Page 66 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 4: Risk and Return Analysis

The stage of the industry's life cycle, international tariffs and/or quotas on the products Notes
produced by an industry, product/industry related taxes (e.g. cigarettes), industry-wide
labour union problems, environmental restrictions, raw material availability, and similar
factors interact with and affect all the firms in an industry simultaneously. As a result of
these common features, the prices of the securities issued by the competing firms tend to
rise and fall together.
These risk factors do not make up an exhaustive list, but are merely representative of the major
classifications involved. All the uncertainties taken together make up the total risk, or the total
variability of return.

Self Assessment

Fill in the blanks:
1. ……………. is the risk for the market as a whole.

2. ……………risk is sometimes used synonymously with systematic risk.
3. Every investment involves ……………. that make future investments returns risk-prone.

4.2 Measurement of Risk

4.2.1 Volatility

Of all the ways to describe risk, the simplest and possibly most accurate is "the uncertainty of a
future outcome." The anticipated return for some future period is known as the expected return.
The actual return over some past period is known as the realized return. The simple fact that
dominates investing is that the realized return on an asset with any risk attached to it may be
different from what was expected. Volatility may be described as the range of movement
(or price fluctuation) from the expected level of return.

Example: The more a stock goes up and down in price, the more volatile that stock is.
Because wide price swings create more uncertainty of an eventual outcome, increased volatility
can be equated with increased risk. Being able to measure and determine the past volatility of a
security is important in that it provides some insight into the riskiness of that security as an
investment.

4.2.2 Standard Deviation

Investors and analysts should be at least somewhat familiar with the study of probability
distributions. Since the return an investor will earn from investing is not known, it must be
estimated. An investor may expect the TR (Total Return) on a particular security to be 10% for
the coming year, but in truth this is only a "point estimate."

4.2.3 Probability Distributions

To deal with the uncertainty of returns, investors need to think explicitly about a security's
distribution of probable TRs. In other words, investors need to keep in mind that, although they
may expect a security to return 10%, for example, this is only a one-point estimate of the entire
range of possibilities. Given that investors must deal with the uncertain future, a number of
possible returns can, and will, occur.

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