Concept of Risk and Return (Including Capital Asset Pricing Model)
After investing money in a project a firm wants to get some outcomes from the project. The outcomes or the benefits that the investment generates are called returns. Wealth maximization approach is based on the concept of future value of expected cash flows from a prospective project.
So cash flows are nothing but the earnings generated by the project that we refer to as returns. Since fixture is uncertain, so returns are associated with some degree of uncertainty. In other words there will be some variability in generating cash flows, which we call as risk. In this article we discuss the concepts of risk and returns as well as the relationship between them.
CONCEPT OF RISK
A person making an investment expects to get some returns from the investment in the future. However, as future is uncertain, the future expected returns too are uncertain. It is the uncertainty associated with the returns from an investment that introduces a risk into a project. The expected return is the uncertain future return that a firm expects to get from its project. The realized return, on the contrary, is the certain return that a firm has actually earned.
Elements of Risk
Various components cause the variability in expected returns, which are known as elements of risk. There are broadly two groups of elements classified as systematic risk and unsystematic risk.
(i) Systematic Risk
Business organizations are part of society that is dynamic. Various changes occur in a society like economic, political and social systems that have influence on the performance of companies and thereby on their expected returns. These changes affect all organizations to varying degrees. Hence the impact of these changes is system-wide and the portion of total variability in returns caused by such across the board factors is referred to as systematic risk. These risks are further subdivided into interest rate risk, market risk, and purchasing power risk.
(ii) Unsystematic Risk
The returns of a company may vary due to certain factors that affect only that company. Examples of such factors are raw material scarcity, labour strike, management inefficiency, etc. When the variability in returns occurs due to such firm-specific factors it is known as unsystematic risk. This risk is unique or peculiar to a specific organization and affects it in addition to the systematic risk. These risks are subdivided into business risk and financial risk.
Measurement of Risk
Quantification of risk is known as measurement of risk.
Two approaches are followed in measurement of risk
(i) Mean-variance approach, and
(ii) Correlation or regression approach.
CONCEPT OF RETURN
Return can be defined as the actual income from a project as well as appreciation in the value of capital. Thus there are two components in return—the basic component or the periodic cash flows from the investment, either in the form of interest or dividends; and the change in the price of the asset, commonly called as the capital gain or loss.
The term yield is often used in connection to return, which refers to the income component in relation to some price for the asset. The total return of an asset for the holding period relates to all the cash flows received by an investor during any designated time period to the amount of money invested in the asset.
It is measured as
Total Return = Cash payments received + Price change in assets over the period /Purchase price of the asset. In connection with return we use two terms—realized return and expected or predicted return. Realized return is the return that was earned by the firm, so it is historic. Expected or predicted return is the return the firm anticipates to earn from an asset over some future period.
CAPITAL ASSET PRICING MODEL – (CAPM)
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm – Rf)
ERi = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
ERm = Expected return of market
(ERm – Rf) = Market risk premium
Assumptions of Capital Asset Pricing Model
- Investors are risk averse, i.e. they place funds in the less risky investments.
- All investors have the same expectations from the market and are well informed.
- No investor is big enough to influence the price of the securities.
- The market is perfect: There are no taxes, no transaction costs, securities are completely divisible, and the market is competitive.
- Investors can borrow and lend unlimited amounts at a risk-free rate (zero bonds).
Generally, the capital asset pricing model helps in the pricing of risky securities, such that the implications of risk and the amount of risk premium necessary for the compensation can be ascertained.