Introduction to the Concept of Return of a Single Asset

Introduction To The Concept Of Return Of A Single Asset

1 Introduction

Risk and Return of the investments are interrelated covenants in the selection any investments, which should be studied through the meaning and definition of risk and return and their classification of themselves in the first part of this chapter and the relationship in between them is illustrated in the second half of the chapter.

Meaning Of Return & Rate Of Return

Return is the combination of both the regular income and capital appreciation of the investments.The regular income is nothing but dividend/interest income of the investments. The capital appreciations of the investments are nothing but the capital gains of the investments i.e. the difference in between the closing and opening price of the investments.

Return symbolized as follows D1 + Pt – Pt – 1 / Pt – 1

These two categories, Earnings yield and Capital gains yield *Earnings Yield = Earnings per share / Market price per share***

2Concept And Types Of Risk

^v   The variability of the actual return from the expected return which is associated with the investment/asset known as risk of the investment. Variability of return means that the Deviation in between actual return and expected return which is in other words as variance i.e., the measure of statistics.

^v   Greater the variability means that Riskier the security/ investment. Lesser the variability means that More certain the returns, nothing but Least risky

.

Interest Rate Risk

It is risk – variability in a security's return resulting from the changes in the level of interest rates.

Market Risk

It refers to variability of returns due to fluctuations in the securities market which is more particularly to equities market due to the effect from the wars, depressions etc.

Inflation Risk

Rise in inflation leads to Reduction in the purchasing power which influences only few people to invest due to Interest Rate Risk which is nothing but the variability of return of the investment due to oscillation of interest rates due to deflationary and inflationary pressures.

Business Risk

. Business risk is nothing but Operational risk which arises only due to the presence of the fixed cost of operations.

Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preference share capital. More the application of fixed charge of financial will lead to Greater the financial Risk which is nothing but the Trading on Equity.

Liquidity Risk

Liquidity risk reflects only due to the quality of benefits with reference to certainty of return to receive after some period which is normally revealed in terms of quality of benefits.

Measurement of Risk

Standard Deviation:

^v    Greater the standard deviation - Greater the risk

^v    Does not consider the variability of return to the expected value

^v    This may be misleading - if they differ in the size of expected values

Coefficient of variation = S.D/ Mean

3 Risk And Return Of The Portfolio

^v   Portfolio is the Combination of two or more assets or investments.

^v   Portfolio Expected Return is the weighted average of the expected returns of the securities or assets in the portfolio.Weights are the Proportion of total funds in each

security which form the portfolio Wj Kj.

^v   Wj = funds proportion invested in the security.

^v   Kj = expected return for security J.

^v   Benefits of portfolio holdings are bearing certain benefits to single assets.

^v   Including the various types of industry securities - Diversification of assets.

^v   It is not the simple weighted average of individual security.

^v   Risk is studied through the correlation/co-variance of the constituting assets of the portfolio. The Correlation among the securities should be relatively considered to maximize the return at the given level of risk or to minimize the risk.

^v   Correlation of the expected returns of the constituent securities in the portfolio.

It is a Statistical expression which reveals the securities earning pattern in the portfolio as together.

Diversification of the Risk of Portfolio

^v Diversification of the portfolio can be done through the selection of the securities which have negative correlation among them which formed the portfolio. The return of the risky and riskless assets is only having the possibilities to bring down the risk of the portfolio.

^v The risk of the portfolio cannot be simply reduced by way adopting the principle of correlation of returns among the securities in the portfolio. To reduce the risk of the portfolio, the classification of the risk has to be studied, which are as follows:

^v The risk can be further classified into two categories viz Systematic and Unsystematic risk of the securities

Systematic Risk: Which only requires the investors to expect additional return/ compensation to bear the

Unsystematic Risk: The investors are not given any such additional compensation to bear unlike the earlier. The relationship could be obviously understood through the study of Capital Asset Pricing Model (CAPM).

^Ø   Developed by William F. Sharpe

^Ø   Explains the relationship in between the risk and expected / required return

^Ø   Behaviour of the security prices

^Ø   Extends the mechanism to assess the dominance of a security on the total risk and

return

^Ø   Highlights the importance of bearing risk through some premium

^Ø   No transaction costs - No intermediation cost during the transaction

^Ø   No single investor is to influence the market Risk and Return

^Ø   Highest return for given level of risk OrLowest risk for a give n level of return

^Ø   Risk - Expected value, standard deviation

4 Relationship Between The Risk And Return

^v   Total Return - Risk free rate of return= Excess return (Risk premium)

^v   Total return = Risk free return + Risk premium

^v   Kj = Rf + bj (Km–Rf)

^v   Bj is nothing but Beta of the security i.e., market responsiveness of the security. It is normally expressed as a b

^v   b = Non Diversifiable risk of asset or Portfolio/ Risk of the Market Portfolio

^v   Risk of the portfolio = after diversification, the risk of the market portfolio is non

^v   diversifiable