1. Lecture 11
Return and Risk

2. Taking a Global Perspective
When investors buy or sell securities in othe countries, they also take exchange rate risk or currency risk
Fluctuation in currency value can be either a source of loss or profit
If the foregin currency strengthens, your returns will increase or vice versa

3. An Example
Suppose you purchased 100 shares of IBM at NYSE for $300 each. The dollar-rupee parity was 60 rupees a dollar at the that time. So your total investment in rupees was 100x$300 = $30000 x 60 =Rs.1800,000
At the end of the year, IBM share price was $310, giving you $10 profit per share, your profit is = 100 x 10 = $1000x60 = Rs.60000
But the dollar-rupee parity had jumped to 78 rupee a dollar, now your total investment is =100x310 = $31000 x 78 = Rs
And your profit is 2,418, ,0000 = Rs.618,000
Or in percentage = 618,000/1800,000 = .339 or 33.9%

4. Equation for calculating returns from foregin stocks
= [(P1/Po)x(C1/Co)] – 1
[(310/300)x(78/60)] – 1
[(1.03) x (1.3)] – 1
1.339 – 1
0.339 or 33.9%
P1 = Ending share price
Po = Beginning share price
C1 = Ending value of demestic currency
Co = Beginning value of domestic currency

5. Risk
Any investment involves some degree of uncertainty about future returns
Risk arises out of variability in returns
If an asset has no variability in returns, the assets is considered to be risk free like one year T-bills

6. Sources of Risk
A. Interest rate risk = variability in returns of securities resulting from changes in interest rates
Securities prices move inversely with interest rates [why]?

7. Interest rates and returns
1. Increase in interest rates increases the required rate of return
 RRR=  Rf+Risk premium which reduces the prices of the securities (intrinsic value)
2. It increases cost of borrowing and hence cost capital
3. It reduces money supply which lower demand for securities and resultantly prices fall-

8. Sources of Risk
Market risk : variability in returns due to fluctuations in aggregate market
Recession, wars etc
Inflation risk
when purchasing power declines.
Inflation also leads to hike in interest rates because lenders demand more to compensate themselves for loss in purchasing power
Business risk = the risk of doing business in a particular industry. Like OGDC has a unique risk of falling oil prices

9. Sources of Risk
Financial risk = It is associated with the use of debt financing by companies. The larger the financial leverage, the larger will be the variability in returns
Liquidity Risk = Whether a particular security can be sold quickly and without price concession in the secondary market.
Exchange risk = for international investors, a source of risk come from exchange rate fluctuation

10. Sources of Risk
Country Risk = For international investors, economic and political stability, law and order situation are important consideration in the investment decision

11. Measuring Risk
The most commonly used measure of risk for securities is standard deviation
SD measure the total risk of a security or a portfolio
It measure deviations of each observation from the arithmetic mean

12. Standard Deviation

13. Interpretation
The 5.89 SD means that the security return can fluctuate between +/-5.89 from the mean value of 16%
More specifically, the return can fluctuate between = or = 21.89
Your return could fall to as low as 10.11% or could rise to %

14. Realized Returns and risk from Investing
Class of assets
Average SD
S&P 500 Composite
9.21%
19.75%
S&P Industrial
9.66
21.57
S&P Utility
8.47
20.54
Small Cap Stock (S&P 600)
14.82
37.23
AAA 20-year Corp Bond
3.87
10.05
US 15-year Bond
3.25
10.22
T-Bills
1.569
4.65