Finance Management

HSMC-ME701

Module 2
Concepts of Returns
and Risks
Measurement of Historical Returns and Expected Returns of a
Single Security and a Two-security Portfolio

Measurement of Historical Risk and Expected Risk of a

Single Security and a Two-security Portfolio.

Time Value of Money: Future Value of a Lump Sum,

Ordinary Annuity, and Annuity Due

Present Value of a Lump Sum, Ordinary Annuity, and

Annuity Due

Continuous Compounding and Continuous Discounting

 Risk and Return

❑ The two key determinants of share/security prices are expected risk and

expected return

❑ Return The (rate of) return on an asset/investment for a given period, say a

year, is the annual income received plus any change in market price,

usually expressed as a per cent of the opening market price. Symbolically,

the one-period actual (expected) return, R

 Risk and Return

❑ Return from the expected returns associated with a given asset/investment

is defined as risk.

❑ The greater the variability, the riskier the security (e.g. shares) is said to be.

❑ The more certain the return from an asset (e.g. T-bills), the less the

variability and, therefore, the less the risk

 Risk and Return

RETURN ON A SINGLE ASSET

If the price of a share on April 1 (current year) is Rs 25, the annual dividend

received at the end of the year is Re 1 and the year-end price on March 31 is

Rs 30. Calculate rate of return.

 Risk and Return

RETURN ON A SINGLE ASSET

India Cements is a large company with several thousand

shareholders. Suppose you bought 100 shares of the

company, at the beginning of the year, at a market price

of 225. The par value of each share is 10. Further, suppose the price of the

share at the end of the year turns out to be 267.50

 Risk and Return

Annual Rates of Return:

Dividend Capital Return

yield Gain %
Div/Pt-1 (Pt – Pt–1)
 Risk and Return
Annual Rates of Return:
 Risk and Return
RISK OF RATES OF RETURN:

❑ There are two measures of this dispersion:

1. variance
2. standard deviation.

❑ The most common statistical measure of risk of an asset is the standard deviation
from the mean/expected value of return. It represents the square root of the average
squared deviations of the individual returns from the expected returns.

❑ Standard deviation is the square root of variance.

 Risk and Return
RISK OF RATES OF RETURN:
 Risk and Return
RISK OF RATES OF RETURN:
 Risk and Return
RISK OF RATES OF RETURN:
 Risk and Return
Expected Return And Risk: Incorporating Probabilities In Estimate
 Risk and Return
Expected Return And Risk: Incorporating Probabilities In Estimate
 Risk and Return
Portfolio Expected Return

The expected rate of return on a portfolio is the weighted average of the expected
rates of return on assets comprising the portfolio.

Symbolically, the expected return for a n-asset portfolio is defined by Equation

Suppose the expected return on two assets, L (low-risk low-return) and H (high-risk
high-return), are 12 and 16 per cents respectively. If the corresponding weights are
0.65 and 0.35, the expected portfolio return is
 Risk and Return
Portfolio Risk (Two-Asset Portfolio)

The overall risk of the portfolio includes the interactive risk of an asset relative to the
others, measured by the covariance of returns. The covariance, in turn, depends on the
correlation between returns on assets in the portfolio.

Let us assume that standard deviations of assets L and H, of our are 16 and 20 per
cents respectively. If the coefficient of correlation between their returns is 0.6 and
the two assets are combined in the ratio of 3:1, the expected return of the portfolio is
determined as follows
 Risk and Return
Portfolio Risk (Two-Asset Portfolio)
 TIME VALUE OF MONEY
❑An important principle in finance is that the value of money is time dependent.
❑The value of a unit of money is different in different time periods.
❑The value of a sum of money received today is more than its value received after
some time.
❑Conversely, a sum of money received in future is less valuable than it is today.
❑The time value of money is also referred as time preference for money.
REASONS FOR TIME VALUE OF
MONEY
❑ Investment Opportunities: Money has the potential to grow over a period of time because it can be
invested somewhere. For example, if Rs. 1000 can be invested in a fixed deposit for one year at 7%
p.a., the money will grow to Rs, Rs. 1070 at the end of one year. Therefore, given the choice of Rs.
1000 now or the same amount in one year’s time, it is always preferable to take Rs. 1000 now.

❑ Inflation: Inflation is the fall in the purchasing power of money. It makes money cheaper and the
goods and services costlier. Suppose you can buy 1 kg of rice with Rs. 50 today. If the inflation rate is
10%, You need Rs. 55 to buy 1 kg of rice a year from now.
 REASONS FOR TIME VALUE OF
MONEY
❑Risk: Money received now is certain, whereas money tomorrow is less certain. This
’bird in the hand’ principle is extremely important in investment appraisals.

❑Personal consumption preference: Many people have a strong preference for

immediate rather than delayed consumption. For a hungry man, promise of a meals
next month means nothing.
 TECHNIQUES

Two methods to calculate the time value of money

❑Compounding Technique
❑Discounting Technique
 COMPOUNDING TECHNIQUE

❑In compounding technique, interest is added (compounded) to the initial deposit

(principal) and becomes part of the principal at the end of each compounding period.
❑Annual compounding, semi-annual compounding, quarterly compounding, monthly
compounding etc.
COMPOUNDING TECHNIQUE
FORMULA
A = P (1+i)n
In which
A = Amount at the end of the period
P= Principal at the beginning of the period
i = Rate of interest
N= number of years
COMPOUNDING TECHNIQUE
FORMULA
For semi-annual compounding, the formula is:
A = P (1+i/2)n x2
For quarterly compounding, the formula is:
A = P (1+i/4)n x4
Alternatively, for compounding more than once a year, the formula can be
expressed as:
A = P (1+i/m)n xm
Where m = number of times per year compounding is made.
Find the Compound Interest when principal = Rs 6000, rate = 10% per annum and
time = 2 years?

Find the compound interest on Rs. 2000 at the rate of 4 % per annum for 1.5 years.
When interest is compounded half-yearly?

What is the compound interest on 10000 for one year at the rate of 20% per annum, if
the interest is compounded quarterly?

Find the compound interest at the rate of 5% per annum for 2 years on that principal
which in 2 years at the rate of 5% per annum given Rs. 400 as simple interest.
Future Value of a Single Cash Flow
Future Value of a Single Cash Flow
Future Value of a Single Cash Flow

If you deposited 55,650 in a bank, which was paying a 15 per cent rate of interest on
a ten-year time deposit, how much would the deposit grow at the end of ten years?
Future Value of an Annuity

Annuity is a fixed amount (payment or receipt) each year for a specified number of
years.
Future Value of an Annuity

Annuity is a fixed amount (payment or receipt) each year for a specified number of
years.
Future Value of an Annuity

Annuity is a fixed amount (payment or receipt) each year for a specified number of
years.

Suppose a firm deposits 5,000 at the end of each year for four years at 6 per cent rate of interest. How
much would this annuity accumulate at the end of the fourth year?
Present Value of a Single Cash Flow

Annuity is a fixed amount (payment or receipt) each year for a specified number of years.

The term in parentheses is the discount factor or present value factor (PVF), and it is always less than
1.0

Find out the present value of 50,000 to be received after 15 years. The interest rate is 9 per cent.
Present Value of an Annuity
CONTINUOUS COMPOUNDING
Sometimes compounding may be done continuously. For example, banks may pay
interest continuously; they call it daily compounding. The continuous compounding
function takes the form of the following formula
1. Calculate the present value of ₹600 (a) received one year from now; (b) received at the
end of five years; (c) received at the end of fifteen years. Assume a 5 per cent time
preference rate.

2. Determine the present value of ₹ 700 each paid at the end of each of the next six years.
Assume an 8 per cent of interest

3. Exactly ten years from now Sri Chand will start receiving a pension of 3,000 a year. The
payment will continue for sixteen years. How much is the pension worth now, if Sri
Chand’s interest rate is 10 per cent?

4. Your father has promised to give you 100,000 in cash on your 25th birthday. Today is
your 16th birthday. He wants to know two things: (a) If he decides to make annual
payments into a fund after one year, how much will each have to be if the fund pays 8 per
cent? (b) If he decides to invest a lump sum in the account after one year