Risk & Return: Measuring, Comparing, and Managing Financial Risk

TAKEAWAYS:

• Risk-return tradeoff: Higher expected returns require higher risk; investors demand compensation for bearing risk.
• Risk types: Market risk (systematic), interest rate risk, business risk, financial risk, and liquidity risk affect investment decisions differently.
• Portfolio diversification: Spreading investments across assets reduces unsystematic risk without sacrificing expected returns.
• Beta (β): Measures an asset’s sensitivity to market movements; β=1 means it moves with the market, β>1 is riskier, β<1 is less risky.
• Capital Asset Pricing Model (CAPM): Links expected return to beta and the market risk premium: $E(R_i)=R_f+{\beta }_i(E(R_m)-R_f)$.
• Real-world tie: NEPSE stocks like Ncell or NMB Bank have higher betas (risk) than government bonds, justifying their higher expected returns.

1. Introduction to Risk and Return

Risk is the uncertainty about future returns, while return is the gain or loss from an investment. Investors demand higher returns for taking on more risk. This relationship is fundamental in finance and guides all investment decisions.

Key Concepts

• Expected Return ($E(R)$): The average return an investor anticipates over time.
• Risk: Measured by the variability or dispersion of returns (standard deviation or variance).
• Risk-Free Rate ($R_f$): The return on a risk-free asset (e.g., government bonds in Nepal, ~7-8% historically).
• Risk Premium: The extra return demanded for bearing risk.

Visual: Risk-Return Tradeoff

pie
    title Risk-Return Tradeoff
    "Low Risk (Bonds)" : 20
    "Moderate Risk (Stocks)" : 50
    "High Risk (Startups)" : 30

2. Types of Risk in Financial Markments

Not all risks are the same. Understanding their sources helps investors and firms manage exposure.

A. Market Risk (Systematic Risk)

• Definition: Risk inherent to the entire market (e.g., economic downturns, inflation).
• Example: If NEPSE crashes, all stocks fall regardless of company performance.
• Cannot be diversified away (affects all assets).
• Measured by: Beta (β) or market volatility indices.

B. Interest Rate Risk

• Definition: Risk from changes in interest rates affecting bond prices or loan costs.
• Example: If NTC raises interest rates, borrowers (e.g., Daraz) face higher financing costs.
• Affected assets: Fixed-income securities (bonds, loans).

C. Business Risk

• Definition: Risk from a company’s operations (e.g., competition, management, product failure).
• Example: A Kathmandu textile shop’s profits may drop if global cotton prices rise.
• Mitigated by: Diversification or hedging.

D. Financial Risk

• Definition: Risk from a company’s capital structure (debt vs. equity).
• Example: Highly leveraged firms (e.g., Ncell) face bankruptcy risk if interest rates rise.
• Measured by: Debt-to-equity ratio.

E. Liquidity Risk

• Definition: Risk of not being able to sell an asset quickly without losing value.
• Example: NEPSE-listed shares like NMB Bank trade daily, but rare stocks (e.g., unlisted startups) may have low liquidity.
• Affected by: Market depth and trading volume.

Comparison Table: Types of Risk

3. Measuring Risk: Standard Deviation and Beta

A. Standard Deviation (σ)

• Measures total risk (both systematic and unsystematic).
• Formula: $$\sigma =\sqrt{\frac{\sum (R_i-E(R){)}^2}{N}}$$ Where $R_i$ = actual return, $E(R)$ = expected return, $N$ = number of periods.
• Example: If a stock’s returns over 5 years are [10%, -5%, 15%, 8%, 12%], its standard deviation quantifies its volatility.

B. Beta (β)

• Measures systematic risk (market risk).
• Interpretation:
  • β = 1: Moves with the market (e.g., NMB Bank).
  • β > 1: More volatile than the market (e.g., Ncell).
  • β < 1: Less volatile (e.g., government bonds).
• CAPM Formula: $$E(R_i)=R_f+{\beta }_i(E(R_m)-R_f)$$ Where:
  • $E(R_i)$ = Expected return of asset $i$.
  • $R_f$ = Risk-free rate (e.g., 7% for Nepal).
  • $E(R_m)$ = Expected market return (e.g., NEPSE’s historical ~12%).

Visual: Beta and Risk

4. Portfolio Theory and Diversification

A. Diversification

• Goal: Reduce unsystematic risk by holding a mix of assets.
• Example: A portfolio with Ncell (high β), NMB Bank (β=1), and government bonds (low β) balances risk.

B. Efficient Frontier

• Concept: Portfolios that offer the highest expected return for a given level of risk.
• Visual:

• Key Insight: No need to hold inefficient portfolios (e.g., all stocks or all bonds).

C. Real-World Example: NEPSE Investor

An investor with Rs 1,00,000 might allocate:

• 40% to NMB Bank (β=0.9, stable).
• 30% to Ncell (β=1.5, growth).
• 30% to government bonds (β=0.2, safe). This reduces overall portfolio risk compared to holding only Ncell.

5. Risk and Return: Worked Example (Nepal Context)

Problem: Calculate the expected return of a stock with:

• β = 1.3
• Risk-free rate ($R_f$) = 7%
• Market expected return ($E(R_m)$) = 12%

Solution: Using CAPM: $$E(R_i)=7\%+1.3\times (12\%-7\%)=7\%+1.3\times 5\%=7\%+6.5\%=13.5\%$$ Interpretation: The stock’s expected return is 13.5%, justified by its higher risk (β=1.3).

Visual: CAPM in Action

6. Determinants of Market Interest Rates

Market interest rates are influenced by:

1. Real Risk-Free Rate: Base rate without inflation (~4% globally, ~3-4% in Nepal).
2. Inflation Premium: Compensation for inflation (e.g., 5% in Nepal).
3. Maturity Risk Premium: Longer-term bonds have higher risk (e.g., 5-year bonds > 1-year).
4. Default Risk Premium: Risk of borrower default (e.g., Ncell > government bonds).
5. Liquidity Premium: Illiquid assets demand higher returns.

Example Calculation

Given:

• Real risk-free rate = 4%
• Inflation premium = 8%
• Maturity risk premium (5-year) = 2%
• Default risk premium (for a corporate bond) = 3%

Nominal Interest Rate: $$4\%+8\%+2\%+3\%=17\%$$ This is the yield on a 5-year corporate bond in Nepal.

7. Risk Management Strategies

In the Real World

1. NEPSE Stocks (Ncell, NMB Bank)

   • Idea Used: Beta and CAPM.
   • How: Investors use Ncell’s β=1.5 to demand a higher return (e.g., 14%) compared to NMB’s β=1 (12% return). This reflects Ncell’s higher growth risk.

2. Khalti and eSewa (Digital Payments)

   • Idea Used: Business and financial risk.
   • How: Khalti faces business risk (competition from NMB’s eSewa) and financial risk (high debt for expansion). To mitigate, it diversifies into loans and insurance.

3. NTC and NRB (Monetary Policy)

   • Idea Used: Interest rate risk.
   • How: When NRB raises repo rates (e.g., from 7% to 8%), NTC’s borrowing costs increase, affecting its bond prices. Investors demand higher yields on NTC bonds to compensate.

4. Daraz’s Working Capital

   • Idea Used: Liquidity risk.
   • How: Daraz holds cash reserves to meet sudden demand spikes (e.g., Dashain sales). Poor liquidity management led to its 2021 cash crunch.

8. Financial Goal of the Firm

Primary Goal: Maximize shareholder wealth by making investment and financing decisions that increase the firm’s value. Key Features:

• Long-term focus (not just short-term profits).
• Risk-adjusted returns (higher risk requires higher returns).
• Market-driven (share price reflects investor expectations).

Visual: Shareholder Wealth Maximization

Exam Tip

1. CAPM is Critical: Always use $E(R_i)=R_f+{\beta }_i(E(R_m)-R_f)$ for stock/bond valuation questions.
2. Beta Interpretation: Know how to explain β=0.8 vs. β=1.4 in terms of risk.
3. Risk Types: Memorize the 5 types (market, interest rate, business, financial, liquidity) and give Nepal-specific examples (e.g., Ncell’s financial risk).
4. Diversification: Explain how combining assets reduces unsystematic risk (not systematic).
5. Numerical Questions: Practice calculating expected returns, betas, and interest rates using given data.
6. Real-World Links: Connect theory to NEPSE, banks, or NTC in answers (e.g., “Like Ncell, high-beta stocks require higher returns”).

Final Note: Risk and return are inseparable. Whether investing in NMB Bank or a startup, always ask: “What’s the risk, and is the return worth it?” Use CAPM, beta, and diversification to make informed choices.