Financial Management MGT201
INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT
After going through this lecture, you would be able to have an understanding of the following
· Introduction to Risk
· Risk and Return for Single Stock Investment
Before discussing this important topic we should go through the area of finance which we have
studied up till now.
Part I (Introduction and Capital budgeting)
FM Markets, Concepts, Definitions
Review of Accounting
Interest Rate Theory & Calculations
Investment Decisions: NPV (Valuation), IRR, Payback
Capital Budgeting: NPV & DCF
Capital Rationing (Budgeting for Real Assets)
Part II (Securities Valuation)
Valuation of Stocks & Bonds (Direct Claim Securities)
The Chapter 4 and 5 of text book cover the topics of risk and return. It is the fundamental concept to
understand the topics of portfolio theory and Capital Asset pricing model (CAPM).In the previous
lectures, we are ignoring the origin of required rate of return.
Chinese Definition of Risk:
It is defined as the combination of danger and opportunity. Risk is the combination of both.
When we talk about risk with the reference to the investment we are talking about risk in term of the
uncertainty in outcome of our investment. We are talking about the variability, spread, or volatility that
can take place in the expected future Value (Cash Flows) or Returns. For example, we are asking
ourselves if we invest Rs 1,000 for buying a share today then what will be the price of the share one
year from now. There is no guarantee about the price of the share after one year therefore there is an
uncertainty or risk we are taking because we do not know the final outcome. So, the difference or
variation in the possible outcomes of a particular investment also represents the risky ness of a particular
As we have studied earlier that there are two major categories of assets
1 Real Physical Assets 2 .Financial Assets (Stock & bonds)
Risk can be understood with reference to the uncertainty of Future Cash Flows produced by
Assets (Physical & Financial Securities). Businesses make forecasts based on certain assumptions which
we have discussed in lecture 5 of your course. These forecasts are not 100% accurate and there is
uncertainty in the possible outcome. The actual cash flows one or five years from now may be very
different from the forecasted and this to represent risk. When we talk about risk in investing in direct
claim securities then we need to keep in mind the distinction between Stand Alone Risk (or Single
Investment Risk) as oppose to market or Portfolio Risk (or Collection of Investments Risk).which is a
risk of particular investment compare to other investments you have made. In Portfolio risk we are
interested in overall risk of entire collection of investments that made by the company. We will study
this topic in the next lectures.
In case of portfolio risk we can further made distinction between Diversifiable Risk and Market
Diversifiable Risk: random risk specific to one company, can be virtually eliminated.
Market Risk: It is defined as uncertainty caused by broad movement in market or economy. More
Causes of Risk:
These can be Company-Specific or General. It may be because of Cash Losses from operations
or poor financial management of the company. This is one possibility but the real question is that why
these losses occurred. One of the reasons for the losses might be the company's Debt, Inflation,
Economy, Politics, War or Fate. Final analysis of risk is that it is a game of fate or chance.
Financial Management MGT201
Measurement of Risk:
It is important to attach different numbers to the risk so that we can rank different investments.
Risk is measured in terms of the standard deviation or variance. You have studied these terms in the
statistics. Risk is still quite subjective even after the numbers you have calculated after standard
deviation. The reason is that you have to keep in mind what kind of risk you are talking about. Are you
Stand Alone Risk or Portfolio Risk?
Market Risk or Diversifiable Risk?
Stock Price Risk or Earnings Risk?
Another important thing is Time Horizon for which you are measuring the risk. Are you
investing in Stocks over 1 Year or over 30 Years?
The level of risk might change as time period of the investment change.
Fundamental Rule of Risk & Return:
This rule can be summed up in saying that No Pain - No Gain. Investors will not take on
additional Market Risk unless they expect to receive additional Return which is common sense and
quite logical. Most investors are Risk Averse. Another important principle that one should to keep in
mind is Diversification.
It states that don't put all your eggs in one basket. Diversification can reduce risk. By
spreading your money across many different Investments, Markets, Industries, Countries you can avoid
the weakness of each. Make sure that they are Uncorrelated so that they don't suffer from the same bad
news. Due to certain change in the interest rates some of the investments in your portfolio may go up
and the others go downward.
Every Day Examples of Risk-Return Pairs:
· Climbing Mount K2
· Gambling on Cricket Matches
· Oil drilling in Badin Block
· Satta / Speculation in Shares
· Construction Commercial Plaza
· Investing "Blue Chip" Stocks
· Crossing Road at Peak Traffic
· Investing TFC's
· Depositing Money in Bank A/c
· Investing in T-Bills
Before taking about the risk we first see the different possible outcomes of a particular investment
by analyzing the expected return. It is mentioned earlier that once we have an idea of the variation then
we can measure the risk of that investment.
Range of Possible Outcomes, Expected Return:
Overall Return on Stock = Dividend Yield + Capital Gains Yield (Gordon's Formula)
Simply, Return is proportional to Capital Gain which is proportional to Selling Price. We can use
Forecasted Selling Price as measure of Return. The wider the range of Possible Outcomes that can occur,
the greater the Risk
The chance that a future event will actually occur is measured using Probability
Expected ROR = < r > =
Where pi represents the Probability of Outcome "i" taking place and ri represents the Rate of Return
(ROR) if Outcome "i" takes place. The Probability gives weight age to the return. The Expected or
Most Likely ROR is the SUM of the weighted returns for ALL possible Outcomes.
Now let us take a look of case of investing in the share of the particular company.
Suppose you are deciding whether to invest in the Stock of Company ABC. You're not sure
because the Future or Forecasted Price of the Stock after 1 year could reach any one of 3 Possible
Values (or Outcomes). Before you can estimate the most likely or Mean or Expected Future Price, you
need to guess the Probability of Each Possible Outcome
Financial Management MGT201
Outcomes (After 1 Yr)
"Bull Market" (Stock Price P1*=140)
30% or 0.3
"Normal Market" (Stock Price P1*=110)
40% or 0.4
"Bear Market" (Stock Price P1*=80)
30% or 0.3
Po= Present Market Price Rs100. P1*=Forecasted Price.
The Sum of Probabilities of all Possible Outcomes MUST Add Up to 100% (or 1.0).
Payoff Table & Expected ROR
Payoff Table for Investment in Stock
Outcomes (1 Yr)
ROR <r> = (P1*-Po)/Po)
Price Rises (P1*=140) 0.3
+ 40 % = (140-100)/100
Price Same (P1*=110) 0.4
+ 10 % = (110-100)/100
Price Falls (P1*=80)
- 20 % = (80-100)/100
Expected ROR of Investment in Stock
Most Likely or Weighted Average or Mean ROR Rate of Return < r >
Expected ROR = < r > =
= p1 (r1) + p2 (r2) + p3 (r3)
= 0.3(40%) + 0.4(10%) + 0.3(-20%)
= 12% + 4% - 6% = 10%
Forecasted Returns for Single Stock Investment
"Expected ROR" or Most
Likely or Mean ROR = 10%
Rate of Return after 1 Year < r >
In the diagram, the probability graphed on y axis and the rate of return is graphed on x axis. All
three outcomes are shown in the form of the bars. In this diagram the largest probability takes place at
the value of the expected rate of return which is 10%. If the top of each vertical bar is connected then
the bell curve is formed. It is easy to calculate the risk after calculating the expected rate of return. We
simply use the formula of standard deviation to calculate the risk
Stand Alone Risk of Single Stock Investment:
The wider the range of Possible Outcomes (i.e. the greater the variability in potential returns)
that can occur, the greater the Risk
Risk Measured using Standard Deviation (Note: Variance = Standard Deviation 2)
Risk = Std Dev =
( r i - < r i > )2 p i . =
Summed over each possible outcome " i " with return "r i " and probability of occurrence "p i ." < r i
> is the Expected (or weighted average) Return
This topic will be discussed in detail in the next lecture
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