Page 74 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 2: Risk and Return

There is always a direct association between the rates of return and the asset prices. Finance Notes
theory stipulates that the price of any asset is equal to the sum of the discounted cash flows,
which the capital asset owner would receive. Accordingly, the current price of any capital asset
can be expected, symbolically, as:

n
E(I ) P n
t
P = t + n ...(3)
0 t=1 (1+ r) (1+ r)
Where, E (R ) = Expected income to be received in year 't'
t
P = Current price of the capital asset
0
P = Price of the asset on redemption or on liquidation
n
R = The rate of return investors expect given the risk inherent in that
capital asset.
Thus, 'r' is the rate or return, which the investors require in order to invest in a capital asset that
is used to discount the expected future cash flows from that capital asset.

Case Study Kinetic Ltd.

r. Amirican has purchased 100 shares of 10 each of Kinetic Ltd. in 2005 at 78
per share. The company has declared a dividend @ 40% for the year 2006-07.
MThe market price of share as on 1-4-2006 was 104 and on 31-3-2007 was 128.
What will be the annual return on the investment for the year 2006-07.

Dividend received for 2004 – 05 = 10 × 40/100 = 4
Solution: Calculation of annual rate of return on investment for the year 2006-07

d 1 (P 1 P ) 4 (128 104)
0
R = 0.2692 or 26.92%
P 0 104
2.3 Risk-Return Relationship

The most fundamental tenet of finance literature is that there is a trade-off between risk and
return. The risk-return relationship requires that the return on a security should be commensurate
with its riskiness. If the capital markets are operationally efficient, then all investment assets
should provide a rate or return that is consistent with the risks associated with them.
The risk and return are directly variable, i.e., an investment with higher risk should produce
higher return.

The risk/return trade-off could easily be called the "ability-to-sleep-at-night test." While some
people can handle the equivalent of financial skydiving without batting an eye, others are
terrified to climb the financial ladder without a secure harness. Deciding what amount of risk
you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the possibility that an investment's
actual return will be different than expected. Technically, this is measured in statistics by standard
deviation. Risk means you have the possibility of losing some, or even all, of your original
investment.

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