Page 71 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Self Assessment

State whether the following statements are true or false:
4. The more a stock goes up and down in price, the more volatile the stock is.
5. The beta factor is the measure of volatility of non-systematic risk of a security.

6. CAPM indicates the expected return of a particular security in view of its systematic/
market risk.

4.3 Risk and Expected Return

Risk and expected return are the two key determinants of an investment decision. Risk, in
simple terms, is associated with the variability of the rates of return from an investment; how
much do individual outcomes deviate from the expected value? Statistically, risk is measured
by any one of the measures of dispersion such as coefficient of range, variance, standard
deviation 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 creditworthiness 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.

Notes 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
Contd...

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