Risk and Return V1

8/8/2019 Risk and Return V1

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RISK AND RETURN

Risk - OpportunitySandeep Koul

Rajesh Gupta

Biranchi Das

Dipanjan

Amit Dubey

Bindu Vineeth

Nikhil Dongre


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Outline

Why study Risk ?..... Sandeep Koul

What is Risk ?..... Sandeep Koul

Buzzword .Sandeep Koul

Components of Risk. Rajesh Gupta

Types of Risk ..Rajesh Gupta

What is return ?.... Bindu Vineeth Risk Management Bindu Vineeth

Risk & Return of a Portfolio Amit Dubey

Portfolio SelectionAmit Dubey

Pricing Models

CAPM Dipanjan

Extended CAPM. Dipanjan

Arbitrage Pricing Model.Biranchi

Multi Factor Model.Biranchi

Regression Model .Nikhil Dongre


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- Panic of 1907

- Great Depression

- Japans Last Decade

2008 Financial Crisis

The financial crisis of 20072010 has been called

by leading economists the worst financialriskfailure since the Great Depression of the 1930s.

The year 2008 financial crisis has been linked toreckless and unsustainable lending practices. The

US mortgage-backed securities, which had

risks that were hard to assess, weremarketed around the world. A more broad based

credit boom fed a global speculative bubble in real

estate and equities, which served to reinforce the

risky lending practices. The emergence ofSub-prime loan losses in 2007 began the crisis and

exposed other risky loans and over-inflatedasset prices..Critics argued that credit ratingagencies and investors failed to accurately price

the

riskinvolved with mortgage-related

financial products.

Black Swan Theory

The Black Swan Theory is used by Nassim Nicholas Taleb to explain theexistence and occurrence of high-impact, hard-to-predict, and rare events

that are beyond the realm of normal expectations.

100 Years of Financial Disasters

Why Study Risk ?

- Year 2008 Financial Crisis


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Risk inherent in Assets/Commodities History

Why Study Risk ?


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What is Risk ?


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Risk Free Return

The risk-free return is the return rate that it is assumed can be obtained by investing in financial instruments

with no default risk. However, the financial instrument can carry other types of risk, e.g. market risk (therisk of changes in market interest rates), liquidity risk (the risk of being unable to sell the instrument forcash at short notice without significant costs).

Risk PremiumIn finance, the risk premium can be the expected rate of return above the risk-free interest rate. Whenmeasuring risk, a common sense approach is to compare the risk-free return on T-bills and the very riskyreturn on other investments. The difference between these two returns can be interpreted as a measure ofthe excess return on the average risky asset. This excess return is known as the risk premium.

Risk DiscountA situation where a particular investor, either an individual or firm, decides to receive less of a return ontheir investment in exchange for less risk. The risk discount is the exact opposite of the risk premium, andthe degree to which any one person chooses the amount of the discount will vary by person to person.

Risk AverseA description of an investor who, when faced with two investments with a similar expected return (but

different risks), will prefer the one with the lower risk.

Risk to reward Ratio

A ratio used by many investors to compare the expected returns of an investment to the amount of riskundertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profitthe trader expects to have made when the position is closed (i.e. the reward) by the amount he or shestands to lose if price moves in the unexpected direction (i.e. the risk).

Buzzwords


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Components of a Risk

Returns are always variable ( Not same as what we expect

always ). The reasons for that is either firm specific or

market specific. The risk happens because of the firm based

reasons affects the investors in the firm itself. But the risk

which happens due to the market conditions affects the

entire market.

Firm specific Affect only one firm

` Project may do better or worse than expected

` Competition may be strong or weaker than

anticipated

` Entire Sector may be affected by action

Market Specific-Affects many firms

` Exchange rate and political risk

` Interest rate , Inflation and news about economy.

Diversifiable and Non diversifiable Risk


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Business Risk

Cash flow risk

Business risk

Financial risk Default risk

Reinvestment rate risk

Interest rate risk

Currency risk

Investment risk

Market Risk

Inflation Risk

Company Risk Credit Risk

Maturity Risk

Legislative Risk

Global Risk Timing Risk

Types of Risk


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Return

Investment Interest Dividends Capital Gains

Bank savings account Yes - -

Bonds Yes - -

Dividends left on deposit Yes - -GICs Yes - -

Mutual funds Yes Yes Yes

Real estate - - Yes

stocks - - Yes

T-bills Yes - -

Term deposits Yes - -

Return

Risk

Investors always like to go for risk return trade off .A given portfolioalways reduces the risk and increases the return .

Expected return is the return an investor expects to earn on an asset , in its price and growthpotential. The requested return is the return the investor requires on an asset , given its risk.


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Diversification

Diversification in finance is a risk management technique, related to hedging, that mixesa wide variety of investments within a portfolio. It is the spreading out of investments to

reduce risks. Because the fluctuations of a single security have less impact on a diverseportfolio, diversification minimizes the risk from any one investment. Diversificationminimizes the risk from any one investment because of the following reasons:

Holding a group of assets allows investors to lower risk, often without lowering E(R) Iindividual assets do not have same pattern of returns.

Ccombining assets, bad returns cancelled out by good returns of other assets,decreasing overall variation in the return of the portfolio. The variance and correlation coefft. across the investments in the portfolio helps tofind our how much diversification is required to reduce the risk.

Risk management

Example

A simple example of diversification is the following: On a particular island the entire economy consistsof two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is completelyinvested in the company that sells umbrellas, it will have strong performance when it rains, but poorperformance when the weather is sunny. The reverse occurs if the portfolio is only invested in thesunscreen company, the alternative investment: the portfolio will be high performance when the sun isout, but will tank when clouds roll in. To minimize the weather-dependent risk in the example portfolio,the investment should be split between the companies. With this diversified portfolio, returns are decentno matter the weather, rather than alternating between excellent and terrible.


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Risk & Return of a Portfolio

Portfolio means combination / collection /groups of securities or assets. A large number of portfolios can be

formed from a given set of assets. Each portfolio has risk-return characteristics of its own. Portfolio risk, unlike

portfolio return is more than a simple aggregation of the risks of individual assets.

Modern Portfolio Theory -

Under the model:

Portfolio return is the proportion-weighted combination of the constituent assets' returns.

Portfolio volatility is a function of the correlation of the component assets. The change in

volatility is non-linear as the weighting of the component assets changes


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PORTFOLIO SELECTION

Selection of optimal portfolio is based on Mean Variance Model developed by Harry

Markowitz.

The model consists of Technical - determination of the set of efficient portfolios from

the available feasible set.

Personal choosing the best risk-return opportunity from the efficient set, which is

consistent with the investors attitude towards risk.

`Based upon the treatment of technical part, there are two approaches

One-step optimization : begins with delimitation of efficient portfolios having

one or more risky assets and culminates with capital market line (CML)

(The CML is a St. line that represents the efficient portfolios that can be formed bycombining a risky asset with risk free lending and borrowing opportunities.)

Two-step optimization: Also called top-down approach. It is more structured

and preferred. It identifies three distinct stages in selection of optimal portfolio

capital allocation, asset allocation decision and security selection decision

`First step of optimal portfolio selection is to determine the risk-return opportunities

available to the investor. Also referred to as determination of feasible set of portfolios

or the portfolio opportunity set or the

minimum-variance portfolio opportunity set.

`Modern portfolio theory (MPT) is a theory of investment which

tries to maximize return and minimize risk by carefully

choosing different assets.


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Capital Asset Pricing ModelA model that describes the relationship between systematic risk and expected return and that is used

in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value

of money and risk.

The time value of money is represented by the risk-free (rf) rate in the formula and compensates

the investors for placing money in any investment over a period of time.

The other half of the formula represents risk and calculates the amount of compensation the

investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that

compares the returns of the asset to the market over a period of time and to the market premium

(Rm-rf).

Graph representing SML (security

market line)


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The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-

free security plus a risk premium. If this expected return does not meet or beat the required

return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

All investorsAim to maximize economic utility.

Are rational and risk-averse.

Are price takers, i.e., they cannot influence prices.

Can lend and borrow unlimited under the risk free rate of interest.

Trade without transaction or taxation costs.

Deal with securities that are all highly divisible into small parcels.

Assume all information is at the same time available to all investors.

Perfect Competitive Markets

Assumptions of CAPM:


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EXTENDED CAPM

CAPM is essentially a single-factor model in that that the securitys expected return depends

on a single factor, namely, beta. Other factors which may affect expected returns are:

Taxes

Inflation

Liquidity

Market capitalisation size

Price-earnings and market to-book value ratios Inclusion of these factors in CAPM equation would provide better explanation of the

variables impacting security returns and is referred to as Extended CAPM

To include dividend yield and tax effect, CAPM equation:

Kj = Rf+bBj + t (Dj Rf)

Kj = expected return

Rf= Required rate of return on security, j

b = coefficient showing the relative importance of beta

Bj = Beta of security, j

t = Coefficient showing the relative importance of tax effect

Dj = Dividend yield on security, j


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Arbitrage Pricing Theory

APT is based on the concept of arbitrage . If two portfolios have same exposure

to risk but offer different returns , investor will go ahead with higher rate ofreturn . And sell the portfolio with lower rate of return and earn the differences

as a riskless return This can be avoided if the 2 portfolios can get the same

expected return .

Here also risk can divide in to firm specific and market specific ie,

R=E(R)+m+,

R is the actual return , E( R) expected return , m is the market risk and is the

firm specific risk . The market component can be decomposed in to economic

factors.

Here the market risk is calculated relative to multiple unspecified

macroeconomic variables , with the sensitivity of the investment relative to

each factor being measured by a beta. The factor Analysis is used to estimatethe no. of factors, the factor betas and the factor risk premiums .


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Multifactor Models

Multifactor Model are determined by the historical data rather than economic

modeling .Once the no. of factors has been identified in the arbitrage pricing model ,

their behavior over time can be extracted from the data . The behavior of the

unnamed factors overtime can be compared to the behavior of the macro economic

variables over that same period to see whether any of the variables is correlated over

time with the identified factors.

Multifactor models like the Arbitrage Pricing Models assumes that the market risk can

be captured best using the multiple macroeconomic factors and betas relative to

each . Unlike the APM , MFM attaempt to identify the macroeconomic factors that

drives the market risk.


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Regression or Proxy ModelsAll the previous models gave importance in defining the market risk first and then

developing the models that might best measure the market risk The market risk isexpressed in terms of Beta using the historical data In the proxy model it gives

importance to the hisorical stock returns and try to explain the differences in returns

over long time periods using the firms market value or price multiples Normally id

some investments earn consistently higher returns than other investments , they must

be riskier . We can find it out the characteristics of the high return investments have in

common and consider these characteristics to be the direct measure or proxies for the

market risk .


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Wish you Happy and

successful Investing

Thank you

Documents

Risk and Return V1