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- risk and return
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- Common Methods of Measurement for Investment Risk Management
- Common Methods of Measurement for Investment Risk Management

*The higher the risk undertaken, the more ample the expected return — and conversely, the lower the risk, the more modest the expected return. Risk refers to the variability of possible returns associated with a given investment. Risk, along with the return, is a major consideration in capital budgeting decisions.*

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To browse Academia. Skip to main content. By using our site, you agree to our collection of information through the use of cookies. To learn more, view our Privacy Policy. Log In Sign Up. Download Free PDF. Download PDF. A short summary of this paper. Investors prefer larger returns to smaller returns, hence risk remaining the same, larger the expected return higher the investment value and vice-versa.

They dislike risk. This dislike for risk is termed as risk-aversion. The degree of risk-aversion differs among investors and from time to time. The relation between degree of risk-aversion and investment value is negative, i.

Return comprises the income, which is in the form of dividends or interest, and the capital gain loss. The company paid a dividend of Rs. In October, , the company paid an interim dividend of Rs. On 31st December, , the market price per share was Rs. Find the return on investment for the year The paid a dividend of Rs. The company paid an interim dividend of Rs. Find the return on investment for year There may be loss of capital, i.

There may be no income from investment or the income may be less than the expected. The answer is that the desire for higher return entices them to go for risky investments. Investment decision should be taken after considering both return and risk.

How to measure the risk? Standard deviation of various possible rates of return is used to measure the risk? Larger the standard deviation, greater the risk, and vice versa.

How to take investment decisions when various opportunities are there? Here two sets of 3 total rules provide help to us. These rules are: SET A : i If expected returns from various securities are different but their standard deviations are same: Decision should be taken on the basis of expected returns.

Security with higher expected return is preferred. Security with lower standard deviation should be preferred. Coefficient of variation is obtained by dividing standard deviation by expected return. Coefficient of variation defines risk as standard deviation per rupee of expected return.

Security with lower coefficient of variation is preferred. Answer i A, B and F have same return. Hence, B and F should be dropped. Now we are left with A, C, D and E. Hence D should be dropped. Now we are left with A, C and E. In fact, expected return, calculated on the basis of probabilities, is weighted average mean return, weights being probabilities. In financial management, it is used as the measurement of the risk. The absolute values of the SDs do not convey any meaning.

For example, if the SD of returns of a particularly investment over 5 year is 20, it do not convey any meaning. If we are given SDs of two or more investments; from their comparison we can rank them of the basis of the risk involved. Suppose, there are three investment opportunities- A, B and C with SDs being 10, 15 and 12 respectively. Variance is also a measurement of risk. Variance is SD 2. The absolute values of the Variances do not convey any meaning.

When used for comparison purpose, variances give the same result as is given by SDs. If we calculate the variances for A, B and C, the values would be , and respectively. It refers to the risk per rupee of return. Moderate investors1 take decisions on the basis of coefficient of variation.

Lower coefficient of variation is preferred by such investors. Calculate coefficient of variation for each share. Which share would you prefer? Share B may be preferred because of lower amount of Coefficient of variation. Such investors neither go for wild investment opportunities i. Find out the expected return and variability of returns of the equity shares. And also advise : whether to accept buy back offer?

In this scenario, the buy back offer should not accepted. If the coupon rate of the debenture is less than the current market interest rate, MV of the debenture will be lower than the face value.

In this scenario, the buy back offer should be accepted. Examples of such factors are: Level of economic activities recession or boom , variation in interest rates, inflation, political developments, etc. Unsystematic risk arises from such factors which are concerned with the firm.

This risk is unique to a particular security. Examples are: strike, change in management, special export order, etc. Unsystematic risk is also referred as firm-specific risk, it is denoted by ei Unsystematic risk is called as diversifiable risk as it can be reduced with the help of diversification, i. Systematic risk is non-diversifiable; it cannot be reduced through diversification.

All equity investors have to bear this risk. The total risk, both systematic and unsystematic risk, of a security or portfolio is measured by the standard deviation. Market portfolio is a very well diversified portfolio. The unsystematic risk of the investment in the market portfolio is eliminated through diversification. It represents systematic risk associated with an investment in relation to total risk associated with market portfolio.

If the Beta of a security is 1. Suppose the beta value of a particular security is 1. Therefore, this security is riskier than the market because we expect its return to fluctuate more than the market on a percentage basis. This beta measures the riskiness of individual security relative to market portfolio. A security with beta greater than one is called as aggressive security; with beta less than one is called as defensive security and with beta equal to one is called as neutral security.

Covariance : It is a statistical measurement that measures the combined variation co-vary between two variables; that is, more or less when one of them is above its mean value, then the other variable tends to be above its mean value too, then the covariance between the two variables will be positive. On the other hand, if one of them is above its mean value and the other variable tends to be below its mean value, then the covariance between the two variables will be negative.

That is to say, the covariance becomes more positive for each pair of values which differ from their mean in the same direction, and becomes more negative with each pair of values which differ from their mean in opposite directions. In this way, the more often they differ in the same direction, the more positive the covariance, and the more often they differ in opposite directions, the more negative the covariance.

A negative covariance means that variables move in different directions. A positive covariance means they move in the same direction. Covariance can range from negative infinity to positive infinity. Covariance is an absolute measure. Covariances cannot be compared with one another. SDy ] Coefficient of Correlation r states relationship between two variables; the two variables may be return from two securities, or return from market portfolio and return from a security, rainfall and agriculture output, inflation and interest rate etc.

The other positive values of r indicate that more or less both the series move in the same direction if one increased, the other also increases; if one decreases the other also decreases but the rates of changes are different. The other negative values of r indicate that more or less both the series move in the reverse direction if one increases, the other decreases; if one decreases the other increases and the rates of changes are different. Using the following data regarding two securities C and D, find which of the two securities is more risky?

It means the total risk of the market portfolio is 5 Remember that total risk of the market portfolio is only systematic risk. Suppose there is security having Beta of 1. It means systematic risk of the security is 1. It is denoted by ei. What are the SDs of A and B? Suppose beta of a security is 1.

To do this, you need to know how to read or use the information available. Perhaps the most critical information to have about an investment is its potential return and susceptibility to types of risk. Returns are always calculated as annual rates of return, or the percentage of return created for each unit dollar of original value. Returns are created in two ways: the investment creates income or the investment gains or loses value. To calculate the annual rate of return for an investment, you need to know the income created, the gain loss in value, and the original value at the beginning of the year. The percentage return can be calculated as in Figure

Chapter 7 cpa Indrajeet Kamble. The coefficient of risk aversion for a risk neutral investor is zero. The market risk premium is defined as beta multiplied by the expected return on the market minus the risk-free rate a of return d. None of the above. The covariance of the returns on the two securities, A and B, is We argue throughout the chapter that, for most nancial risk management purposes, the conditional perspective is distinctly more relevant for monitoring daily market risk.

Skip to search form Skip to main content You are currently offline. Some features of the site may not work correctly. Shamsabadi and M. Shamsabadi , M. The significance of risk-return relationship is advocated from both investors and organizations.

express investment results as rates of return, or percentage returns. ® For example, the rate of return on the 1-year stock investment, when $1, is received.

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Risk and return Part 3. Financing and payout decisions 3. Risk is associated with the possibility that realized returns will be less than the returns that were expected. A framework is provided to estimate the risk of investment loss and the maximum potential investment loss.

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rate of return but minimize their risk at the same time. Thinking about that question resulted in the development of some techniques that enable investors to.

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