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The objective in decision making is not to eliminate or avoid risk-- often it may be
neither feasible nor necessary to do so -- but to properly assess it and determine whether
it is worth bearing. Once the risk characterising future cash flows is properly measured,
an appropriate risk-adjusted discount rate should be applied to convert future cash flows
into their present values.
To estimate the risk-adjusted discount rate−a task that we have glossed over so
far−you should be able to measure and price financial risk. While the meaning of risk and
return is grasped by almost every person, as a manager you need an explicit and
quantitative understanding of these concepts and, more importantly, the nature of
relationship between them. This chapter presents a framework that will help you in doing
this. It is organised into five sections as follows:
The rate of return on an asset for a given period (usually a period of one year) is defined
as follows:
Annual income + Ending price – Beginning price
Rate of return =
Beginning price
The rate of return of 19 per cent in our example may be broken down as follows:
When you invest in a stock you know that its return can take various possible values.
For example, it may be -5 percent, or 15 percent, or 35 percent. Further, the likelihood of
these possible returns can vary.
1
The probability of an event represents the likelihood of its occurrence. When you define the
probability of rate of return (or for that matter any other variable) remember that:
• The probability outcomes must be mutually exclusive and collectively exhaustive.
• The probability assigned to an outcome may vary between 0 and 1.
• The sum of the probabilities assigned to various possible outcomes is 1.
Based on the probability distribution of the rate of return, you can compute two key parameters, the
expected rate of return and the standard deviation of rate of return.
Exhibit 11.1
Probability Distribution of the Rate of Return on Bharat Foods Stock and Oriental
Shipping Stock
Economy Occurrence
Boom 0.30 40
Normal 0.50 10
Recession 0.20 -20
n
E(R) = Σ pi Ri
i=1
where E(R) is the expected rate of return, Ri is the return for the i th possible outcome, pi
is the probability associated with Ri , and σ is the standard deviation of return.
E (R) and σ for the equity stock of Oriental Shipping are calculated in Exhibit 11.2.
Exhibit 11.2
Expected Return and Standard Deviation
i. State of the
Economy pi Ri piRi Ri - E(R) (Ri - E(R))2 pi (Ri - E (R))2
By combining risky securities in a portfolio, you can reduce risk. Consider the example
given in Exhibit 11.3. Suppose there are two firms, Company A and Company B,
operating in a Caribbean island , where tourism is the main industry. Company A makes
and sells suntan lotion. It does well in sunny years but poorly in rainy years. The return
on its stock will vary from 30% to -10%, depending on weather conditions, as shown in
Exhibit 11.3.
Company B makes and sells disposable umbrellas. It does well during rainy years but
poorly in sunny years. The return on its stock varies between 30 percent and -10 percent
depending on weather conditions, as shown in Exhibit 11.3.
If you buy the stock of only Company A or Company B, you are exposed to a lot of
risk. However, if you split your funds equally across the stocks of A and B, you can enjoy
a stable return of 10 percent as shown in the last column of Exhibit 11.3.
Exhibit 11.3
Risk Reduction through Diversification
Weather Return on Return on Return on
Conditions Stock A, RA Stock B, RB Portfolio, RP
In this example, the returns on stocks A and B are perfectly negatively correlated. So, by
appropriate diversification, it is possible to eliminate risk completely. In the real world, however,
returns from most stocks tend to move together and hence it is not possible to eliminate risk
completely. However, as long as returns on stocks do not move in a perfect lockstep,
diversification reduces risk. In technical terms, diversification reduces risk if returns are not
perfectly positively correlated.
Risk
Unique
Risk
Market Risk
1 5 10 No. of
Securities
The unique risk of a security represents that portion of its total risk which
stems from firm-specific factors like the development of a new product, a labour
strike, or the emergence of a new competitor. Events of this nature primarily
affect the specific firm and not all firms in general. Hence, the unique risk of a
stock can be washed away by combining it with other stocks. In a diversified
portfolio, unique risks of different stocks tend to cancel each other−a favourable