Risk and Return

Lecture No2 SAPM

Revision: Time Value of Money

Future Value of Re.1 due at the end of n years from today Present value of Re.1 due at the end of n years from today Future value of an annuity of Re.1 at the end of n years from today Present Value of an annuity of Re.1 at the end of n years from today

Risk and Return

What is risk?
Possibility that actual outcome may differ from expected outcome Investors worried about downside risk and not about the potential upside

Sources of risk
Business risk Market risk

How is risk measured? Relationship between expected return and risk

Risk and Return

What is return? Why should return be measured?
Performance evaluation As an input for estimating future returns

Ex post facto (historical) and ex ante (expected return)

Measurement of historical return

Total return = (Cash payment received + price change over the period)/ Price at the beginning of the period Total return = Current return + capital gain/loss The cumulative wealth index
Measures the terminal value of an investment

Measurement of historical return

Arithmetic mean indicates the typical performance for a single period
Correctly measures multi-period returns if each period starts with same initial investment

Geometric mean measures average compounded growth that has actually occurred over multiple periods
Explains how an initial investment grows over the years untouched by human hands

Large swings in rates of return = greater discrepancy between arithmetic and geometric returns Geometric mean is always less than or equal to Arithmetic mean
Geometric mean = Arithmetic mean- * ^2 (an approximation)

Arithmetic Mean V/s Geometric Mean

Arithmetic mean is generally favored by academicians..why? Market returns vary over time Investments with uncertain returns have a higher expected terminal value than those with certain geometric returns When returns are expected to be volatile, arithmetic mean accounts for the uncertainty and is the appropriate measure of expected return

What is expected return?

Measures likely future return Is a random variable Based on a probability distribution
What is a probability distribution? Discrete and continuous For discrete distributions expected rate of return is weighted average of all possible returns multiplied by respective probabilities

E(R) = SUM (RixProb(Ri))

Measurement of Risk
Risk refers to the variability or dispersion in data Measured by the Variance or its square root the Standard Deviation

Above formula measures historical volatility or realized risk Standard deviation is expressed in the same units as the mean

When distribution is discrete

Variance is the sum of from the expected return weighted by associated probabilities squares of deviations of actual returns

Limitations of Standard Deviation

Considers all deviations positive and negative
Investors concerned with negative deviations only

Not the best measure of risk when probability distribution is not normal
Skew of the distribution must be measured Kurtosis > 3 indicates a leptokurtic distribution or presence of fat tails

Comparison of return
Comparison of investments that yield return at different compounding frequencies Investors need to know actual effective rate of return on each investment Comparison of investments with different holding periods Investors need to know how their investment has fared compared to some benchmark Computation of effective annualized return necessary

Return v/s Compounding frequency

To compute effective annualized rate at different compounding frequencies Given the effective annualized rate of return it is possible to work out the nominal return or quoted return for an instrument As compounding frequency tends to infinity, it is known as continuous compounding Possible to convert a continuously compounded rate to a rate with m times compounding

Return v/s Holding periods

Annualizing returns over multiple years [(1 + return)1/(No.of days/365)] 1

Adjusting returns for inflation

Real rate of return = (1+Nominal return)/(1+ Inflation rate)-1

Excess return or Risk Premium

Reward expected for investing in a risky asset Measured as the difference between expected return on a risky asset and the risk-free rate Example: Expected return on an index fund is 14% while the Treasury Bill rate is 6%. The risk premium on stocks is hence 8% Investors are essentially risk-averse A positive risk premium is essential to make risk-averse investors invest in risky assets