Risk and Return analysis, Study notes of Financial Management

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Risk and Return

Risk

• (^) It is the variability in return
• (^) It means there is a possibility of loss or damage which may or may not happen.
• (^) It is the possibility of unfavorable results following any occurrence.
• (^) According to Irvin Father 1971, risk is a combination of hazards measured by profitability

Types of Risk Types of risk affect the investments are called systematic risks.

• (^) Market Risk : it is the risk that the value of the investment will decline as a result of market conditions.
• (^) Interest Rate Risk : - It is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.
• (^) Inflation or Purchasing Power Risk : The probability of loss from decline in the value of cash due to inflation.

Some risks are unique to a Firm’s specific investment called un-systematic risks.

• (^) Business Risk : This is the risk that issuers of an investment may run into financial difficulties and not be able to live up to market expectations.
• (^) It is the chance that the firm will be unable to cover its operating costs.
• (^) Credit Risk : It refers to the risk that a borrower will default on any type of debt by failing to make required payments.

Factors affecting Risk/ Causes of risk

1. Wrong method of investment
2. Wrong timing of investment
3. Wrong quantity of investment
4. Interest rate variation
5. Nature of investment instruments
6. Nature of industry in which the company is operating
7. Credit worthiness of the issuer
8. Maturity period or length of investment
9. Terms of lending 10.National or international factors 11.Natural calamities etc

Return

• (^) It is the motivating force inspiring the investor in the form of rewards for undertaking the investment.
• (^) It is the realizable cash flow earned by its owner during a given period of time. Eg: on a bond, interest, dividend.

Types of return

1. Realized return or Historical return Return that could have been earned 2. Expected return This is the return from an asset that investors anticipate or expect to earn over some future period.

Risk return relationship

• (^) The risk-return tradeoff is the balance an investor must decide on between the desire for the lowest possible risk for the highest possible returns.
• (^) This is demonstrated graphically in the chart above. A higher standard deviation means a higher risk and higher possible return.

Measurement of Risk and Return

• (^) Methods:

1. The risk and return of a single asset or investment
2. The risk and return of a portfolio investment

2.Measurement of portfolio risk Components:

1. Systematic Risk (market related)
2. Unsystematic risk (company specific)

Causes of portfolio Risk;

1. Wrong decision of what to invest in
2. Wrong timing of investment on stock
3. Investment in worthless investment
4. Lack of credit worthiness of the issuer
5. Length of maturity period of investment
6. Amount of investments in wrong projects
7. Methods of investment
8. Term of periodicity of servicing
9. Nature of business 10.National and international factors

Forms of Diversification;

1. Diversification into different type of assets like gold, real estate, govt. securities, corporate securities etc.
2. Diversification into different instruments like bonds, stocks, debentures, govt. securities etc.
3. Diversification into different industry line like plastics, chemicals, engineering, cements, steel, fertilizers etc.
4. Diversification into different companies at different growth levels like new companies, growing companies, new products etc.