Finance Management

ILOC Class
SEM-VIII Module 2 D17A & D18
(2021-22)

Concepts of Returns and Risks

Risk is present in virtually every decision. Assessing risks and incorporating
them in the final decision is an integral part of financial analysis. Note that,

– Returns and risks are highly correlated in investing. Increased po-

tential returns on investment usually implies increased risk. So the
decisions are not taken to eliminate or avoid the risk, but often in the
financial analysis, it is assessed that whether the risk is worth to be
taken.

– In a well-ordered market there is a linear relationship between market

risk and expected return.

In financial systems, assets are expected to generate cash flows and hence
the riskiness of a financial asset is measured in terms of the riskiness of its
cash flows. Furthermore, The riskiness of an asset may be measured on a
stand-alone basis or in a portfolio context. An asset may be very risky if
held by itself but maybe much less risky when it is part of a large portfolio.
In the context of a portfolio, the risk of an asset is divided in to two
parts: diversifiable risk and market risk.

• Diversifiable risk arises from company-specific (or sector specific)

factors and hence one can do away with it through diversification. It
allows investors to reduce the overall risk associated with their port-
folio, however that may result into limited potential returns.

• Market risk, arises from general market movements and hence can
not be diversified away.

For example
Making investments in only one of the securities in one of the sectors may
generate superior returns if that sector significantly outperforms the overall
market.

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 But should the sector decline then you may experience lower returns
than could have been achieved with a broadly diversified portfolio.
For a diversified investor what matters is the market risk and not the
diversifiable risk.

Historical Returns and Risks

Historical returns helps you to estimate the distribution of returns expected
in future.

Computation of Historical Returns over a period

Suppose that, PB = Price of the investment at the beginning. PE = Price of the investment in the end
C = Cash Payment Received during the period. So % return R on the in-
vestment can be given by,

C + (PE − PB )
R= × 100
PB
Note that, PB > 0, C ≥ 0 and PE can be 0, P ositive or N egative. So,
return R can be 0, P ositive or N egative.

For example
Suppose that, an investor bought 100 equity shares at the price of | 600 per
share. After one year the price of an equity share was | 684 and he received
dividend of | 300 on his investment.
So his return on Investment can be calculated as follows. PB =| 600×100=| 60000,
PE =| 684×100=| 68400 and C=| 300
So % return R on the investment is given by,

C + (PE − PB )
R= × 100
PB
300 + (68400 − 60000)
= × 100
60000
8700
= × 100 = 14.5 %
60000
Note that,(300/60000) × 100 = 0.5% is current yield and (8400/60000) ×
100 = 14% is capital gain/loss yield.

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Average Annual Returns
There are two commonly used ways to calculating the average annual return
of an investment one is an arithmetic mean and another is geometric mean
that calculates annual compounded growth.

Arithmetic Mean
An arithmetic mean is simple average of annual realized returns, given by
Pn
Ri
R̄ = i=1
n
Where, Ri is annual return for the ith year and n is period of investment in
years.

For example
Suppose that for an investment of | 60000 for 5 years has annual returns
on each years as R = {10.5%, 6.5%, −3.4%, 7.5%, 11.6%}. So the simple
average returns can be obtained as
10.5 + 6.5 − 3.4 + 7.5 + 11.6
R̄ = = 6.54%
5
So average yield on the investment is 6.54% or | 3924 per year.

Compounded Annual Growth Rate (CAGR)

To calculate the Compound Average Growth Rate (CAGR) over a period
of time, the geometric mean is used.

Geometric Mean
An geometric mean for the realized returns can be given by,

n
!1/n
Y
GM = (1 + Ri ) −1
i=1

Where, Ri is annual return (normalized to 1) for the ith year and n is period
of investment in years.

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For example
Suppose that for an investment of | 60000 for 5 years has annual returns
on each years as R = {10.5%, 6.5%, −3.4%, 7.5%, 11.6%}. So the CAGR is
given by

CAGR = (1.105 × 1.065 × 0.966 × 1.075 × 1.116)1/5 − 1 = 0.064

So CAGR on the investment is 6.4% or | 3840 per year.

Variance of returns
Suppose you are analyzing the return of an equity stock over a period of
time. In addition to the arithmetic mean return, you would also like to
know the variability of returns. The variance is a measure of variability. It
is calculated by taking the average of squared deviations from the mean.

Varaince
Let R be the return from the investment, R̄ be the arithmetic mean and σ
be standard deviation, then variance is given by
Pn
2 (Ri − R̄)2
σ = i=1
n−1

For example
Suppose that for an investment of | 60000 for 5 years has annual returns
on each years as R = {10.5%, 6.5%, −3.4%, 7.5%, 11.6%}. So the simple
average returns can be obtained as
10.5 + 6.5 − 3.4 + 7.5 + 11.6
R̄ = = 6.54%
5
So average yield on the investment is 6.54% or | 3924 per year. Furthermore,
Here period n = 5 years. So Variance is given by,
Pn
i=1 (Ri− R̄)2
σ2 =
n−1
(10.5 − 6.54)2 + (6.5 − 6.54)2 + (−3.4 − 6.54)2 + (7.5 − 6.54)2 + (11.6 − 6.54)2
=
4
141.012
= = 35.253
4
√
So the Variance is 35.253 and standard deviation is σ = 35.253 = 5.9374.

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Expected Return and Risk of the Single Asset
So far we have discussed about past returns.Now we discuss about prospective returns.
When you have invested in an asset, return on the investment can be any value positive,
negative or zero return. Likelihood of return therefore vary from value to value. So one
should think in terms of a probability distribution. The probability of an event represents
the likelihood of its occurrence. For instance, suppose that you think that there is a 4:1
chance that the market price of an asset will increase.
So probability distribution can be given by,

Outcome Probability
Stock Price will rise 80%
Stock Price will not rise 20%

Expected Rate of Return

It is calculated by taking the average of the probability distribution of all possible returns.
Suppose that there are n possible returns (outcomes) Ri , i = 1, 2, · · · , n, then expected
rate of return can be given by
Xn
E(R) = pi R i
i=1

Where, pi is probability of occurrence of Ri return.

For example, if a stock has a 50% probability of providing a 10% rate of return, a
30% probability of providing a 15% rate of return, and a 20% probability of providing a
20% rate of return.
So the expected rate of return is,
n
X
E(R) = pi Ri = 0.5 × 10 + 0.3 × 15 + 0.2 × 20 = 13.5%
i=1

Standard Deviation of Expected Returns

Note that, risk refers to the dispersion of a variable and it is commonly measured by the
variance or the standard deviation.
The variance of a probability distribution is the sum of the squares of the deviations
of actual returns from the expected return weighted by the associated probabilities. So the
variance is given by,
Xn
σ2 = pi (Ri − E(R))2 (1)
i=1
th
Where, Ri is i possible outcome, E(R) is expected return and pi is the probability of
the ith possible income.

For example
If a stock has a 50% probability of providing a 10% rate of return, a 30% probability of
providing a 15% rate of return, and a 20% probability of providing a 20% rate of return.

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 So the expected rate of return is,
n
X
E(R) = pi Ri = 0.5 × 10 + 0.3 × 15 + 0.2 × 20 = 13.5%
i=1

So variance of expected returns is given by,

n
X
σ2 = pi (Ri − E(R))2
i=1

=0.5 × (10 − 13.5)2 + 0.3 × (15 − 13.5)+ 0.2 × (20 − 13.5)2 = 15.25
√
and standard deviation is σ = 15.25 = 3.9051%.

Features of Standard Deviation

• Because Ri − E(R) is squared, therefore farther the possible value of Ri higher it
impacts on standard deviation.
• As squared difference (Ri −E(R))2 is multiplied by associated probability pi , there-
fore lesser the probability of occurrence of particular Ri smaller is the effect on
standard deviation.
• As standard deviation and expected value are measured in the same units and hence
the two can be directly compared.

Rationale for Standard Deviation

Why is standard deviation employed commonly in finance as a measure of
risk?
If a variable is normally distributed, its mean and standard deviation contain all the
information about its probability distribution.
• Note that, the normal distribution is a continuous probability distribution used
most commonly in finance. Typically, It is given by
 2
1 1 Ri − E(R)
P DF = √ e 2
σ 2π σ

• It has bell shape characteristics as given bellow,

• If the utility of money is represented by a quadratic function (a function commonly
suggested to represent diminishing utility of wealth),then the expected utility is a
function of mean and standard deviation.
• Standard deviation is analytically more easily tractable.
• Typically, it can be characterized as in Fig. .

Risk Aversion and Required Returns

Suppose that you are given a choice to take one of the two boxes among them one is
empty and another contains | 10000. So expected return is | 5000. If you are offered to
forfeit the option to choose a box at cost of | 3000. Let us assume you deny it and want
to take a risk for additional | 2000. Then you are offered | 3500 for the same. Now you

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 Figure 1: Typical normal distribution of possible returns

may accept the offer as, it is certain that you are getting | 3500. Thus certain returns,
”amounts offered | 3500 is a ”Certainty Equivalent” which is less than the risky expected
value | 5000.
• If the certainty equivalent of a person is less than the expected value, then he is a
risk-averse person.
• If the certainty equivalent of a person is equal to the expected value, then he is a
risk-averse person.
• If the certainty equivalent of a person is greater than the expected value, then he
is a risk-loving person.

0.1 Standard deviation and Risk

Risk and return go hand in hand.This indeed is a well-established empirical fact,particularly
over long periods of time.

0.1.1 For example

Suppose that an equity has expected return of E(R) = 15% each year with standard
deviation of σ = 30%. Assume that there are two equally possible outcomes each year,
E(R) ± σ. i.e 45% and -15%.
Clearly AM = (45 − 15)/2 = 15% and
Y 
GM = (1 + Ri )1/2 − 1 × 100 = ([(1.45)(0.85)]1/2 − 1) × 100 = 11%

So compounded value for | 1 is year 1 : 1.45 or 0.85

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 year 2: 1.45 − 0.45 × 1.45 = 2.10 or 0.85 − 0.15 × 0.85 = 0.72
While median value (Geometric mean) is given by (1.11)2 = 1.23. (1.11*0.11+0.11)
For two years probability is 0.25 for each 45% and -15% returns, So median value has
p=50%. However, expected value of all possible returns is, E(R) = (0.25 × 2.10) + (0.50 ×
1.23) + (0.25 × √0.72) = 1.32
Note that, 1.32 = 1.15. This means that the expected value of the terminal wealth
is obtained by compounding up the arithmetic mean,not the geometric mean.

Risk and Return of Portfolio

The expected return on a portfolio is simply the weighted average of the expected returns
on the assets comprising the portfolio.
So in general, we can write expected return on multiple security portfolio as,
n
X
E(Rp ) = wi E(Ri )
i=1

Where, wi is the proportion of portfolio invested in ith security and E(Ri ) is the expected
return on it.

Return of Portfolio comprising Two Securities

Suppose that, a portfolio comprises two stocks with the expected returns E(R1 ) and E(R2 )
respectively, then effective expected return on the portfolio can be given by

E(Rp ) = w1 E(R1 ) + w2 E(R2 )

Where w1 is proportion of first stock in the portfolio and w1 is proportion of first stock
in the portfolio i.e. w2 = 1 − w1 .

For example
Let Stock A and B has expected returns of 13% and 16% respectively. Portfolio consists
of 45% Stock A and 55% of Stock B. Then expected return on the portfolio is given by,

E(Rp ) = 0.45 × 13 + 0.55 × 16 = 14.65%

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Measurement of Market Risk
As a risk on individual stock can diversifiable by changing the its proportion in portfolio.
So its important to see market risk though the portfolio is well-diversified.
The market risk of a security reflects its sensitivity to the market movements. Gen-
erally, every security has different sensitivity to market movements. The sensitivity of a
security to market movements is called as β.
By definition β for a Market Portfolio is 1. So if a particular security has β > 1 is
more sensitive to the fluctuations in market portfolio while β < 1 is less sensitive. Clearly,
β = 1 is insensitive to the market fluctuations.

Standard deviation (σ) and Risk (β)

Figure shows, the returns on the market portfolio RM over a time, along with returns on
two other securities, a risky security,whose return is denoted by Rr and a conservative
security,whose return is denoted byRc .It is evident that Rr is more volatile than RM where
as Rc is less volatile than RM . So β for risky stock is higher than conservative.

Calculation of β
β of the security can be calculated using simple linear regression as follows,

Rjt = αj + βj RM t + ej

Where,
Rjt is return of the j th security over a period t.
αj is intercept term (It’s value at which regression line intercepts y axis). βj is
regression coefficient (slope of the regression line).
RM t is a market returns over a period t, and
ej is random error.

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 Note that, covariance between return Rjt on j th security and return RM t on market
portfolio can be given by,
n
X
cov(Rj , RM ) = (Rjt − R̄j )(RM t − R̄M )/(n − 1)
t=1

= ρjM σj σM

Where, ρjM is correlation coefficient between Rjt and RM t . σj and σM are SD in j th

security and market portfolio.
β reflects the slope of regression, so we can write as the ratio of covariance between
return Rjt and RM t to variance of return on market RM t . i.e
cov(Rj , RM ) ρjM σj
βj = 2
=
σM σM

For example
Consider a security and Market has returns for the period of 5 years on YOY basis as in
Table 1. Find βj and αj .

Year Return on security (%) Return on Portfolio (%)

1 10 12
2 7 4
3 -3 -5
4 6 8
5 11 10

Table 1:

Solution
Covariance between Rjt and RM t is given by,
n
X
cov(Rj , RM ) = (Rjt − R̄j )(RM t − R̄M )/(n − 1)
t=1

Here,
10 + 7 − 3 + 6 + 11 31
R̄j = = = 6.2%
5 5
12 + 4 − 5 + 8 + 10 29
R̄M = = = 5.8%
5 5

Now, Rj1 − R̄j = 3.8, Rj2 − R̄j = 0.8, Rj3 − R̄j = −9.2, Rj4 − R̄j = −0.2 and
Rj5 − R̄j = 4.8 and,
RM 1 − R̄M = 6.2, RM 2 − R̄M = −1.8, RM 3 − R̄M = −10.8, RM 4 − R̄M = 2.2 and
RM 5 − R̄M = 4.2.

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 So covariance is
23.56 − 1.44 + 99.36 − 0.44 + 20.16
cov(Rj , RM ) = = 35.3%
4
and variance in market portfolio,
5
X
2
σM = (RM t − R̄M )2 /(n − 1)
t=1
38.44 + 3.24 + 116.64 + 4.84 + 17.64
= = 45.2
4
So SD is σM = 6.72%.
Hence, βj is,
cov(Rj , RM ) 35.3
βj = 2
= = 0.78
σM 45.2
and αj is,
αj = R̄j − βj R̄M = 6.2 − 0.78 × 5.8 = 1.68%

Time value of Money

Money has time value. A rupee today is more valuable than a rupee a year hence. Reason
for that is an inflation. So a rupee today represents a greater real purchasing power than a
rupee a year hence. Suppose that, a capital is employed productively to generate positive
returns. So an investment of one rupee today would grow to (1 + r) a year hence if r is
rate of return.
Most financial problems involve cash flows occurring at different points of time. There-
fore, these cash flows have to be brought to the same point of time for purposes of com-
parison and aggregation.

Future value of amount

The process of investing money as well as reinvesting the interest earned thereon is called
compounding. The future value or compounded value of an investment after n years when
the interest rate is r% is given by

F Vn = P V (1 + r)n

Where, F Vn is future value over the period n, P V present value and r is interest rate.
Also, the term (1 + r)n is called as future value interest factor.

Fro example
Suppose you deposit | 1,000 today in a bank which pays 10 percent interest compounded
annually.Flow much will the deposit grow to after 8 years and12years?

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Solution
The future value 8 years hence will be,

F Vn = P V (1 + r)n = 1, 000(1 + 0.10)8 = 1, 000 × 2.144 = | 2144

The future value 12 years hence will be,

F Vn = P V (1 + r)n = 1, 000(1 + 0.10)1 2 = 1, 000 × 3.138 = | 3138

Note that, if we compute the future value with simple interest rate, then we can write,

F Vn = P V (1 + n · r)

Doubling period
As the name suggests, doubling period is the period for which future value of the invest-
ment is doubled.
Indeed the doubling period can be obtained by the formula stated above in which n is
unknown while all other terms are known. However, it involves logarithmic calculations.
So there are two thumb rules that can approximately provide the value of doubling period.
• Rule of 72: doubling period, n = 72/r where r is the rate of interest.
• Rule of 69: doubling period, n = 0.35 + 69/r where r is the rate of interest.

For example
Suppose that an investment of | 10000 has been done with the rate of interest of 8% and
12%. So the actual doubling period and by the rule of 72 and 69 are as follows.

rate of interest actual n n by rule of 72 n by rule of 69

8% 9.0065 9 8.9750
12% 6.1163 6 6.10

Growth rate
It is possible to compute the growth rate of an investment if the terminal value of an
investment over the specified period is known. It can be given by,

F Vn =P V (1 + g)n
p
⇒ g = n F Vn /P V − 1

Where, F Vn is future value over the period n, P V present value and r is interest rate.
Also, the term (1 + r)n is called as future value interest factor.

For example
Suppose that an investment of |150000 is grown to |350000 over the period of 6 years.
What is the annual growth rate?

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Solution
p p
g = n F Vn /P V − 1 = 6 350000/150000 − 1 = 1.1517 − 1 = 0.1517

So growth rate is 15.17 %.

Present Value of future amount

F Vn
PV =
(1 + r)n
Where, r is discount rate and the term 1/(1 + r)n is called as discounting factor.

For example
What is the present value of | 15000 receivable after 6 years if the discount rate is 8%?

Solution
F Vn 15000
PV = = = | 9452.5
(1 + r)n (1 + 0.08)6

Present value of cash flow stream

In financial analysis cash flow streams are not even. For example, the cash flow stream
associated with a capital investment project or the dividend stream associated with an
equity share are usually uneven. In such situation, the present value of the cash flow over
the specified for known discount rate can be given by,
n
A1 A2 An X At
PV = + + ··· + =
(1 + r) (1 + r)2 (1 + r)n t=1
(1 + r)t

For example
Suppose that following table shows the cash flow after every year. What is the present
value if the discounting rate is 6%?

year 1 2 3 4 5
cash flow | 1000 1200 1250 1400 1550

Solution
1000 1200 1250 1400 1500
PV = + + + + = | 5328.1
(1 + 0.06) (1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4 (1 + 0.06)5

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Future value of annuity
An annuity is a stream of constant cash flows (payments or receipts) occurring at regular
intervals of time.For instance the premium payments of a life insurance.
Ordinary or deferred annuity: When the cash flows occur at the end of each pe-
riod,the annuity is called an ordinary annuity or a deferred annuity.
Annuity due: When the cash flows occur at the beginning of each period, the
annuity is called an annuity due.
In general future value of an annuity over the specified period can be given by,
n−1
X
F V An = A(1 + r)t
t=0

To simplify it, multiply both the sides by 1 + r and subtract the given expression of P V
from it, we get,
n
X n−1
X
F V An (1 + r) − F V An = A(1 + r)t − A(1 + r)t
t=1 t=0

⇒ F V An · r =A(1 + r)n − A
(1 + r)n − 1
 
⇒ F V An =A
r
Where, F V An is the future value of annuity over the period n and r is the interest rate.
(1 + r)n − 1
The term is the future value interest factor (F V IF Ar,n ).
r

For example
Suppose that you are planning to deposit | 50000 every year for 25 years in provident
fund with assured interest rate of 8%. How much will be the funds accumulated in you
account at the end of period?

Solution
Interest factor for 25 years with the rate 8% is,

(1 + r)n − 1 (1.08)2 5 − 1
F V IF A8,25 = = = 73.11
r 0.08
So the future value of annuity is,

F V A2 5 = A · F V IF A8,25 = 50000 × 73.11 = | 3655500

For example
Suppose that you want to buy a car of | 500000 after 3 years. How much should you save
every month if the rate of returns on savings is 6% every year?

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Solution
Interest factor for 3years with the rate 6% is,

(1 + r)n − 1 (1.06)3 − 1
F V IF A8,25 = = = 3.1836
r 0.06
So the future value of annuity is,

F V A3 =A · F V IF A6,3
⇒ 500000 =A × 3.1836
⇒ A = | 157050

So monthly saving should be 157050/12 = | 13088

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