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.

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.