1. Investment Risk and Return

2. Learning Goals Know the concept of risk and return and their relationship How to measure risk and return What is Capital Asset Pricing Model (CAPM)

3. The Concept of Return Returns are the rewards from investing received as current income and increased value. The level of profit from an investment. Component of return: Periodic payments, such as dividend or interest which is called current income. Appreciation value, the gain from selling an investment for more than the purchase price which is called capital gain. Total Return is the sum of the current income and capital gain (or loss) earned on an investment over specified period of time.

4. Measuring Return Historical Performance. Past data often provide a meaningful basis for future expectation. Expected Return. It’s the future that matters when we make investment decisions. Therefore, expected return is a vital measure of performance. Level of return: Internal characteristics; include type of investment vehicle, the quality of management, how the investment financed, and the customer base of the issuer. External forces such as war, price control and political events may also affect the level of return.

5. Calculating Return The Time Value of Money as long as an opportunity exists to earn interest, the value of money is affected by the point when the money is received E.g: Imagine at the age of 25 you begin making annual cash deposits of RM1,000 into a savings account that pays 5% annual interest. After 40 years, at the age of 65, you will make deposits totaling RM40,000 (40 years x RM1,000 per year).

6. Simple Interest is where interest is paid only on the initial deposit for the amount of time it is held. E.g.: If you held a RM100 initial deposit in an account paying 6% interest for 1½ years, you would earn RM9 in interest. Compound Interest is interest paid not only on the initial deposit but also on any interest accumulated from one period to the next. Future value is the amount to which a current deposit will grow over a period of time. FV n = PV x (1 + r) n or FV n = PV (FVIF i,n ) E.g: RM1,000 was deposited in the savings account that earns 8% interest compounded annually. What is your account balance at the end of 5 years? Future Value of an Annuity; An annuity is a stream of equal cash flows that occur at equal intervals over time. FV n = PV x [(1 + r) n - 1] / r or FV n = PV (FVIFA i,n ) E.g: Depositing RM1,000 per year at the end of each of the next 2 years.

7. Present value calculated the value today of a sum to be received at some future date. PV n = FV x 1 n or PV n = FV (PVIF i,n ) 1 + r E.g: How much would have to be deposited today into the account paying 8% interest in order to received RM1,000 2 years from now? Present Value of an Annuity is an equal periodic return PV n = FV x [1 – 1 n / r or PV n = FV (PVIFA i,n ) 1 + r E.g: How much would have to be deposited today into the account paying 8% interest in order to received RM1,000per year for 2 years?

8. Holding Period Return (HPR) refers to total return of a security i.e. the rate of return over a given investment period. HPR=Cash Payment Received + Price change Purchase price HPR can be used to compare returns received from investment vehicle either stock or bond which give the greater profit at the same period of time.

9. Real return is inflation-adjusted returns E.g: If inflation is 2% and nominal returns are 5%, then real returns are 3% (5% -2%) 1 + nominal rate=(1 + real rate) x (1 + inflation rate) 1 + 0.05=(1 + real rate) x (1 + 0.02) Rearranging terms: Real rate = 1.05 - 1= 0.0294 = 2.94% 1.02 Required rate of returns is the rate of return an investor must earn on an investment to be fully compensated for its risk. Required Return = [ Real rate + Expected ] + Risk Premium on investment of return inflation for investment premium = Risk free rate (R F ) + Risk Premium for investment (RP j )

10. Risk and Risk Premium Risk is the possibility that we won’t achieve our expectations or the chance that actual investment returns will differ from those expected. Positive relationship – high risk; high return - low risk; low return The relationship between risk and return is called risk- return tradeoff.

11. Sources of Risk Business risk refers to the risk of doing business in a particular industry or environment. Financial risk refers to the degree of uncertainty of payment attributable to the mix of debt and equity used to finance a business. Purchasing Power Risk refers to the chance that changing price levels (inflation or deflation) will adversely affect investment returns. Interest rate risk is the chance that changes in interest rates will adversely affect a security’s value.

12. Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price. Market risk is the risk that investment returns will decline because of market factors such as political event, economic, and social events as well as changes in investors’ tastes and preferences. Exchange rate or currency risk is the variability of returns caused by currency fluctuations

13. Investor’s Level of Risk Risk Averse – describes an investor who requires greater return in exchange for greater risk. Risk Indifferent – describes an investor who does not require a change in return as compensation for greater risk. Risk Seeking (Risk Taker) – describes an investor who will accept a lower return in exchange for greater risk.

15. Risk-Return Tradeoffs for Various Investment Vehicles Treasury bills Risk Risk-free rate, R F Expected Return Certificate of deposit Bond Preferred stock Mutual fund Convertible securities Common stock Option Futures A risk-return tradeoff exists such that for a higher risk one expects a higher return, and vice versa. Low risk and low return is government t-bill.

16. Measuring Risk Basic Risk Concept: A Single Asset Expected value of return for asset, E(Ri) is: E(R i )=  (R j x Pr j ) Where Rj = return for the jth outcome Prj = probability of occurrence of the jth outcome n = number of outcomes considered Standard deviation is indicator of risk asset (an absolute measure of risk) of that asset’s expected return, σ (Ri), which measures the dispersion around its expected value. This can be calculated using equation below: σ (Ri) = √  [R j - E(R i ) ] 2 x Pr j

17. Coefficient of Variation is a statistical measurement of relative dispersion of an asset return. It is useful in comparing the risk of assets with differing average or expected return. Formula for CV is: Coefficient of Variation = Standard Deviation Average or Expected Return CV= σ (Ri) E(R i ) It is often preferable to measure dispersion as an asset’s variance, Var(R j ) where it is defined in equation below: Var(R j )= σ 2 (Ri) =  [R j - E(R i ) ] 2 x Pr j

18. Diversifiable and Nondiversifiable Risk Diversifiable Risk Called as unique risk or unsystematic risk Controllable Factors - management capability, labor strikes, consumer preferences and competition from other firms E.g: business risk, financial risk and liquidity risk; labor strikes, lawsuits, and regulatory actions

19. Nondiversifiable Risk Called as systematic risk Uncontrollable Macroeconomic and political forces - war, inflation and changes in political events, changes in market interest rates, etc. E.g: market risk, interest-rate risk, inflation risk and purchasing power risks.

20. TOTAL RISK = UNSYSTEMATIC RISK + SYSTEMATIC RISK Unsystematic risk Systematic risk Risk σ (R i ) Diversification (No. of securities in portfolio) Effect of Diversification Total Risk 1510152025

21. Capital Asset Pricing Model (CAPM) Developed by Sharpe (1964), Lintner (1965) and Mossin (1966). Generated to predict risk and return characteristics of individual assets ß i = Cov (R i, R m ) Var R m Beta (β j ) = cov j,m s 2 m β j = The beta coefficient of security j cov j,m = covariance of the returns on security j with the return on the market s 2 m = variance

22. Beta Measures nondiversifiable or market risk Beta indicates how the price of a security responds to market forces. Beta = 1.00 – equal to market risk Beta > 1.00 - more risky than the market. Beta < 1.00 - less risky than the market. Higher the beta, the greater level of expected return.

23. Risk –free Rate (r f ) The interest rate that can be earned with certainty. The government securities (treasury bills) or bank can be considered as risk-free rate. Required Return = Risk-free rate + [Beta for x (Market - Risk-free) on Investment j investment j return rate E(R j ) = R F + [ß i x (R m – R F )

24. Risk Premium Risk faced by the investors depending on type of vehicle (stock, bond, etc.), financial condition of the company and etc. E.g: risk-free rate is 6% per year, and the expected index fund return is 14%, then the risk premium on stocks is 8% per year. Assume you are considering security Z with a beta of 1.25. The risk-free rate is 6% and the market return is 10%. E(R j )= R F +[ß i x (R m – R F ) =6 % + [1.25 x (10% - 6% )] =6% + 5% = 11%

25. If the beta were lower, say 1.00, the required return would be lower E(R j )= R F +[ß i x (R m – R F ) =6 % + [1.00 x (10% - 6% )] =6% + 4 % = 10%

26. Security Market Line (SML) For each level of nondiversifiable risk (beta), SML reflects the required return the investor should earn in the market place. 6 1.01.25 11 10 SML Required return (%) Risk (beta) SML depicts the tradeoff between risk and return. At beta of 0, the required return is the risk-free of 6%. At a beta of 1.0 the required return is market return of 10%. Given these data, the required return on an investment with a beta of 1.25 is 11%. 0