Question

Summarize key facts from this week’s material. In your reflection, focus on the ideas of risk, return and expectation. Explain why this is an important concept for the firm. The Reflection should be roughly one page in length (you can write your explanation in Excel, or you can import your information to Word) and follow the directions in the syllabus.

thats all the question

In your reflection, focus on the ideas of risk, return and expectation. Explain why this is an important concept for the firm.

Answer 1

An investment is always evaluated on the basis of return and risks it offers. “Risk” and “return” are frequently used terms in the field of corporate finance.

A return is what your investment at any point of time gives back to you at a later time. The simplest way to calculate a return is what you receive till investment horizon over and above what you invested. So, if an investment of value V₀ grows to V_t at the end of investment horizon with intermediate payments in between then

A risk is a probability of unfavorable outcome. All investments are subjected to risks. And all such risks can be broadly classified into two types:

• Systematic risks
• Unsystematic risks.

Table below presents a comparison between the two types of risks. Diagram above is the pictorial depiction of the presence of risk.

Sl. No.	Parameter	Systematic Risk	Unsystematic Risk
1.	Nature	Risks inherent inside a system; common to all the entities inside the system; prevalent in every instrument traded in the market	Risks specific to an entity, company or instrument; independent to external changes in economy or politics
2.	Another way to look at it	These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole.	Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks.
2.	Mitigation	Undiversifiable and cannot be controlled or eliminated merely by diversifying one's portfolio.	Controllable; can be considerably reduced by sufficiently diversifying one's portfolio through hedging or right asset allocation strategy
3.	Also known as	Market risk, undiversifiable risk, volatility	Diversifiable risk
4.	Examples	Interest rate changes, inflation, recessions, wars.	Business risks, financial risks

Different types of risks:

Sl. No.	Type of risk	What it means?
1.	Credit risk	Risk that the counterparty will default in making the scheduled and timely payment. Lenders are subjected to credit risk that borrowers may not make the scheduled payments
2.	Foreign exchange risk	Risk that investment return is unfavourably impacted due to changes in foreign exchange risks
3.	Interest rate risk	Risk that investment value and / or return is impacted by the interest rate movements
4.	Market risk	Risk that investment value or return declines due to market risk factors such as share prices, commodity prices, inflation, interest rate etc
5.	Industry risk	All the risks prevalent in the industry put together. Example: high level of fragmentation is an industry risk in airlines industry. High fixed costs in refinery business is an industry risk
6.	Political risk	Risks originating from the political / government decisions in a country

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk. Hence risk and return will go hand in hand. They should not be seen in isolation. It should not be difficult for us to see that a riskier investment should offer higher return to attract an investor. Hence we can conclude that:

1. An investment with higher expected risk should offer higher expected return and vice versa
2. Given same level of expected risk in two investment opportunities, their expected returns should be equal and vice versa otherwise there will be risk return arbitrage

Expected return

Returns of an investment will fall in a range and may be different under different scenarios. Hence we calculate an expected return which is probability weighted average of returns in various scenarios.

where p_i is the probability of occurrence of scenario “i” and R_i is the return in this scenario “i”

Standard deviation of return

When return is not certain, it will be measured by a measure of central tendency (in this case the probability weighted return or expected return acts as a measure of central tendency) and its various values will have a dispersion around its measure of central tendency. This will lead to standard deviation. Thus, standard deviation of return is a measure of volatility (fluctuation) in the return. It shows fluctuation / deviation / dispersion around the expected return and is mathematically given by

Variance

The term inside the square root is called variance. Hence, variance = (standard deviation)². Standard deviation is a measure or expression of volatility in return and hence is representative of risks inherent in the investment opportunity. It’s therefore a measure of total risk (systematic as well as unsystematic).

Coefficient of variation

Coefficient of variation (“CV”) is the ratio of standard deviation with the expected return (mean). It’s a measure of risk per unit of return. The ratio may not make sense in isolation but definitely acts as a relative measure of risk.

Lower the CV, more attractive will be the project to an investor.

Expectation

CAPM is an economic model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. CAPM says

The general idea behind CAPM is that investors need to be compensated in two ways – the time value of money and risk Time value of money: The time value of money is represented by the risk-free rate in the formula and compensates the investors for placing money in any investment over a period of time. Risk: 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 β that compares the returns of the asset to the market over a period of time and to the market premium E(Rm) – Rf.

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. While there is nothing risk free, any security backed by the government (Treasury bills, notes, bonds) is considered to be risk free. Government securities are considered to be risk free because a government is never expected to default. If it runs out of money or is on the verge of default, it can always print money or increase the level of direct and / or indirect taxes in the country, collect the money from you and give it back to you. Hence risk free rate should be surrogated by the yield on government securities. Stock market can be taken as a surrogate of market and historical return from the stock market of a company over a long period of time can be taken as a measure of expected return from the market. Historical equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium. Stock market return in excess of risk free rate is market premium and β times market premium is the expected premium from the security. Expected return from a security as calculated by using CAPM equation is also the expected risk adjusted return (a return adjusted for its risk).