Risk: risk and return, risk is not

Risk: Risk refers to
potential variability in future cash flows. The wider the range of possible
future events that can occur, the greater the risk.Thus the returns on common
stock are riskier than returns from investing in a savings account in the bank. Feelings about
risk:  Most people have negative
feelings about bearing risk, risk-averse investors prefer lower risk when
expected returns are equal, most people see a trade-off between risk and
return, risk is not to be avoided, but higher risk investments must offer a
higher expect the return to encourage investment. Cause of risk in the
investment: Wrong method of investment and Wrong timing of investment,
wrong quantity of investment, Interest rate risk, Nature of investment
instruments, Nature of industry in which the company is operating,
Creditworthiness of the issuer, Maturity period or length of investment, Terms
of lending, Natural and international factors and Natural Calamities. Risk
control: Once the consistency and evaluation processes are complete, it is
time to create the structures and processes to control or avoid risk. The
processes and structures will be determined by the type of risk identified and
the type of analysis associated with the risk. Risk control involves
determining procedures for risk avoidance, forfeit control, risk transfer
strategies and potential risk retention. risk avoidance will include setting up
procedures and controls that allow the organization to avoid the risk
completely. Avoidance strategies include dropping hazardous products or
removing potentially hazardous situations from the organization completely.

Risk avoidance ability to be one of the most felicitous strategies for risk
management but not all organization risks can be avoided. For ones that cannot
be avoided, the risk manager needs to identify loss control measures and risk
transfer strategies. A successful risk manager must also consider risk
retention and the consequences of risk retention as well. Type of risk: Systematic
risk (not diversified) also known as “market risk” interest rate risk
and purchasing power risk they represent sources of systematic risk.

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Unsystematic risk (diversified) include business risk and financing risk. Beta:
Beta is a measure of the volatility, of a security or a portfolio in comparison
to the market as a whole. also beta is used to compare a stock’s market risk to
that of other stocks. Investment analysts use the Greek letter ‘ß’ to represent
beta. Beta is used in the capital asset pricing model (CAPM) Beta is calculated using regression analysis, Beta is
a measure of the volatility, or systematic risk, of a security or a portfolio
in comparison to the market as a whole. Beta is also used to compare a stock’s
market risk to that of other stocks. Investment analysts use the Greek letter
‘ß’ to represent beta. Beta is used in the capital asset pricing model (CAPM)
beta is calculated using regression analysis. A beta of 1 indicates that the
security’s price will move with the market. A beta of less than 1 means that
the security will be less volatile than the market. A beta of greater than 1
indicates that the security’s price will be more volatile than the market. For
example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than
the market (Investopedia,2017). Sources of risk: First we have
Market risk which mean the variability in returns due to fluctuation in the
aggregate market. Then we have interest rate risk which is the interest rate
refers to the variability of total returns, particularly on fixed income
securities due to fluctuation in interest rates purchase. Also, we have power
risk it’s when we purchase power declines. Inflation also leads to hiking in interest
rates because lenders demand more to compensate themselves for loss in
purchasing power. Then exchange risk that is for international investors, a
source of risk comes from exchange rate fluctuation. Finally, Country risk it
also for international investors, economic and political stability, law and
order situation are an important consideration in the investment decision. Required return: The required return depends on two
elements, which are: Required return = Risk-free return + Risk premium
Risk-free return: The risk-free return is the return required by investors to
compensate them for investing in a risk-free investment. The risk-free return
compensates investors for inflation and consumer preference, the fact that they
are deprived of using their funds while tied up in the investment. The return
on treasury bills is often used as a surrogate for the risk-free rate. Risk
premium: means that the future actual return may vary from the expected
return. If an investor undertakes a risky investment he needs to receive a
return greater than the risk-free rate in order to compensate him. The higher
risky the investment the greater the indemnification required. This is not
surprising and it is what we would expect from risk-averse investors. Total risk: The standard deviation of returns is a
measure of total risk. For well-diversified portfolios, unsystematic risk is
very small. Consequently, the total risk for a diversified portfolio is
basically amounting to the systematic risk. Total
risk = systematic risk + unsystematic risk. Unsystematic risk:
Refers to the impact on a company’s cash flows of largely random events like
industrial relations problems, equipment failure, R&D achievements, changes
in the senior management team etc. In a portfolio, such random factors tend to
cancel as the number of investments in the portfolio increase. Systematic
risk: Public economic performers are those macroeconomic factors that
affect the cash flows of all companies in the stock market in a consistent
manner, a country’s rate of economic growth, corporate tax rates, unemployment
levels, and interest rates. Since these factors cause returns to move in the
same direction they cannot cancel out. Decomposing Risk: Fundamental
truth of the investment world.The returns on securities tend to move up and
down together (Not exactly together or proportionately). Events and Conditions
Causing Movement in Returns,  Some things
influence all stocks (market risk) as Political news, inflation, interest
rates, war, etc. Some things influence only particular firms (business-specific
risk) as Earnings reports, unexpected death of the key executive, etc. Some
things affect all companies within an industry as a labor dispute, shortage of
a raw material. Movement in return as risk. The total movement in a stock’s
return is the total risk inherent in the stock. Separating Movement/Risk into
Two Parts, a stock’s risk can be separated into systematic or market risk and
unsystematic or business-specific risk. Diversification- How Portfolio Risk
Is Affected When Stocks Are Added: Diversification means adding different
stocks to a portfolio. Can reduce (but not eliminate) risk in a portfolio.

Business-Specific Risk and Diversification, Business-specific risk is a series
of essentially random events that push the returns of individual stocks up or
down. Their effects purely repeal when added together over a large number of
stocks. Is essentially random and can be diversified away for this to work, the
stocks within the portfolio must be from fundamentally different industries.

Systematic (Market) Risk and Diversification: If the returns of all stocks move
up and down more or less together, it’s not possible to reduce risk completely,
systematic risk can be reduced but never entirely eliminated. The Portfolio if
we have a portfolio that is as diversified as the market, its return will move
in tandem with the market. The Impact on Portfolio Risk of Adding New Stocks if
we add a stock to the portfolio which has returned perfectly positively
correlated with the portfolio, it will generally add risk to the diversified
portfolio. If we add a stock that is perfectly negatively correlated with the
portfolio, it will decrease the risk of the portfolio. The Risk of the New
additions by Themselves and in Portfolios: Stocks with equal stand-alone risk
can have opposite risk impacts on a portfolio because of the timing of the
variation in their returns, a stock’s risk in a portfolio sense is its market
risk. Choosing Stocks to Diversify for Market Risk:  add stocks that move counter-cyclically
with the market, but it’s difficult to find stocks that move in that direction.

numerous stocks exist that have returns that are less than positively
correlated with the market. Adding these stocks to the portfolio will generally
reduce the risk somewhat, but will not eliminate it. The Importance of Market
Risk: Modern portfolio theory is based on the assumption that investors focus
on portfolios rather than on individual stocks. The stocks affect portfolios
depends only on market risk. the small investor with a limited portfolio, these
concepts do not apply. Return: The meaning of the return is
what you gain or loss of a something in a period of time. The return on the
income that you invested in. it might be gaining or losing. It usually
calculated as a percentage. The rule is that the more risk you take, the
greater (gain/ loss) you will have. There are several ways to calculate the
return in the businesses such as the simple growth formula when the return of
the investment is a function of growth, ROI, ROE, and ROA. The ROA and ROE are
mainly used to measure the performance of the business rather than the growth.

Most investors are looking for the returns while they invest in certain time. The
Return on Investment (ROI) is usually the most common return measure.

There is a basic formula to calculate ROI is by dividing the difference between
the cost of the investment and the gain on the investment by the cost of the
investment. It’s used to calculate other return measures. Usually, the
successful businesses have a positive ROI which means that the company is in a
good shape. It also used to determine which investment is better than the
other. For example, if an investor has multiple opportunities available to
invest in. there are several ways to decide which opportunity is better than
the other is by calculating the ROI. Return on Equity (ROE) is the other
most common return measure. It used to analyze the businesses performance. ROE
is the net income returned as a percentage of shareholders. The way to
calculate the ROE is by dividing the net income by the shareholder equity. The
investor to calculate the return on the company’s equity capital mainly uses
ROE. For example, if company A makes $100 in the net income for the year, and
the average equity of the company is $1000 over the same period, the return on
equity is 10%. Return on Assets one more measurement of return that gets used
to calculate which is the return on assets of can be called ROA. This measurement
it usually gets used by those who analyze the financial stocks.  To calculate ROA is by dividing the net
income by the average total assets to have the ROA. Moreover, ROA tells to the
investor what is the earning that was generated for the investment. ROA gives
the investor multiple things such as how effective are the company by turning
the investment into net income. Higher the ROA number is better than low ROA
because the company, in this case, is earning more money in less investment.

ROA is usually get used by comparing company in the same industry which makes
it the most helpful tools to use. What is Average Return? The
average return is the simple calculation the average returns that generated
over the period of time. The way to calculate the average return is by adding
all the numbers together and then dividing the number by the count of the
numbers in the set.

Average Return on Assets and Return on Equity: The
rate of return is the profit on the investment at the period of time. The time
period is usually a year so in this case, the return called an annual return. Return
from growth the
simple growth rate is a function of past and present values. It is calculated
by subtracting the past value from the present value and then dividing by the
past value. Portfolio Expected Return the expected Return on a
Portfolio is computed as the weighted average of the expected returns on
the stocks, which comprise the portfolio. The weights reflect the proportion of
the portfolio invested in the stocks. This can be expressed as follows:

  Portfolio’s Expected Rate of Return (rP): The
portfolio’s Expected Rate of Return is the weighted average of expected returns
on any investment in the portfolio. The way to calculate the portfolio expected
rate of return, which is similar to the expected return for a single investment
as follows: rP* = r1 x 1 + r2 x 2 + r3 x 3 + . . . + rn x n Return On Capital Gain: The
return that one gets from an increase in the value of a capital asset For
example investment. The return on capital gain is the measure of the investment
gain for an asset holder, relative to the cost at which an asset was purchased
return on capital gains is a measure of return on realized gains, after
consideration for any taxes paid, commissions or interest. Breaking down
‘Return on capital gains’ return on capital gains is measured on realized gains
recognized from the sale or maturity of an investment asset, net of costs. For
example, selling a stock for $10, which was purchased for $5, while accounting
for a total of $2.50 in commissions and applicable taxes, would equate to a 50%
return on capital gains. Other investment measures tend to measure returns of
unrealized gains, which is why some may prefer to use return on capital gains,
instead.  A capital loss is incurred when
there is a decrease in the capital asset value compared to an asset’s purchase
price. While capital gains are generally associated with stocks and funds due
to their inherent price volatility, a capital gain can occur on any security that
is sold for a price higher than the purchase price that was paid for it. So
realized capital gains and losses occur when an asset is sold and triggers a
taxable event. Unrealized gains and losses, sometimes referred to as paper
gains and losses, reflect an increase or decrease in an investment’s value but
have not yet triggered a taxable event.

 Active Return active return is the percentage gain or
loss of an investment relative to the investment’s benchmark. An active return
is a difference between the benchmark and the actual return. It can be
positive or negative and is typically used to assess performance. For example,
if the benchmark return is 7% and the return is 10% then the active return is
10% – 7% = 3%. In case in same portfolio gets a return of 5% then the result
would be negative 5% – 7% = -2%. The total return is
when we measuring performance, is the actual rate of return on
an investment or a pool of investments over a given evaluation period. Total
return has multiple things such as interest, capital gains,
dividends and distributions realized
over a given period of time. Total return accounts for two categories of
return: income including interest paid by fixed-income investments,
distributions or dividends and capital appreciation,
representing the change in the market price of
an asset. Risk and return
relationship: Relationship between
risk and return means to study the effect of both elements on each other. It
measures the effect of increase or decrease risk on return of investment. For
the most part, the higher the potential return of an investment, the higher the
risk. The balance between risk and return is the essence of the distribution of
investments. It is easy for everyone to say that they want to achieve the
highest levels of returns; However, choosing the most “potential”
investments are not the solution. What distinguishes between investors who are
hungry for returns from successful investors is the ability to balance risks
and returns. Investors who can afford higher risk must invest more money in stocks.

But if they cannot continue to invest and carry
short-term fluctuations in the markets, you should reduce your equity
investments. If we have “direct” relationship between risk and
return, high risk – high return, the investor will take more risk, he will get
more reward. So, if he invested two million, his risk of loss is two million
dollars. Second, low risk – low return, if investor decreases investment. He
will be decreasing his risk of loss, his return will also decrease. So now we
know about the direct relationship between risk and return. What about negative
relationship between risk and return? 
First, high risk low return, Sometime, investor increases investment
amount in order to get high return but with increasing risk, he faces low
return because it is the nature of that

project. There is no
benefit to increase investment in such project. Second, low risk-

high return, there
are some projects, if you invest small amount, you can earn high

return. This
is desirable and an excellent opportunity for investment in such projects

because the nature of
low risk and high return. Now we will take about
Portfolio theory, it is very important to understand the principles that
underpin portfolio theory. The reason investors should establish portfolios.

The logic is that an investor who puts all their funds into one investment
risks everything on the performance of that individual investment. But the best
solution would be to spread the funds over several investments (establish a
portfolio) so that the unexpected losses from one investment may be offset to
some extent by the unexpected gains from another. Thus, the key motivation in
establishing a portfolio is the reduction of risk. So now we will Understanding
an net present value calculation from an investor’s perspective, for example:
Rayan currently has his savings safely deposited in his local bank. He is think
buying some shares in a Programmable Logic Controller. He is trying to
determine if the shares are going to be a viable investment. He asks this
question: ‘What is the future expected return from the shares? What extra
return would I require to compensate for undertaking a risky investment?
Expected return Investors receive their returns from shares in the form of
dividends and capital gains/ losses. The formula for calculating the annual
return on a share is:    Suppose
that a dividend of 5p per

share was paid during the year
on a share whose value was 100p at the start

of the year and 117p at the end
of the year:  Required return.The total return is made up of
a 5% dividend yield and a 17% capital gain The lower prospective return you
would need in order to purchase an asset, that is, to make the in exploitation.

The required return consists of two elements, which are: Required return
=Risk-free return + Risk premium, so We should know what is risk-free return
and risk premium, First the risk premium is the return in excess of the
risk-free rate of return on investment is expected to yield, second the
risk-free rate is the theoretical rate of return attributed to an investment
with zero risk. Also, we should know about net present value, the present value
is the difference between the present value of cash inflows and the present
value of cash outflows. For example: Assume that Rayan is considering investing
£100 in A plc with the intention of selling the shares at the end of the first
year. that the expected return will be 20% at the end of the first year. Given
that Rayan requires a return of 16% should he invest?  accept if the net present value is

zero or positive. The NPV is
positive, so Rayan should invest. A positive net present value Chance is where
the expected return greater than compensates the investor for the perceived
level of risk, i.e. the expected return of 20% is more than the required return
of 16%. No, if we want to Compute the risk premium is the basic part of the discount rate.

This thus makes the net present value count conceivable. We need to Calculate
the risk of premium to compute the risk premium, we should have the capacity to
characterize and measure risk. So far, we have restricted
our decision to a single investment. presently we will expect ventures can be
joined into a two-resource portfolio. The risk and return relationship will now
be measured regarding the portfolio’s normal return and the portfolio’s
standard deviation.

 

 

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