Risk is uncertainty and return is a reward for taking the risk. Return is the expected cash inflows from the investment. The risk is good. Chinese use symbols like danger and opportunity. When we talk about the quantification of uncertainty which is a risk.
Simple Return(R) = ((Dividend Paid + (Pt-(Ptmin1))/(Ptmin1)
We have to calculate the arithmetic mean and then we can calculate the rate of return. Sometimes Arithmetic returns are not working. We can calculate the CAGR using PV and FV formula.
So the formula is (V Final/V Initial) ^1/t — 1
If the return is not predictable then it is called a risk
Risk is not about bad or good. Risk is managing it. The way we manage risk will determine the return.
Systematic Risk: The risk that cannot be controlled or is uncontrollable is called Systematic Risk. This is called Beta Risk. A measure of how the asset covaries with the entire economy(cannot be diversified). e.g interest rate business cycle.
Non Systematic Risk: The risk that can be controlled is called Non-Systematic Risk. This is called alpha risk. loss of key contract.
The 2 forms of return are XPost is the Actual return and Ex-ante is the expected return. For the future, we will have an Ex ante return. So we want to predict the future. Earlier we have a Total return based on historical data.
XPost is returned based on past data. Based on XPort we look at the performance of the portfolio. X Ante can be determined from Xpost. The portfolio is a collection of assets. We want the portfolio to be diversified and have optimum return. Now we are going to calculate what would be expected return measuring with beta. Before that, we need to learn CAPM(Capital Asset Pricing Model)
So what we are measuring is the expected return, we use the CAPM.
We will have to start with assumptions. Investor rationale means they want to maximize or optimize return at a given level of risk. There are homogenous expectations which means at the same level of risk maximum return would be the same for any return.
Properties of CAPM, Standard deviation is to measure total risk. in equilibrium, every asset must be priced so that its risk-adjusted required rate of return falls exactly on the security market line. In equilibrium, every asset must be priced so that its risk-adjusted required rate of return is exactly on that security market line.
Total Risk = Systematic Risk + In Systematic Risk
CAPM quantifies the systematic risk of any asset as its Beta. The expected return of any risky asset depends linearly on its exposure to the market(systematic) risk, measured by beta. There are two types of graph Security market line and the CAMP line. There are 2 graphs, CAPM line graph takes Standard Deviation as the independent variable.
Assets with higher beta require a higher risk-adjusted rate of return.
How to calculate the Expected Return(Ke)
Rf+(Rm-Rf)*beta
Rf is the risk-free return, and Rm: Return from the market which is a minimum return. Rf is the existing risk-free rate.
Rf is the 10-year government bond(Rf).
Rm-Rf is the difference between the minimum return and the market. this is always expected to be positive.
Beta is the covariance X, Y divided by SD. If we have an expected return line then beta is the slope. Beta measures the degree of comovement of the market and the stock.
Beta is calculated as [COV(Ri, Rm)/Var(Rm)] OR Covirance/Variance.
If the market is on rising. we want the beta to be more which can be greater than 1.
if the market is in fall then the beta can be less than 1.
Can beta be negative? Is it mathematically possible?
What is the difference between security market time and capital market line?
For a particular stock how do we capture a risk, we have to quantify the risk, and what is meant for risk diversification. portfolio diversification can be done by Markovic’s theory. CAPM model is a cornerstone in finance. How to calculate return. We need to calculate the Geometric Mean, and Arithmetic Average. Price is varying constantly, but need to check at the end of the day what is the return once we calculate the return based on closing prices. we have to calculate the return based on the last 30 or 60 data points. How do we define risk? Risk is taken to optimize the return and both return and return go together.
In the stock market, we see variability, to quantify the variability we have to check the risk. FD is lower risk, Bonds are higher risk, and derivative is higher risk. Derivative depending on higher return will earn more returns as compared to the other instrument. Govt debt is a risk-free return as they can pay back at least the principal. Government power, there are 2 unique power, Government can increase the taxes, and if required then the govt can increase the income tax rate or service tax rate. During election time they can defer the increase of tax, and the govt can use the printing press where the currencies are printed and distributed to the stakeholders.
Bank deposits from public sector banks are close to risk-free. The govt may bail out the bank in case the bank face problem. There is also insurance to save banks from bankruptcy. In the US there is the treasury that issues Long term debt. The higher the risk and more the return. There is also a risk attitude, some people are interested in taking risks. some people are hesitant to take risks. Some people put the money in bank deposits. Portfolio diversification can be done in systematics and unsystematic risk.