4.1 Concept of Risk 
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 co-efficient of range, variance, standard deviation etc
The risk involved in investment depends on various factors such as:
- The length of the maturity period – longer maturity periods impart greater risk to investments.
- The credit-worthiness 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.
- 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.
- 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.
- The liquidity of an investment also determines the risk involved in that investment. Liquidity of an asset refers to its quick sale ability without a loss or with a minimum of loss.
- 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.
4.2 Concept of Return
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 of return expected by an investor from a risk-free capital asset assuming a world without inflation. However, in real life, inflation is a common feature of a capitalist economy. If the investor is not compensated for the effects of inflation, the real rate of return may turn out to be either zero or negative. Therefore, the investors, generally, add expected inflation rate to the real rate of return to arrive at the nominal rate of return.
For example, assume that the present value of an investment is Rs. 100; the investor expects a real time rate of 3% per annum and the expected inflation rate is 3% per annum. If the investor were to receive only the real time rate, he would get back Rs. 103 at the end of one year. The real rate of return received by the investor would be equal to zero because the rime preference rate of 3% per annum is matched by the inflation of 3% per annum. If the actual inflation rate is greater than 3% per annum, the investor would suffer negative returns. Thus, nominal rate of return on a risk-free asset is equal to the time preference real rate plus expected inflation rate.
If the investment is in capital assets other than government obligations, such assets would be associated with a degree of risk that is idiosyncratic to the investment. For an individual to invest in such assets, an additional compensation, called the risk premium will have to be paid over and above the nominal rate of return.
4.3 Determinants of Rate of Return
There are three major determinants of the rate of return expected by the investor are:
- The time preference risk-free real rate
- The expected rate of inflation
- The risk associated with the investment, which is unique to the investment.
Hence, Required return = Risk-free real rate + Inflation premium + Risk premium
It was stated earlier that the rate of return from an investment consists of the yield and capital appreciation, if any. The difference between the sale price and the purchase price is the capital appreciation and the interest or dividend divided by the purchase price is the yield.
Accordingly,
Rate of Return (Rt)= It + (Pt-Pt-1)/ Pt-1
Where, Rt = Rate of return per time period ‘t’
It = Income for the period ‘t’
Pt = Price at the end of time period ‘t’
Pt-1 = Initial price, i.e., price at the beginning of the period ‘t’
In the above equation ‘t’ can be a day or a week or a month or a year or years and accordingly daily, weekly, monthly or annual rates of return could be computed for most capital assets. The above equation can be split in to two components i.e
Rate of Return (Rt)= It/Pt-1 + Pt-Pt-1/Pt-1
Where It/Pt-1 is called the current yield, and Pt-Pt-1/Pt-1 is called the capital gain yield
Or ROR = Current yield + Capital gain yield
4.4 Calculation of Return
Example 1-
The following information is given for a corporate bond. Price of the bond at the beginning of the year: Rs. 90, Price of the bond at the end of the year: Rs. 95.40, Interest received for the year: Rs. 13.50. Thus,
Rate of return= {13.50 + (95.40-90)}/90= 0.21= 21% per annum
The return of 21% consists of 15% current yield and 6% capital gain yield.
There is always a direct association between the rates of return and the asset prices. Finance 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.
Example 2-
Mr. Batra has purchased 100 shares of Rs. 10 each of Kinetic Ltd. in 2005 at Rs. 78 per share. The company has declared a dividend @ 40% for the year 2006-07. The market price of share as on 1-4-2006 was Rs. 104 and on 31-3-2007 was Rs. 128. Calculate the annual return on the investment for the year 2006-07. Dividend received for 2004-05 = Rs. 10 x 40/100 = Rs. 4
Calculation of annual rate of return on investment for the year 2006-07
R = {D1 + (P1-P0)}/ P0= {4+ (128-104)}/ 104= 0.269= 26.9%
