.
Because different investments move in different directions and to different
degrees as the market as a whole moves,
as one asset’s market price decreases, another asset’s market price might
increase and offset the loss
efficient portfolio provides the highest possible rate of return for a particular
level of risk or the lowest possible level of risk for a particular rate of return

Asset allocation is the process of selecting assets to combine in a portfolio to

achieve the best risk/return tradeoff possible. The assets can include bonds,
stock, real estate, high-risk, low-risk, long term, short term and other types of
investments in order to achieve the correct balance of risk and return.
individual asset’s risk that can be minimized in a diversified portfolio is called
diversifiable, unsystematic, or non-market risk.
 Correlation in portfolio refers to the degree to which the returns of different
investments move together over time. A positive correlation means that two
investments move in the same direction, while a negative correlation means
that they move in opposite directions. A correlation coefficient is used to
measure the strength of the relationship between two investments, with
values ranging from -1 to +1.

In a portfolio context, having investments with low or negative correlations is

desirable because it can help to reduce overall risk. This is because when one
investment is performing poorly, others might still be able to perform well
and offset the loss. On the other hand, if all investments in a portfolio have
high positive correlations and move together, the portfolio may be more
volatile and risky because losses in one investment would likely be reflected
across the portfolio.