Module 2:

Concept of Return and risks

Ms. Swati Abhang
Contents
• Measurement of Historical Returns and Expected Returns of a
Single Security and a Two-security Portfolio
• Measurement of Historical Risk and Expected Risk of a Single
Security and a Two-security Portfolio
• Time Value of Money
• Future Value of a Lump Sum
• Ordinary Annuity and Annuity Due, Ordinary Annuity and Annuity
Due Present Value of a Lump Sum,
• Continuous Compounding and Continuous Discounting
What Is a Return?
• A return, also known as a financial return, in its simplest terms, is
the money made or lost on an investment over some period of time.
• A return can be expressed nominally as the change in dollar value of
an investment over time.
• A return can also be expressed as a percentage derived from the ratio
of profit to investment.
• Returns can also be presented as net results (after fees, taxes,
and inflation) or gross returns that do not account for anything but
the price change. It even includes a 401(k) investment.
Key takeaways
• A return is the change in price of an asset, investment, or project over
time, which may be represented in terms of price change or percentage
change.
• A positive return represents a profit while a negative return marks a loss.
• Returns are often annualized for comparison purposes, while a holding
period return calculates the gain or loss during the entire period an
investment was held.
• The real return accounts for the effects of inflation and other external
factors, while the nominal return is only interested in price change.
• The total return for stocks includes price change as well as dividend and
interest payments.
• Several return ratios exist for use in fundamental analysis.
Historical return
• The historical return of a financial asset, such as a bond, stock, security,
index, or fund, is its past rate of return and performance.
• The historical data is commonly used in financial analysis to project future
returns or determine what variables may impact future returns and the extent
to which the variables may influence returns.
• Concerning standard deviations, historical returns can be used to predict
future data points.
• The historical returns of a financial asset are usually recorded from the
beginning of a year (i.e., January 1st) to the end of the year (i.e., December
31st) to determine the annual return of a particular year.
• A compilation of past annual returns is needed to depict historical returns
over many years.
• By obtaining the historical returns data, analysts and investors can compute
the average historical returns of a financial asset.
Calculating Historical Returns
• The difference between the most recent price and the past price needs to be
computed and then divided by the past price multiplied by 100 to get the
result as a percentage.
• The calculation can be done iteratively to cater for longer time periods – e.g.,
5 years or more.
• Example : Consider following data
• December 31, 2016: 2,105
• December 31, 2017: 2,540

Historical Return(s) = [(2,540 – 2,105) / 2,105] x 100 = 0.20665 x 100

Historical Return(s) = 20.7%

Average Historical return= ∑ historical returns/ no of years

Expected return
• Expected return is an important financial concept investors use when
determining where to invest their funds.
• Calculating the expected return of a specific investment or portfolio
allows you to anticipate the profit or loss on that investment based on
its historical performance.
• Expected return is the amount of profit or loss an investor can
anticipate from an investment.
• Expected return is calculated by multiplying potential outcomes by
the odds that they occur and totaling the result.
• Expected return is not guaranteed to be the final outcome.
 How to calculate the expected return
Expected return = (return A x probability A) + (return B x probability B).

• First, determine the probability of each return that might occur. To do this, refer
to the historical data on past returns. For example, you could consider evaluating
past asset performances.

• Next, determine the expected return for each possible return.

• Once you have determined the expected return and probability of success for each
return, multiply each expected return by its corresponding percentage (weight).

• Add each of the products together to find the weighted average expected return
for that investment.
 As an investor, you are considering three different investment options. You look at the performance of each
investment option over the past five years and find the following performance results:

Investment A 10% 25% -4% 6% 15%

Investment B 5% 12% 8% 3% 7%

Investment C 20% 7% 18% -10% 4%

Assuming the probability of each return scenario occurring again is equal, the probability of each return
occurring is 20%. You calculate the expected return of each investment as follows:

Investment A
(10 x .20) + (25 x .20) + (-4 x .20) + (6 x .20) + (15 x .20) Equals 10.4%
Expected Return

Investment B Expected
(5 x .20) + (12 x .20) + (8 x .20) + (3 x .20) + (7 x .20) Equals 7%
Return

Investment C Expected
(20 x .20) + (7 x .20) + (18 x .20) + (-10 x .20) + (4 x .20) Equals 7.8%
Return
What Is a Portfolio?
• A portfolio is a collection of financial investments like stocks, bonds,
commodities, cash, and cash equivalents, including closed-end
funds and exchange traded funds (ETFs).
• People generally believe that stocks, bonds, and cash comprise the
core of a portfolio.
• Though this is often the case, it does not need to be the rule.
• A portfolio may contain a wide range of assets including real estate,
art, and private investments.
Managing a Portfolio
• You may think of an investment portfolio as a pie that's been divided
into pieces of varying wedge-shaped sizes, each piece representing a
different asset class and/or type of investment.
• Investors aim to construct a well-diversified portfolio to achieve a risk-
return portfolio allocation that is appropriate for their level of risk
tolerance.
• Although stocks, bonds, and cash are generally viewed as a portfolio's
core building blocks, you may grow a portfolio with many different
types of assets—including real estate, gold stocks, various types of
bonds, paintings, and other art collectibles.
The sample portfolio allocation
• A full 50% is allocated to bonds,
which might contain high-grade
corporates and government
bonds,
including municipals (munis).
• The 20% stock allocation could
comprise blue-chip or large-cap
equities, and 30% of short-term
investments might include cash,
certificates of deposit (CDs), and
high-yield savings accounts.
Types of Portfolio
• The Aggressive Portfolio
• The Defensive Portfolio
• The Income Portfolio
• The Speculative Portfolio
• The Hybrid Portfolio
The Aggressive Portfolio
• An aggressive portfolio seeks outsized gains and accepts the outsized
risks that go with them.
• Stocks for this kind of portfolio typically have a high beta, or sensitivity
to the overall market.
• High beta stocks experience greater fluctuations in price than the overall
market.
• If a stock has a beta of 2.0, it will typically move twice as much as the
overall market in either direction.
• Aggressive investors seek out companies that are in the early stages of
their growth and have a unique value proposition.
• Most of them are not yet common household names.
• E.g. Mutual funds,
Beta : a measure of how an individual asset moves when the overall stock market
increases or decreases
The Defensive Portfolio
• Defensive stocks do not usually carry a high beta.
• They are relatively isolated from broad market movements.
• Unlike cyclical stocks, which are sensitive to the underlying economic
business cycle, defensive stocks do well in bad times as well as good times.
• No matter how rotten the economy is generally, companies that make
products that are essential to everyday life will survive.
• Examples :
• Cash or cash equivalents
• Bonds of most kinds, though not junk bonds
• Consumer staples,etc.
The Income Portfolio
• An income portfolio focuses on investments that make money from
dividends or other types of distributions to stakeholders.
• Some of the stocks in the income portfolio could also fit in the defensive
portfolio, but here they are selected primarily for their high yields.
• An income portfolio should generate positive cash flow.
• Real estate investment trusts (REITs) and master limited
partnerships (MLP) are examples of income-producing investments.
• These companies return much of their profits to shareholders in exchange
for favorable tax status.
• REITs, in particular, are a way to invest in real estate without the hassles of
owning real property.
• E.g. Certificates of deposit , Savings accounts, US savings bonds, Money
market accounts ,Corporate bonds ,Peer-to-peer loans (P2P),Preferred
stocks, Dividend-paying common stocks.
The Speculative Portfolio
• Among these choices, the speculative portfolio is closest to gambling.
• It entails taking more risk than any of the others discussed here.
• Speculative plays could include initial public offerings (IPOs) or stocks that
are rumored to be takeover targets.
• Technology or health care firms in the process of developing a single
breakthrough product would fall into this category.
• A young oil company about to release its initial production results would be
a speculative play.

• Financial advisors generally recommend that no more than 10% of a

person's assets be used to fund a speculative portfolio.
 The Hybrid Portfolio
• Building a hybrid portfolio requires venturing into other investments such
as bonds, commodities, real estate, and even art.
• There is a great deal of flexibility in the hybrid portfolio approach.
• Traditionally, this type of portfolio would include a core of blue-chip stocks
and some high-grade government or corporate bonds. REITs and MLPs
may also make up a portion of the assets.
• A hybrid portfolio would mix stocks and bonds in relatively fixed
proportions.
• This approach offers diversification across multiple asset classes.
• That in itself is beneficial because equities and fixed income securities have
historically tended to have a negative correlation with one another
Risk
• Risk refers to the possibility that the actual outcome of an investment
will differ from its expected outcome.
• In other words, risk is the possibility of loss or the probable outcome
of all the possible events.
• Most investors are concerned about the actual outcome being less than
the expected outcome.
• The degree of risk depends upon the features of assets, investment
instruments, mode of investment etc.
• The wider the range of possible outcomes, the greater the risk.
Types of Financial Risk
1. Market Risk
• The risk which is related to the marketplace in which the business activities
take place, is known as market risk.
• For example, if you are running a brick-and-mortar clothing store, then the
rise in customers' tendency to online shopping would be a market risk.
• In this situation, only those businesses can survive which can adapt to the
online selling system and serve the online crowd.
• On the other hand, the businesses who stuck to the offline business model will
bear losses.
• Every business sector faces the risk of being outpaced by competitors.
• The market conditions and customers' demands and preferences change
rapidly.
• So it is a must for a business to keep up with market trends and pricing
demands to grab the market and compete with other producers.
2. Foreign Exchange Risk
• Foreign exchange risk refers to the risk associated with any financial
instrument denominated in a foreign currency.
• For example, if an American company invests in India and the
domestic investment does well in rupee terms, the American company
may nevertheless lose money since the rupee's value has declined
against the US dollar.
• As a result, when the firm redeems its investment at maturity, it will
receive fewer US Dollars.
• The rupee has dropped dramatically in recent years due to the
pandemic.
• Because of which our country's forex risk as an investment destination
has skyrocketed.
3. Credit Risk
• Credit risk refers to the possibility of losing money because the
performance of a creditor is not as per the terms of the contract.
Such debts are categorized as bad debts.
• For example, if the goods are delivered to customers on 30-days
payment terms and the customer couldn't pay the invoice on time (or
in the future also), then the company will suffer a credit risk.
• This risk can also increase the possibility of a cash flow shortage.
• So, it is advisable to retain sufficient cash reserves to cover the
company's accounts payable.
4. Liquidity Risk
• Liquidity risk includes all those risks that arise when the organization tries to
sell assets or raise funds.
• This risk is also known as funding risk.
• If something is becoming a barrier in the path of raising funds fast, then it
will be called liquidity risk.
• For example, a seasonal business can suffer from a shortage of cash flow
during the off-season.
• So here the financial manager should figure out, does the company has
enough cash available to meet the potential liquidity risk? And how quickly
the company can dispose of old inventory or assets to regulate the cash flow
in the business?
• Interest rate and currency risk are both examples of liquidity risk.
• As a result, the financial manager must be aware of the impact of a rapid
shift in interest rates or exchange rates on the cash flow of the organization.
5. Operational Risk /6. Other Risks
5. Operational Risk
• All other risks that the business can face in its daily operations are
called operation risks.
• These risks include staff turnover, fraud, poor budgeting, theft,
unrealistic financial projections, lawsuits, and improper market plans.
• All these risks can affect the bottom line of the business if they are not
dealt with and handled carefully.
6. Other Risks
• Some other types of risks are legal risk, equity risk, reputational risk,
interest rate risk, reinvestment risk, country risk, inflationary risk,
political risk, valuation risk, model risk, IT risk, etc.
 Process of Financial Risk Management
• What are the sources of the
• Put a numerical value for
revenue of the business?
the identified risk
• Which customers are getting credit
• the regression method and
from the company and what are the
standard deviation method
credit terms for them?
are used by the analysts to
• Does the company have long-term
find out the exposure of the
debt or short-term debt?
company to various risk
• What change will occur if the
factors
interest will be increased?

• The financial manager decides how to deal with

the information that is collected after analyzing
the sources of risk.
• Can the organization run with the risk
exposure? Is it required to mitigate the risk or
hedge against it?
• Factors considered are : the goals of the
organization, business environment, its risk
appetite, and whether the cost of mitigation
justifies the decrease in risk.
Tools to Control Financial Risk
• A person, a corporation, or the government can use a variety of tools
to evaluate the amount of financial risk that may occur.
• Some of the most prevalent strategies for analyzing risks linked with
long-term investments or the stock market are presented below:
• Fundamental Analysis
In this method, the intrinsic value of the security is measured by evaluating
all aspects of the underlying business. It includes the assets and earnings of
the firm.
• Technical Analysis
In this method, the evaluation of securities by using statistics and checking
the historical returns, share prices, trade volumes, and other performance
data is done.
• Quantitative Analysis
In this method, the financial manager evaluates the historical performance of
the firm with the help of specific financial ratio calculations.
Time Value of Money (TVM)
Time Value of Money (TVM)
• The time value of money (TVM) is the concept that a sum of money is
worth more now than the same sum will be at a future date due to
its earnings potential in the interim.
• This is a core principle of finance.
• A sum of money in the hand has greater value than the same sum to be
paid in the future.
• The time value of money is also referred to as present discounted
value.
• Example, say you have the option of receiving $10,000 now or $10,000
two years from now. Despite the equal face value, $10,000 today has
more value and utility than it will two years from now due to the
opportunity costs associated with the delay.
Formula for Time Value of Money
• Depending on the exact situation, the formula for the time value of
money may change slightly.
• For example, in the case of annuity or perpetuity payments, the
generalized formula has additional or fewer factors.
• But in general, the most fundamental TVM formula takes into account
the following variables:
• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
• Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t)
 FV = PV x [ 1 + (i / n) ] (n x t)

Time Value of Money Examples

• Assume a sum of $10,000 is invested for one year at 10% interest
compounded annually.
• The future value of that money is:
FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
• The formula can also be rearranged to find the value of the future sum
in present day dollars.
• For example, the present day dollar amount compounded annually at
7% interest that would be worth $5,000 one year from today is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673
Future value of lump sum
• Lump Sum : a single complete sum of money

Example Future Value Calculations for a Lump Sum Investment:

You put $10,000 into an investment account earning 6.25% per year
compounded monthly. You want to know the value of your investment in 2
years or, the future value of your account.

Investment (pv) = $10,000

Interest Rate (R) = 6.25%
Number of Periods (years) (t) = 2
Compounding per Period (per year) (m) = 12
FV=$10,000(1+0.062512)12×2=$11,327.81
Annuity , annuity-due
• Each payment of an ordinary annuity refers to the payment at the end
of the period.
• The payment of an annuity-due refers to a payment period starting
beginning of the period.
Ordinary annuity
• An ordinary annuity is a series of regular payments made at the end of
each period, such as monthly or quarterly.
• An ordinary annuity is a series of equal payments made at the end of
consecutive periods over a fixed length of time.
• While the payments in an ordinary annuity can be made as frequently as
every week, in practice they are generally made monthly, quarterly, semi-
annually, or annually.
• In an annuity due, by contrast, payments are made at the beginning of
each period.
• Consistent quarterly stock dividends are one example of an ordinary
annuity; monthly rent is an example of an annuity due.
Ordinary annuity
• Examples of ordinary annuities are interest payments from bonds,
which are generally made semiannually, and quarterly dividends from a
stock that has maintained stable payout levels for years.
• The present value of an ordinary annuity is largely dependent on the
prevailing interest rate.
• Because of the time value of money, rising interest rates reduce the
present value of an ordinary annuity, while declining interest rates
increase its present value.
• This is because the value of the annuity is based on the return your
money could earn elsewhere.
• If you can get a higher interest rate somewhere else, the value of the
annuity in question goes down.
Present Value of an Ordinary Annuity
Example
• The present value formula for an ordinary annuity takes into account
three variables. They are as follows:
PMT = the period cash payment
r = the interest rate per period
n = the total number of periods
• Given these variables, the present value of an ordinary annuity is:
Present Value = PMT x ((1 - (1 + r) ^ -n ) / r)
• For example, if an ordinary annuity pays $50,000 per year for five years
and the interest rate is 7%, the present value would be:
Present Value = $50,000 x ((1 - (1 + 0.07) ^ -5) / 0.07) = $205,010
Present Value of an Annuity Due Example
• The formula for an annuity due is as follows:

Present Value of Annuity Due = PMT + PMT x ((1 - (1 + r) ^ -(n-1) / r)

• If the annuity in the above example was instead an annuity due, its
present value would be calculated as:

Present Value of Annuity Due = $50,000 + $50,000 x ((1 - (1 + 0.07) ^ -(5-1)

/ 0.07) = $219,360.
Future value of annuity
What Is Continuous Compounding?
• Continuous compounding is the mathematical limit that
compound interest can reach if it's calculated and reinvested into an
account's balance over a theoretically infinite number of periods.
• While this is not possible in practice, the concept of continuously
compounded interest is important in finance.
• It is an extreme case of compounding, as most interest is
compounded on a monthly, quarterly, or semiannual basis.
Formula and Calculation of Continuous
Compounding
• Instead of calculating interest on a finite number of periods, such as
yearly or monthly, continuous compounding calculates interest
assuming constant compounding over an infinite number of periods.
• The formula for compound interest over finite periods of time takes
into account four variables:
PV = the present value of the investment
i = the stated interest rate
n = the number of compounding periods
t = the time in years
• The formula for continuous compounding is derived from the formula
for the future value of an interest-bearing investment:
Future Value (FV) = PV x [1 + (i / n)](n x t)
Example of How to Use Continuous
Compounding
• As an example, assume a $10,000 investment earns 15% interest over
the next year.
• The following examples show the ending value of the investment when
the interest is compounded annually, semiannually, quarterly, monthly,
daily, and continuously.
• Annual Compounding: FV = $10,000 x (1 + (15% / 1)) (1 x 1) = $11,500
• Semi-Annual Compounding: FV = $10,000 x (1 + (15% / 2)) (2 x 1) = $11,556.25
• Quarterly Compounding: FV = $10,000 x (1 + (15% / 4)) (4 x 1) = $11,586.50
• Monthly Compounding: FV = $10,000 x (1 + (15% / 12)) (12 x 1) = $11,607.55
• Daily Compounding: FV = $10,000 x (1 + (15% / 365)) (365 x 1) = $11,617.98
• Continuous Compounding: FV = $10,000 x 2.7183 (15% x 1) = $11,618.34
Note: With daily compounding, the total interest earned is $1,617.98,
while with continuous compounding the total interest earned is $1,618.34, a marginal difference
Examples
• Tina invested $3000 in a bank that pays an annual interest rate of 7%
compounded continuously. What is the amount she can get after 5
years from the bank? Round your answer to the nearest integer.
• What should be the rate of interest for the amount of $5,300 to
become double in 8 years if the amount is compounding
continuously?
• Jim invested $5000 in a bank that pays an annual interest rate of 9%
compounded continuously. What is the amount he can get after 15
years from the bank?
• An amount of Rs. 2340.00 is deposited in a bank paying an annual
interest rate of 3.1%, compounded continuously. Find the balance
after 3 years.
Important Questions
1. What is expected return , explain with example?
2. Compare expected return and historical return.
3. Explain portfolio and discuss different types of portfolio.
4. List and explain different types of financial risks.
5. Illustrate process of Financial risk management , also list and explain
tools to control financial risk.
6. Discuss continuous compounding, explain with example.
7. How to find present value of ordinary annuity.
8. What is annuity and annuity due? What is significance of annuity?
9. Explain Time value of money.
Important Questions
1. Tina invested $3000 in a bank that pays an annual interest rate of
7% compounded continuously. What is the amount she can get after
5 years from the bank? Round your answer to the nearest integer.
2. What should be the rate of interest for the amount of $5,300 to
become double in 8 years if the amount is compounding
continuously?
3. Jim invested $5000 in a bank that pays an annual interest rate of
9% compounded continuously. What is the amount he can get after
15 years from the bank?
4. An amount of Rs. 2340.00 is deposited in a bank paying an annual
interest rate of 3.1%, compounded continuously. Find the balance
after 3 years.