Page 72 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 2: Risk and Return

any one of the measures of dispersion such as co-efficient of range, variance, standard deviation Notes
etc.
The risk involved in investment depends on various factors such as:

1. The length of the maturity period – longer maturity periods impart greater risk to
investments.
2. The credit-worthiness of the issuer of securities – the ability of the borrower to make
periodical interest payments and pay back the principal amount will impart safety to the
investment and this reduces risk.

3. The nature of the instrument or security also determines the risk. Generally, government
securities and fixed deposits with banks tend to be riskless or least risky; corporate debt
instruments like debentures tend to be riskier than government bonds and ownership
instruments like equity shares tend to be the riskiest. The relative ranking of instruments
by risk is once again connected to the safety of the investment.
4. Equity shares are considered to be the most risky investment on account of the variability
of the rates of returns and also because the residual risk of bankruptcy has to be borne by
the equity holders.
5. The liquidity of an investment also determines the risk involved in that investment.
Liquidity of an asset refers to its quick saleability without a loss or with a minimum of
loss.
6. In addition to the aforesaid factors, there are also various others such as the economic,
industry and firm specific factors that affect the risk an investment.
Another major factor determining the investment decision is the rate of return expected by the
investor. The rate of return expected by the investor consists of the yield and capital appreciation.
Before we look at the methods of computing the rate of return from an investment, it is necessary
to understand the concept of the return on investment. We have noted earlier that an investment
is a postponed consumption. Postponement of consumption is synonymous with the concept of
'time preference for money'. Other things remaining the same, individuals prefer current
consumption to future consumption. Therefore, in order to induce individuals to postpone
current consumption they have to be paid certain compensation, which is the time preference
for consumption. The compensation paid should be a positive real rate of return. The real rate of
return is generally equal to the rate of return expected by an investor from a risk-free capital
asset assuming a world without inflation. However, in real life, inflation is a common feature of
a capitalist economy. If the investor is not compensated for the effects of inflation, the real rate
of return may turn out to be either zero or negative. Therefore, the investors, generally, add
expected inflation rate to the real rate of return to arrive at the nominal rate of return.

Example: Assume that the present value of an investment is 100; the investor expects
a real time rate of 3% per annum and the expected inflation rate is 3% per annum. If the investor
were to receive only the real time rate, he would get back 103 at the end of one year. The real
rate of return received by the investor would be equal to zero because the rime preference rate
of 3% per annum is matched by the inflation of 3% per annum. If the actual inflation rate is
greater than 3% per annum, the investor would suffer negative returns.
Thus, nominal rate of return on a risk-free asset is equal to the time preference real rate plus
expected inflation rate.
If the investment is in capital assets other than government obligations, such assets would be
associated with a degree of risk that is idiosyncratic to the investment. For an individual to

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