Risk and Return

Risk and return are highly correlated with one another. The high risk of an investment always provides a higher return. Similarly, low-risk investments only deliver low returns. That is the difference between bank interest rates and share market investment returns. However, understanding risk is important to minimise its effects as much as possible while achieving the highest return possible from an investment.

Welcome to Topic 6: Risk and Return. In this topic, you will learn about:

• Risk and return of a single financial asset
• Sources of financial risks
• Systematic and unsystematic risk
• Efficient capital market
• Expected returns on a portfolio of securities.

These relate to the Subject Learning Outcomes:

1. Understand the role of the finance and accounting functions in an organisation.
2. Identify the terminology and concepts that underlie the preparation of general-purpose financial reports.
3. Apply mathematics of finance to determine risk, return, evaluation of investment, financing, working capital and distribution decisions.
4. Develop analytical skills drawing from key finance theories, concepts and techniques.

Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these prior to attending your scheduled seminar with your lecturer.

Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.

Risk and return of a single financial asset

"In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risk include:

• project-specific risk
• industry-specific risk
• competitive risk
• international risk
• market risk" (CFI 2015).

"Return refers to either gains or losses made from trading a security. The return on an investment is expressed as a percentage and considered a random variable that takes any value within a given range" (CFI 2015).

“Several factors influence the type of returns investors can expect from trading in the markets. Diversification allows investors to reduce the overall risk associated with their portfolio but may also limit potential returns. Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate superior returns, but should the sector decline then you may experience lower returns than could have been achieved with a broadly diversified portfolio” (CFI 2015).

The following formulas are used to calculate the return and risk of a single financial asset.

Return

$$\begin{aligned}\mathsf{Return}&=\mathsf{stock\;price\;end\;of\;period}\;–\;\mathsf{stock\;price\;start\;of\;period}+\mathsf{dividends} \\\\\mathsf{Return\;percentage}&=\frac{\mathsf{return}}{\mathsf{stock\;price\;start\;of\;period}}\\\\\overline{\mathsf{R}} &=\frac{\sum^{n}_{t=1} \mathsf{R}_{t}}{n}\end{aligned}$$

Where:

• R = average rate of return
• R_t = stock return of the period
• ∑ = Sum of
• n = number of periods
• t = time.

Risk

$$\begin{aligned}\mathsf{Deviation}&=\mathsf{stock\;return\;of\;the\;period}\;–\, \mathsf{average\;rate\;of\;return}\\\mathsf{Sum\;of\;the\;deviations} &= \mathsf{zero}\end{aligned}$$

The variance formula is as follows:

$$\begin{aligned}\sigma^2 &= \frac{\sum^n_{t\,=\,1}(\mathsf{R}_t\,–\,\overline{\mathsf{R}})^2}{(n\,–\,1)} \\\\\mathsf{Standard\;deviation} &= \sqrt{\mathsf{variance}}\end{aligned}$$

Sources of financial risks

Different risks arise from different sources and identifying them can help manage them effectively. Some of the common risk types include the following.

Business risk

Business risk is the risk involved with the operational aspects of the business. Selling prices need to keep adjusting according to the material prices and wage rates in the market. In the meantime, if the government intervenes and controls the selling price you might end up losing the profit margin.

Exchange risk

Exchange risk is the risk associated with changing currency exchange rates. When a business expands to international markets, it is exposed to exchange risks – every time the value of the other currency declines, your profit margins are affected.

Purchasing power risk

Purchasing power risk is the risk that the amount the customer can buy with a set value of money will change according to inflation, where it is not always possible to increase the prices.

Financial risk

Financial risk is the risk that a business may not be able to make loan repayments due to changes in profits. When business’s borrow funds to cover capital expenses, they are bound to repay a fixed amount periodically. If the business is start losing profits, the repayments will be at risk.

Interest rate risk

Interest rate risk is the risk that a business may not be able to make loan repayments due to changes in interest rates. The amount of the borrowing repayments are, in part, determined by market interest rates. If the market interest rates go up, the repayments may be at risk if the business does not have the profits to cover the increase.

Tax risk

Tax risk is the risk that changes in tax rates in an economy may affect the business.

The following table outlines the different components of a business’s income statement and the potential sources of risk associated with each component:

Systematic and unsystematic risk

"Systematic risk can be defined as a type of total risk that arises as a result of various external factors such as:

• Political factors
• Economic factors
• Sociological factors" (Thakur n.d.)

Businesses cannot control, minimise or avoid systematic risks because they are linked to external factors. They have the tendency to not just disrupt the whole market but also the economy as well. Systematics risks are generally related to the wider environmental factors such as:

• Inflation
• Price movements
• Fluctuations in interest rates
• Unemployment rates (Thakur n.d.)

On the other hand, unsystematic risks arise due to internal factors within a business, hence businesses can control, minimise and even avoid these risks. While unsystematic risks can definitely disrupt a business, it also has the ability to disrupt the industry as well. Examples of unsystematic risk include a higher rate of operational costs and a rise in labour turnover (Thakur n.d).

Efficient capital market

According to Melicher & Norton (2017, p. 355), “security prices are determined by the pattern of expected cash flows and a discount rate. Therefore, any change in price must reflect a change in expected cash flows, the discount rate, or both. Sometimes, identifiable news can cause assets' prices to change. Unexpected, good news may cause investors to view an asset as less risky or to expect increases in future cash flows. Either reaction leads to an increase in an asset's price. Unexpected bad news can cause an opposite reaction: the asset may be viewed as more risky or its future cash flows may be expected to fall. Either reaction results in a falling asset price.”

“A market with systems that allow for quick execution of customers' trades is said to be operationally efficient. If a market adjusts prices quickly and in an unbiased manner after the arrival of important, unpredicted news, it is said to be an informationally efficient market, or an efficient market” (Melicher & Norton 2017, p. 355).

“If the market for Microsoft stock is efficient, we should see a quick price change shortly after any announcement of an unexpected event that affects sales, earnings, or new products or after an unexpected announcement by a major competitor. A quick movement in the price of a stock, such as Microsoft, should take no longer than several minutes. After this price adjustment, future price changes should appear to be random. That is, the initial price reaction to the news should be unbiased—that is, on average, the initial price change will fully reflect the effects of the news. Put another way, we should not observe a consistent trend in a firm's stock price, on average, after the initial price reaction” (Melicher & Norton 2017, p. 355).

Calculate the expected return on a portfolio of securities

The following formula is used to calculate the expected return on a portfolio of securities:

$$ E(R_p)=\sum\limits^n_{i = 1}{w_iE(R_i)}$$

Where:

• E = Expected
• R_p = Return of the portfolio
• R_i = Return of the asset i
• ∑ = Sum of
• n= Time period
• i = Asset
• w_i = Weight or the investing percentage of the asset, i.

In simple terms, expected portfolio return will be calculated by:

$$\mathsf{Expected\;portfolio\;return} = (\mathsf{expected\;investing\;percentage}\times\mathsf{expected\;rate\;of\;return})+(\mathsf{expected\;investing\;percentage}\times\mathsf{expected\;rate\;of\;return})\;$$

Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.

Click here to access your seminar.

The following learning tasks will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.

Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)

In-seminar learning tasks

The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.

Welcome to your post-seminar learning tasks for this week. Please ensure you complete these after attending your scheduled seminar with your lecturer. Your lecturer will advise you if any of these are to be completed during your consultation session. Click on each of the following headings to read more about the requirements for each of your post-seminar learning tasks.

Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.

Click here to access your consultation session.

Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.

Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)

• Black, F1993, Beta and return, Journal of Portfolio Management, 20:8-18. 
• Fama, EF & MacBeth, J 1973, Risk, return and equilibrium: Empirical tests, Journal of Political Economy, 81:607-636. 
• Pettengill, GN, Sundaram, S & Mathur, I 1995, The Conditional Relation Beta and Returns, Journal of Financial Quantitative Analysis, 30:101-116. 

References

• Baillie, RT & DeGennaro, RP 1990, ‘Stock Returns and Volatility’, Journal of Financial and Qualitative Analysis, 25(7):203-214, https://www.jstor.org/stable/2330824
• CFI 2015, Risk and return, CDI Education Inc, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/risk-and-return/
• DeBondt, W 1993, ‘Betting on trends: Intuitive forecasts of financial risk and returns’, International Journal of Forecasting, 9(3):355–371, https://doi.org/10.1016/0169-2070(93)90030-Q
• Hilmola, O 2021, ‘Inflation and Hyperinflation Countries in 2018–2020, Risks of Different Assets and Foreign Trade’, Risk and Financial Management, 14(12):618, https://www.mdpi.com/1911-8074/14/12/618
• Kennon, J 2021, Investment portfolio analysis for beginners, The Balance, https://www.thebalance.com/portfolio-analysis-for-beginners-4154345
• Melicher, RW & Norton, EA 2017, Introduction to Finance: Markets, Investments, and Financial Management, 16th edn., John Wiley & Sons, Inc.
• Thakur, M n.d., Systematic risk vs unsystematic risk, EDUCBA, https://www.educba.com/systematic-risk-vs-unsystematic-risk/
• Theintactone n.d., Risk & return: concept of risk, component & measurement of risk, https://theintactone.com/2019/07/06/iapm-u2-topic-1-risk-return-concept-of-risk-component-measurement-of-risk/