Risk & Return Relationship

CHAPTER 1 INTRODUCTION
Any rational investor, before investing his or her invertible wealth in the stock, analyses the risk associated with particular stock. The actual return he receives from a stock may vary from his expected return and the risk is expressed in terms of variability of return. The down side risk may be caused by several factors, either common to all stock or specific to a particular stock. Investor in general would like to analyze the risk factors and a thorough knowledge of the risk help him to plan his portfolio in such a manner so as to minimize the risk associated with the investment. RISK & RETURN: Investment decisions are influenced by various motives. Some people invest in a business to acquire control & enjoy the prestige associated with in. some people invest in expensive yachts & famous villas to display their wealth. Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment. For earning returns investors have to almost invariably bear some risk. In general, risk & return go hand in hand.

Sometimes the best investments are the ones you don't make. This is a maxim which best explains the complexity of making investments. There are many investment avenues available for investors today.

Different people have different motives for investing. For most investors their interest in investment is an expectation of some positive rate of return. But investors cannot overlook the fact that risk is inherent in any investment. Risk varies with the nature of return commitment. Generally, investment in equity is
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considered to be more risky than investment in debentures & bonds. A closer look at risk reveals that some are uncontrollable (systematic risk) and some are controllable (unsystematic risk).

RETURN: Return is the primary motivating force that drives investment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realized (historical) returns is necessary to assess how well the investment manager has done.

In addition, historical returns are often used as an important input in estimating future prospective returns.

Components of Return: The return of an investment consists of two components.

Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow, such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginning price of the investment.

Capital Return: The second component of return is reflected in the price change called the capital return- it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return
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predominates. Thus, the total return for any security (or for that matter any asset) is defined as:

Total Return = Current return + Capital return

The current return can be zero or positive, whereas the capital return can be negative, zero, or positive.

Risk & Return Relationship

CHAPTER 2 CONCEPT OF RETURN AND RISK

Investment return and risk are fundamental to understanding market behavior. The entire scenario of security analysis is built on two concepts; Risk & return. The risk and return constitute the framework for taking investment decision. There are different motives for investment. The most prominent among all is to earn a return on investment. Risk can be viewed as it is related either to a single asset or to a portfolioa collection, or group, of assets but first it is important to introduce some fundamental ideas about risk, return and the risk preferences. RISK Risk is the chance of financial loss. Assets having greater chances of loss are viewed as more risky than those with lesser chances of loss. More formally, the term risk is used interchangeably with uncertainty to refer to the variety of returns associated with a given asset. For example: A Rs 5,000 government bond that guarantees its holder 5 interest after 30days has no risk because there is no variability associated with the return. But on the other hand a 5,000 investment in a firms common stock, which over the same 30days earn anywhere from 0 to 10,is very risky because of a high variability of it return. RETURN The return is the basic motivating force and the principal reward in the investment process. The return may be defined in terms of (i) realized return, i.e., the return which has been earned, and (ii) expected return, i.e., the return which the investor anticipates to earn over some future investment period. The expected return is a predicted or estimated return and may or may not occur. The realized returns in
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the past allow an investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return can be measured as the total gain or loss to the holder over a given period of time and may be defined as a percentage return on the initial amount invested. Some risk directly affects both financial managers and shareholders.

Risk & Return Relationship

CHAPTER 3 RISK PREFERENCES

Feelings about risk differ among managers and firms. Thus it is important to specify a generally acceptable level of risk. The three basic risk preferences behaviors ---risk-averse, risk-indifferent and risk-seeking as depicted graphically. For the risk-indifferent manager, the required return does not change as risk goes from x1 to x2. In essence, no change in return would be required for the increase in risk. Clearly this attitude is nonsensical in almost any business context. For the risk-averse manager, the required return increases for an increase in risk. Because they shy away from risk, These managers require higher expected returns to compensate them for taking greater risk For the risk-seeking manger, the required return decreases for an increase in risk. Theoretically, because they enjoy risk, these managers are willing to give up some return to take more risk. However, such behavior would not be likely to benefit the firm. More mangers are risk averse for a given increase in risk,

they require an increase in return, and they generally tend to be conservative

Risk & Return Relationship

rather than aggressive when accepting risk for their firm. Accordingly, a risk averse financial manager requiring higher returns for greater risk.

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CHAPTER 4 CLASSIFICATION OF RISK

Systematic Risk: It refers to that portion of variability in return which is caused by the factors affecting all the firms. It refers to fluctuation in return due to general factors in the market such as money supply, inflation, economic recessions, interest rate policy of the government, political factors, credit policy, tax reforms, etc. these are the factors which affect almost all firms. The effect of these factors is to cause the prices of all securities to move together. This part of risk arises because every security has a built in tendency to move in line with fluctuations in the market. No investor can avoid or eliminate this risk, whatever precautions or diversification may be resorted to. The systematic risk is also called the non-diversifiable risk or general risk. Types of Systematic Risk: 1. Market Risk: market prices of investments, particularly equity shares may fluctuate widely within a short span of time even though the earnings of the company are not changing. The reasons for this change in prices may be varied. Due to one factor or the other, investors attitude may change towards equities resulting in the change in market price. Change in market price causes the return from investment to very. This is known as market risk. The market risk refers to variability in return due to change in market price of investment. Market risk appears because of reaction of investors to different events. There are different social, economic, political and firm specific events which affect the market price of equity shares. Market psychology is another factor affecting market prices. In bull phases, market prices of all shares tend to increase while in bear phases, the prices tend to decline. In such situations, the market prices are pushed beyond far out of line with the fundamental value.
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2. Interest-rate Risk: interest rates on risk free securities and general interest rate level are related to each other. If the risk free rate of interest rises or falls, the rate of interest on the other bond securities also rises or falls. The interest rate risk refers to the variability in return caused by the change in level of interest rates. Such interest rate risk usually appears through the change in market price of fixed income securities, i.e., bonds and debentures. Security (bond and debentures) prices have an inverse relationship with the level of interest rates. When the interest rate rises, the prices of existing securities fall and vice-versa. 3. Purchasing power or Inflation Risk: The inflation risk refers to the uncertainty of purchasing power of cash flows to be received out of investment. It shows the impact of inflation or deflation on the investment. The inflation risk is related to interest rate risk because as inflation increases, the interest rates also tend to increase. The reason being that the investor wants an additional premium for inflation risk (resulting from decrease in purchasing power). Thus, there is an increase in interest rate. Investment involves a postponement in present consumption. If an investor makes an investment, he forgoes the opportunity to buy some goods or services during the investment period. If, during this period, the prices of goods and services go up, the investor losses in terms of purchasing power. The inflation risk arises because of uncertainty of purchasing power of the amount to be received from investment in future.

Unsystematic Risk: The unsystematic risk represents the fluctuation in return from an investment due to factors which are specific to the particular firm and not the market as a whole. These factors are largely independent of the factors affecting market in general. Since these factors are unique to a particular firm, these must be examined separately for each firm and for each industry. These
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factors may also be called firm-specific as these affect one firm without affecting the other firms. For example, a fluctuation in price of crude oil will affect the fortune of petroleum companies but not the textile manufacturing companies. As the unsystematic risk results from random events that tend to be unique to an industry or a firm, this risk is random in nature. Unsystematic risk is also called specific risk or diversifiable risk.

Types of Unsystematic Risk: 1. Business Risk: Business risk refers to the variability in incomes of the firms and expected dividend there from, resulting from the operating condition in which the firms have to operate. For example, if the earning or dividends from a company are expected to increase say, by 6%, however, the actual increase is 10% or 12 %. The variation in actual earnings than the expected earnings refers to business risk. Some industries have higher business risk than others. So, the securities of higher business risk firms are more risky than the securities of other firms which have lesser business risk.

2. Financial Risk: It refers to the degree of leverage or degree of debt financing used by a firm in the capital structure. Higher the degree of debt financing, the greater is the degree of financial risk. The presence of interest payment brings more variability in the earning available for equity shares. This is also known as financial leverage. A firm having lesser or no risk financing has lesser or no financial risk.

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3. Regulation Risk: Some investment can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Municipal bonds, for example pay interest that is exempt from local, state and federal taxation. As a result of that special tax exemption, municipal can price bonds to yield a lower interest rate since the net after-tax yield may still make them attractive to investors. The risk of a regulatory change that could adversely affect the stature of an investment is a real danger. In 1987, tax laws changes dramatically lessened the attractiveness of many existing limited partnership that relied upon special tax considerations as part of their total return. Prices for many limited partnership tumbled when investors were left with different securities, in effect, than what they originally bargained for. To make matter worse, there was not an extensive secondary market for these liquid securities and many investors found themselves unable to sell those securities at anything but fire sale prices if at all. 4. Reinvestment Risk: It is important to understand that YTM is a promised yield, because investors can earn the indicated yield only if the bond is held to maturity and the coupons are reinvested at the calculated YTM (yield to maturity). Obviously, no trading can be done for a particular bond if the YTM is too earned. The investor simply buys and holds. Reinvestment risk the YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to computed YTM at the bond, thereby earning interest over interest over the life of the bond at the computed YTM rate .in effect; this calculation assumes that the reinvestment rate is the yield to maturity.

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If the investor spends the coupons, or reinvest them at a rate different from the assumed reinvestment rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised yield. This gives rise to reinvestment rate risk. This interest-on-interest concept significantly affects the potential dollar return. The exact impact is a function of coupon and time of maturity, with reinvestment becoming more important as either coupon or time to maturity, or both, rises specifically. 1. Holding everything else constant, the longer maturity of a bond, the greater the reinvestment risks. 2. Holding everything else constant, the higher the coupon rate, the greater the dependence of the total dollar returns from the bond on the reinvestment of the coupon payments. 3. In fact, for long-term bonds the interest-on-interest component of the total realized yield may account for more than three-fourths of the bonds total dollar return. 5. International Risk: International risk can include both country risk and exchange rate risk. a) Exchange Rate Risk: All investors who invest internationally in todays increasingly global investment arena face the prospect of uncertainty in the returns after they convert the foreign
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gain back to their own currency. Unlike the past when most U.S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. Currency risk affects international mutual funds, global mutual funds, closed-end single country funds, American depository receipts, foreign stocks and foreign bonds. For example, a U.S. investor who buys a German stock denominated in marks must ultimately convert the returns from this stock back to dollars. If the exchange rate has moved against the investor, losses from these exchange rate movements can partially or totally negate the original return earned. b) Country Risk: Country risk, also referred to as political risk, is an important risk for investors today. With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a countrys economy needs to be considered. The United States has the lowest country risk, and other countries can be judged on a relative basis using the United States as a benchmark. Example of countries that needed careful monitoring in the 1990s because of country risk included the former Soviet Union and Yugoslavia, China, Hong Kong and South Africa. c) Liquidity Risk: Liquidity risk is the risk associated with particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more uncertainty about the
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time element and the price concession, the greater the liquidity risks. A treasury bill has little or no liquidity risk, whereas a small OTC stock may have substantial liquidity risk.

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CHAPTER 5 RISK AVOIDANCE

Investment planning is almost impossible without a thorough understanding of risk. There is a risk/return trade off. That is, the greater risk is accepted, and the greater must be the potential return as reward for committing ones fund to an uncertain outcome. Generally, as the level of risk rises, the rate of return should also rise, and vice versa. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses to completely avoid the activity the risk is associated with. In the investment world, avoidance of some risk is deemed to be possible through the act of investing in risk-free investments. Stock market risk can be completely avoided by one choosing to have no exposure to it by not investing in equity securities. a) Risk transfer: Another way to handle risk is to transfer the risk. Risk transfer in investing can be done where one may choose to purchase a municipal bond that is insured. One may purchase a put option on a stock, which allows the person to put to or sell to someone his or her stock at a set price, regardless of how much lower the stock may drop. There are many examples of risk transfer in the area of investing.

b) The Risk Adverse Investor: Do investors dislike risk? In economics in general, and investments in particular, the standard assumption is that investors are rational. Rational investors prefer certainty to uncertainty. A risk-averse investor is one who will not assume risk simply for its own sake and will not incur any given level of risk unless there is an expectation of adequate compensation for having done so. In fact, investors cannot reasonably expect to earn larger returns without assuming larger risks. Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are
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willing to incur. Some investors choose to incur high level of risk with expectation of high levels of return. Other investors are unwilling to assume much risk, and they should not expect to earn large returns.

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CHAPTER 6 MEANING OF RETURN

Return is one of the primary objectives of investment, which acts as a driving force for investment. Risk is inevitable and it is positively correlated with expected return. Return to an investor is of two types, current yield and capital appreciation. Current yield is the return, which is got in the form of individuals/interest whereas capital appreciation is the return, which we get after liquidation of shares. Return = Current yield (dividend/interest) + Capital Appreciation/ Capital Gain TYPES OF RETURN 1. HISTORICAL RETURN: Return calculated are on past data which has already occurred is called as historical return. Historical return is a post-mortem analysis of investment, which lacks insight for future. Historical return is less risky and more accurate compared to expected return since it does not involve prediction of interest or dividend or closing price. Historical return is also called as post return or actual return. Return = Cash payment + Closing price Beginning price 2. EXPECTED RETURN Return calculated based or future estimates and calculation is called as expected return. Expected Return = Expected Dividend + Capital Gain (expected) Beginning price

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Risk & Return Relationship

CHAPTER 7 MEASUREMENT OF RISK

Measurement of Risk Measurement of risk is associated with single asset from two ways: Risk Assessment / behavioral measure of risk Statistical measure of risk 1. Risk Assessment: Behavioral view of risk and risk assessment includes: Sensitivity analysis Probability Distribution

2. Sensitivity Analysis: The sensitivity analysis takes into account a number of possible outcomes/returns estimates while evaluating an asset/assessing risk. In order to have a sense of variability among return estimates, a possible approach is to estimate the worst (pessimistic), the expected (most likely) and the best (optimistic) return associated with the asset. Alternatively, the level of outcomes may be related to the state of the economy, namely, recession, normal and boom conditions. The difference between the optimistic and the pessimistic outcomes is the range which, according to the sensitivity analysis, is the basic measure of risk. The greater the range, the more variability (risk), the asset is said to have.

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1. Probability Distribution: The risk associated with an asset can be assessed more accurately by the use of probability 9distribution) than sensitivity analysis. The probability of an event represents the likelihood/percentage chance of its occurrence. For instance, if the expectation is that a given outcome (return) will occur seven out of ten times, it can be said to have a seventy percent (0.70) chance of happening; if it is certain to happen, the probability of happening is 100 per cent. An outcome which has a probability of zero will never occur. n = number of outcomes considered Based on the probabilities assigned (probability distribution of) to the rate of return, the expected value of the return can be computed. The expected rate is the weighted average of all possible returns multiplied by their respective probabilities. Thus the expected return, K is ni=1 KiPri Where K = return for the ith possible outcome

Pri = probability associated with its return

1. Statistical measure of Risk: A statistical measure of risk includes three things: a) Variance b) Standard Deviation

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c) Coefficient of Variation

a) Variance: Variance is computed by summing squared deviations and dividing by the number of observations minus one (n - 1). Squaring the differences ensures that both positive and negative deviations are given equal consideration. The sum of the squared differences is then divided by the number of observations minus one ( n 1).

b) Standard Deviation: Risk refers to the dispersion of returns around an expected value. The most common statistical measure of risk of an asset is the standard deviation from the mean/expected value of return. It represents the square root of the average squared deviations of the individual returns from the expected returns. Symbolically, the standard deviation is (ni=1 (Ki - K-) ^2 * Pri)

The greater the standard deviation of returns, the greater would be the variability/dispersion of returns and the greater the risk of the asset/investment. However, standard deviation is an absolute measure of dispersion and does not consider the variability of returns in relation to the expected value. It may be misleading in comparing the risk surrounding alternative assets if they differ in size of expected returns.

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c) Coefficients of Variation: Coefficient of Variation is a relative measure of risk per unit of expected return. It converts the standard deviation of expected values into relative values to enable comparison of risks associated with assets having different expected values. The coefficient of variation (CV) is computed by dividing the standard deviation for an asset by its expected value. Symbolically, CV = k / KThe larger the CV, the larger the relative risk of the asset. As a rule, the use of coefficient of variation for comparing asset risk is the best since it considers the relative size (expected value) of assets. Risk of a Portfolio A portfolio means a combination of two or more securities and an investment portfolio is any collection or combination of financial assets. If we assume all investors are rational and therefore risk averse that investor will always choose to invest in portfolios rather than in single assets this extends the analysis of risk and returns associated with single investment to portfolio investments. In real world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light of their impact on the risk and return of the portfolio of assets. The financial managers goal is to create an efficient portfolio, one that maximizes return for a given level of risk or minimizes risk for a given level of return. We therefore need a way to measure the return and the standard deviation of a portfolio of assets. Once we can do that, we will look at the statistical concept of correlation, which underlines the process of diversification that is used to develop an efficient portfolio.
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Correlation: Correlation is a statistical measure of the relationship between any two series of numbers. The numbers may represent data of any kind, from returns to test scores. If two series move in the same direction, they are positively correlated. If the series move in opposite directions, they are negatively correlated

The Correlation between M and series N The degree of correlation is measured by the correlation coefficient, which ranges from +1 for perfectly correlated series to -1 for perfectly negative correlated series. These two extremes are depicted for series M and N in above figure .The perfectly positive correlated series move exactly together; the perfectly negatively correlated series move in exactly opposite direction.

Diversification: The concept of correlation is essential to developing an efficient portfolio. To reduce overall risk, it is best to diversify by combining or adding to the portfolio
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assets that have a negative correlation. Combing negatively correlated assets can reduce the overall variability of returns. Some assets are uncorrelated that is, there is no interaction between their returns. Combining uncorrelated assets can reduce risk, not as effectively as combining negatively correlated assets but more effectively than combining positively correlated assets. The correlation coefficient for uncorrelated assets is close to zero and acts as the midpoint between perfect positive and perfect negative correlation. The creation of a portfolio that combines two assets with perfectly positive correlated return result in overall portfolio risk that at minimum equals that of the least risky asset and at maximum equals that of the most risky asset. However, o portfolio combining two assets with less than perfectly positive correlation can reduce total risk to a level below that of either of that component, which in certain situations may be zero. For example, assume that you manufacture machine tools. The business is very cyclical, with high sales when the economy is expanding and low sales during a recession. If you acquired another machine tool company with sales positively correlated with those of your firm, the combined sales would still be cyclical and risk would remain the same. Alternatively, however you could acquire a sewing machine manufacturer, whose sales are countercyclical. It typically has low sales during economic expansion and high sales during recession. Combination with the sewing machine manufacturer, which has negatively correlated sales, should reduce risk.

International Diversification: The ultimate example of portfolio diversification involves including foreign assets in a portfolio. The inclusion of assets from countries with business cycles that are
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not highly correlated with the U.S. business cycle reduces the portfolios responsiveness to market movements and to foreign currency fluctuations. Returns from International Diversification: Over long periods, returns from internationally diversified portfolios tend to be superior to those of purely domestic ones. This is particularly so if the US economy is performing restively poor and the dollar are depreciating in value against more foreign currencies. At such times, the dollar returns to US investors on a portfolio of foreign assets can be very attractive. However over any single short to intermediate period, international diversification can yield subpar returns, particularly during periods when the dollar is appreciating in value relative to other currencies. When the U.S currency gains in value, the dollar value of foreign currency denominated portfolio of assets declines. Even this portfolio yields a satisfactory return in local currency; the return to US investors will be reduced when translated into dollars. Subpar local currency portfolio returns, coupled with appreciating dollar, can yield truly dismal dollar returns to US investors. Overall, though the logic of international portfolio diversification assumes that these fluctuations in currency value and relative performance will average out over long periods. Compared to similar, purely domestic portfolios an internationally diversified portfolio will tend to yield a comparable return at a lower level of risk.

Risk of International Diversification: U.S. investors should also be aware of the potential dangers of international investing. In addition to the risk induced by currency fluctuations, several other financial risks are unique to international investing. Most important is political
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risk, which rises from the possibility that a host government will take actions harmful to foreign investors or that political turmoil in a country will endanger investment there. Political risks are particularly acute in developing countries, where unstable or ideologically motivated governments may attempt to block return of profits by foreign investors or even seize their assets in the host country. An example of political risk was the heightened concern during 2003-2004 that operation enduring freedom would oil production facilities in Iraq and cause a worldwide oil shortage and higher gas prices. This concern was indeed validated by the rapid rise in fuel prices that began early in 2004 and continued throughout the year. Even where governments do not impose exchange controls of seize assets, international investors may suffer if a shortage of hard currency prevents payment of dividends or interest to foreigners. When governments are forced to allocate scare foreign exchange, they rarely give top priority to the interest of foreign investors. Instead, hard currency reserves are typically used to pay for necessary imports such as food, medicines and industrial materials and to pay interest on the government debts. Because most of the debts of developing countries are held by banks rather than individuals, foreign investors are often badly harmed when a country experiences political or economic problems.

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CHAPTER 8 CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (RF) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (rm-rf).

Beta Beta tells us how much the securitys rate of return changes when the return on the market portfolio or measure of the volatility (tending to fluctuate sharply and regularly), or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of
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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. Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

Example As an example, let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that XYZ Company has a beta of 1.7. What rate of return should you get from this company in order to be rewarded for the risk you are taking? Remember investing in XYZ company (beta =1.7) is more risky than investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%, right?

ra = rf + ( rm - rf) ra = 5% + 1.7 (12.5% - 5%) ra = 5% + 1.7 (7.5%) ra = 5% + 12.75% ra= 17.75%

So, if you invest in XYZ Company, you should get at least 17.75% return from your investment. If you don't think that XYZ Company will produce those kinds of returns for you, then you would probably consider investing in a different stock

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Security Market Line The Security Market Line can be thought of as the graphical representation of the Capital Asset Pricing Model. It illustrates the concept that it is possible to obtain any combination of risk and expected return along the slope of the graph by

investing some portion of your investment in the market portfolio and borrowing the rest.

The Security Market Line is useful for determining whether an investment in an asset offers a good expected return for the risk taken. By providing the Beta of the asset, the Risk free rate and the Market Risk Premium, we will be able to plot the asset on the Security Market Line graph. If the Expected return versus Beta of the asset is plotted above the Security Market Line, the asset can be thought of as being able to provide a greater return for the inherent risk. An asset with a point below the Security Market Line can be thought of as getting less return for the amount of risk taken.

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ASSUMPTIONS OF CAPM All investors: 1. Aim to maximize economic utilities. 2. Are rational and risk-averse. 3. Are broadly diversified across a range of investments. 4. Are price takers, i.e., they cannot influence prices. 5. Can lend and borrow unlimited amounts under the risk free rate of interest. 6. Trade without transaction or taxation costs. 7. Deal with securities that are all highly divisible into small parcels. 8. Assume all information is available at the same time to all investors

FLAWS IN CAPM
1. If you go to a casino, you basically pay for risk. It's possible that the folks on

Wall Street sometimes have the same mindset as well. Now remember that CAPM assumes that given "X%" expected return investors will prefer lower risk (in other words lower variance) to higher risk. And the opposite would be true as well - given a certain level of risk investors would prefer higher returns to lower ones. OK, but maybe the Wall Street people get a kick out of "gambling" their investment. Not saying it's been proven to be the case, just saying it could be. CAPM doesn't allow for investors who will accept lower returns for higher risk.

2. CAPM assumes that asset returns are jointly normally distributed random

variables. But often returns are not normally distributed. So large swings, swings as big as 3 to 6 standard deviations from the mean, occur in the market more frequently than you would expect in a normal distribution.
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Risk & Return Relationship 3. CAPM assumes that the variance of returns adequately measures risk . This

might be true if returns were distributed normally. However other risk measurements are probably better for showing investors' preferences. Coherent risk measures come to mind.

4. With CAPM you assume that all investors have equal access to information

and they all agree about the risk and expected return of the assets. This idea, by the way is called "homogeneous expectations assumption".

5. CAPM kind of skips over taxes and transaction costs. Some of the more

complex versions of CAPM try to take this into consideration.

6. CAPM assumes that all assets can be divided infinitely and that those small

assets can be held and transacted.

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CHAPTER 9 CONCLUSION
Diversification reduces risk, more the diversification, less is the risk associated. Past returns does not promise future returns. Risk Persists even after diversification. Analyses of individual securities bring out the performance of risk & return of the securities

In India most of the industries require huge amount of investments. Funds are raised mostly through the issue of share. An investor is satisfied from the reasonable return from investment in shares. Besides the investors are motivated to buy the shares from the stock market either for speculation or investments. Speculation involves higher risks to get return on the other hand investment involves no such risks and returns will be fair.

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CHAPTER 10 REFERENCES/BIBLIOGRAPHY
Book Reference Investment Analysis & Portfolio Management --- Prasanna Chandra Security analysis and portfolio management --- Punithavathy pandian

Websites: www.google.com www.economictimes.com www.rediff.com

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