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Unit 2 of 4 · B.Com Sem 6

Unit 2: Risk & return analysis

Security Analysis & Portfolio Management notes · PTU syllabus (BCOP 611-18)

3 min read5 topics10 exam questions
On this page
  1. Unit summary
  2. Return and its measurement
  3. Meaning and types of risk
  4. Measurement of risk
  5. Risk–return relationship and trade-off
  6. Management of risk
  7. Key terms
  8. Quick revision
  9. Important questions

Unit summary

Return is the reward for investing; risk is the uncertainty of that reward. This unit covers the meaning and management of risk, analysis of risk and return, their relationship, types and measurement of risk, and the risk–return trade-off.

After this unit you can

  • Define return and risk and compute holding period and expected returns
  • Classify risk into systematic and unsystematic components
  • Measure risk using standard deviation, variance and beta
  • Explain the risk–return relationship and ways to manage risk

PTU syllabus topics

  • Meaning and management of risk
  • analysis of risk and return
  • relationship between risk and return
  • types and measurement of risk
  • the risk-return trade-off
ClassificationTypes of risk
Total risk

  • Systematic (market) risk

    Interest rate, inflation, market; cannot be diversified away

  • Unsystematic (specific) risk

    Business and financial risk of one company; reduced by diversification

1

Topic 1

Return and its measurement

Key formulasReturn measures

  • Holding period return

    (Dividend + (P1 − P0)) ÷ P0 × 100

  • Annualised return (CAGR)

    (Ending value ÷ Beginning value)^(1/n) − 1

  • Expected return

    E(R) = Σ pi × Ri

  • Real return

    (1 + nominal) ÷ (1 + inflation) − 1

Example

Bought a share at ₹200, received dividend ₹6, sold at ₹230 after a year. HPR = (6 + 30) ÷ 200 = 18%.

2

Topic 2

Meaning and types of risk

Risk is the possibility that the actual return differs from the expected return.

ClassificationTypes of risk
Total risk

  • Systematic (market, non-diversifiable)

    Interest rate risk, market risk, purchasing power (inflation) risk, exchange rate risk, political risk

  • Unsystematic (specific, diversifiable)

    Business risk, financial risk (leverage), management risk, credit/default risk, liquidity risk

  • Total risk = Systematic risk + Unsystematic risk.
  • Diversification across 15–20 well-chosen securities removes most unsystematic risk; systematic risk remains.
3

Topic 3

Measurement of risk

Key formulasRisk measures

  • Variance

    σ² = Σ pi (Ri − E(R))²

  • Standard deviation

    σ = √variance

  • Historical SD

    √[Σ (R − R̄)² ÷ (n − 1)]

  • Coefficient of variation

    σ ÷ E(R)

  • Beta

    β = Cov(Ri, Rm) ÷ Var(Rm) = ρim σi ÷ σm

  • Covariance

    Cov(A, B) = Σ pi (RA − E(RA))(RB − E(RB))

StateProbabilityReturn of X
Boom0.330%
Normal0.515%
Recession0.2−5%

Example

E(R) = 9 + 7.5 − 1 = 15.5%. Variance = 0.3 (14.5)² + 0.5 (−0.5)² + 0.2 (−20.5)² = 63.08 + 0.13 + 84.05 = 147.25; σ ≈ 12.1%.

  • Beta interpretation: β = 1 moves with the market; β > 1 aggressive (more volatile); β < 1 defensive; β estimated by regressing stock returns on market (Nifty) returns — characteristic line.
4

Topic 4

Risk–return relationship and trade-off

  • Positive relationship: investors demand higher expected return for higher risk.
  • Risk-free rate (T-bills) + risk premium = required return.
ProcessRisk–return spectrum (low to high)
  1. 1

    Treasury bills and bank deposits

  2. 2

    Government bonds

  3. 3

    Corporate bonds

  4. 4

    Large-cap equity

  5. 5

    Mid and small-cap equity

  6. 6

    Derivatives and venture investments

  • Risk attitudes: risk-averse (most investors), risk-neutral, risk-seeking.
  • Indifference curves of a risk-averse investor slope upward in the risk–return space.
5

Topic 5

Management of risk

  • Diversification across securities, sectors and asset classes.
  • Asset allocation according to risk profile and horizon.
  • Hedging with derivatives (futures, options), currency hedges.
  • Stop-loss orders and position limits.
  • Duration matching for bond portfolios (interest rate risk).
  • Credit analysis and ratings for default risk; insurance for real assets.
  • Rupee cost averaging (SIPs) to manage timing risk.

Exam tip

Only unsystematic risk can be diversified; systematic risk is managed through asset allocation and hedging.

Key terms

Holding period return
Total return over the holding period as a percentage of cost
Systematic risk
Market-wide risk that cannot be diversified
Unsystematic risk
Company-specific risk reducible by diversification
Standard deviation
Measure of dispersion of returns around the mean
Beta
Sensitivity of a security's return to market return

Quick revision

  • HPR, CAGR, expected return, real return.
  • Total risk = systematic + unsystematic.
  • Measures: variance, SD, CV, covariance, beta.
  • Higher risk → higher required return.
  • Manage risk: diversification, allocation, hedging, stop-loss.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.What is holding period return?
  2. Q2.Distinguish systematic and unsystematic risk.
  3. Q3.What is beta?
  4. Q4.What does a beta of 1.5 indicate?
  5. Q5.What is the coefficient of variation?
  6. Q6.State two methods of managing investment risk.

Long-answer questions

  1. Q1.Explain the types of risk faced by investors.
  2. Q2.Explain the measurement of risk and return with an illustration.
  3. Q3.Explain the relationship between risk and return.
  4. Q4.Discuss the methods of managing investment risk.

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