Risk and return (Modul MKL 2010-2011)

RISK AND RETURN

BRIEF CONCEPT

The concept that the higher the return or yield, the larger the risk; or vice versa. All financial decisions involve some sort of risk-return trade-off. The greater the risk associated with any financial decision, the greater the return expected from it. The proper assessment and the balance of the various risk-return trade-off is part of creating a sound investment plan.

RISK

The chance of financial loss, or, more formally, the variability of returns associated with a given asset (Gitman, 2006 : 226). There will be uncertainty in every business; the level of uncertainty present is called risk.

Ø  Risk Averse
Ø  Risk Indifferent
Ø  Risk Seeking

Types of risk :

1. Diversifiable Risk (unsystematic risk)

Represent the portion of an asset’s risk that is associated with random causes that can be eliminated through diversification.

2. Nondiversifiable Risk (systematic risk)

Attributable to market factors that affect all firms; it cannot be eliminated through diversification. (Gitman 2006 : 247)

RETURN

The total gain or loss experienced on an investment over a given period of time (Gitman, 2006 : 226).

Return is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. When a share is purchased, the return investors will expect from the share will come in two forms :

• A dividend (a special form of cash interest payment to shareholders as a return for their investment in the firm).
• A capital gain or loss (which will depend upon whether the price of the share has increased or decreased relative to the purchase price)

                                                

RISK AND RETURN MEASUREMENT

CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) links nondiversifiable risk and return for all assets.

(Gitman, 2006: 247)

Capital Asset Pricing Model (CAPM) uses beta to relate an asset’s risk relative to the market to the asset’s required return. CAPM consist of two parts, risk free rate and asset risk premium. The asset risk premium consist of market risk premium and beta (β). Market risk premium is the return required for investing any risky asset rather than the risk free rate. Beta is a risk coefficient, which measure the sensitivity of the particular asset’s return to changes in market conditions.

K = Rf + (

β X (Rm - Rf))

 

K         = required return on asset j

Rf        = risk-free rate of return

β          = beta coefficient or index of nondiversifiable risk for asset j

Rm     = market return; return on the market portfolio of assets

Rm – Rf         = risk premium

βj X (Rm-Rf) = market risk premium 

CAPM Assumptions: Efficient Market

1.    Many  small  investors, all  having the same  information and expectations with respect to

securities,

2.    No restrictions on investment, no taxes, no transaction costs,

3.    Rational  investors,  who  view securities  similarly and are  risk-averse,  preferring higher returns and lower risk.