Lesson 3:
Risk and Expected Return
Introduction
Now it should be clear that to make any investment or financing decision you must make your best determination
of the costs involved and the benefits, or return, which will result from it. What may not yet be as clear is that
there is always risk that returns may not turnout to be what you thought they would be. What we’re getting at, of
course, is risk. Specifying a return by itself doesn’t mean very much unless you also specify its risk.
After we have explained the concept of risk, we will look at how to quantify the risk of an expected return and how
to incorporate risk in financial decision-making. By becoming familiar with modern portfolio theory and the role of
risk in valuing assets, you will understand how a financial manager can manage risk and its relation to expected
return.
RISK
Whenever you make a financing or investment decision, there is some uncertainty about the outcome.
Uncertainty means not knowing exactly what will happen in the future. There is uncertainty in most everything we
do as financial managers, because no one knows precisely what changes will occur in such things as tax laws,
consumer demand, the economy, or interest rates
Risk is how we characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is
the degree of uncertainty.
The chance that some unfavorable event will occur.
Stand-Alone Risk
The risk an investor would face if he or she held only one asset.
In financing and investment decisions there are many types of risk we must consider. These include:
■ Cash flow risk
1. Business risk
Sales risk
Operating risk
2. Financial risk
3. Default risk/Credit Risk
■ Reinvestment risk
1. Prepayment risk
2. Call risk
■ Interest rate risk
■ Purchasing power risk
■ Currency risk
■ Portfolio risk
1. Diversifiable risk
2. Non diversifiable risk
Cash Flow Risk
Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any investment,
the risk that cash flows may not be as expected—in timing, amount, or both—is related to the investment’s
business risk.
Business Risk
1
,Business risk is the risk associated with operating cash flows. Operating cash flows are not certain because neither
do the revenues nor the expenditures comprise the cash flows.
Revenues: depending on economic conditions and the actions of competitors, prices or quantity of sales
(or both) may be different from what is expected. This is sales risk.
Expenditures: operating costs are comprised of fixed costs and variable costs. The greater the fixed
component of operating costs, the less easily a company can adjust its operating costs to changes in sales.
We refer to the risk that comes about from the mix of fixed and variable costs as operating risk. The greater the
fixed operating costs relative to variable operating costs, the greater the operating risk.
Let’s take a look at how operating risk affects cash flow risk. Remember back in economics when you learned
about elasticity? That’s a measure of the sensitivity of changes in one item to changes in another. We can look at
how sensitive a firm’s operating cash flows are to changes in demand, as measured by unit sales. We’ll calculate
the operating cash flow elasticity, which we call the degree of operating
Leverage (DOL).
The degree of operating leverage is the ratio of the percentage change in operating cash flows to the percentage
change in units sold. Let’s simplify things and assume that we sell all that we produce in the same period. Then,
Example
Suppose the price per unit is Ksh300, the variable cost per unit is Ksh200, and the total fixed costs are Ksh50, 000.
If we go from selling 1,000 units to selling 1,500 units, an increase of 50% of the units sold, operating cash flows
change from:
Operating Cash flow = Sales - (Variable Cost + Fixed cost)
Solution: Class activity
How much do operating cash flows change when the number of units sold changes? It changes by the difference
between the price per unit and the variable cost per unit—called the contribution margin—times the change in
units sold. The percentage change in operating cash flows for a given change in units sold is:
Class Activity: Calculate the DOL for 1,000 units and interpret the results
Confirm Answer: 2
A DOL of 2.0 means that a 1% change in units sold results in a 1% X 2.0 = 2% change in operating cash flow.
2
, Financial risk
~ is the risk associated with how a company finances its operations. If a company finances with debt, it is a legally
obligated to pay the amounts comprising its debts when due.
The more fixed-cost obligations (i.e., debt) incurred by the firm, the greater its financial risk. We can quantify this
risk somewhat in the same way we did for operating risk, looking at the sensitivity of the cash flows available to
owners when operating cash flows change. This sensitivity, which we refer to as the degree of financial leverage
(DFL), is:
Default Risk/Credit Risk
When you invest in a bond, you expect interest to be paid (usually semiannually) and the principal to be paid at the
maturity date. However, the more burdened a firm is with debt—required interest and principal payments—the
more likely it is that payments promised to bondholders will not be made and that there will be nothing left for the
owners. We refer to the cash flow risk of a debt security as default risk or credit risk.
Technically, default risk on a debt security depends on the specific obligations comprising the debt. Default may
result from:
■ Failure to make an interest payment when promised (or within a specified period).
■ Failure to make the principal payment as promised.
■ Failure to make sinking fund payments (that is, amounts set aside to pay off the obligation), if these payments
are required.
■ Failure to meet any other condition of the loan.
■ Bankruptcy.
Q &A Why do financial managers need to worry about default risk?
Because they invest their firm’s funds in the debt securities of other firms; because they are concerned about how
investors perceive the risk of their own debt securities; and because the greater the perceived default risk of a
firm’s securities, the greater the firm’s cost of financing.
Default risk is affected by both business risk—which includes sales risk and operating risk—and financial risk.
Interest Rate Risk
Interest rate risk is the sensitivity of the change in an asset’s value to changes in market interest rates. And, you
should remember that market interest rates determine the rate we must use to discount a future value to a
present value. The value of any investment depends on the rate used to discount its cash flows to the present. If
the discount rate changes, the investment’s value changes.
INTEREST RATE HEDGING
Class activity
Forward rate agreement (FRA) hedge against risks by fixing the interest rate on future borrowing.
Terminology:
a) 5.75-5.70 means that you fix borrowing rate at 5.75%
b) A ‘3-6’ forward rate agreement is one that starts in three months and lasts for three months.
c) A basis point is 0.01%
Illustration:
It is 30th June. Suraya ltd will need kshs10Million 6 month fixed rate from October. Suraya wants to hedge using
an FRA. The relevant FRA rate is 6% on 30th June.
a) Determine the FRA is required.
3
Risk and Expected Return
Introduction
Now it should be clear that to make any investment or financing decision you must make your best determination
of the costs involved and the benefits, or return, which will result from it. What may not yet be as clear is that
there is always risk that returns may not turnout to be what you thought they would be. What we’re getting at, of
course, is risk. Specifying a return by itself doesn’t mean very much unless you also specify its risk.
After we have explained the concept of risk, we will look at how to quantify the risk of an expected return and how
to incorporate risk in financial decision-making. By becoming familiar with modern portfolio theory and the role of
risk in valuing assets, you will understand how a financial manager can manage risk and its relation to expected
return.
RISK
Whenever you make a financing or investment decision, there is some uncertainty about the outcome.
Uncertainty means not knowing exactly what will happen in the future. There is uncertainty in most everything we
do as financial managers, because no one knows precisely what changes will occur in such things as tax laws,
consumer demand, the economy, or interest rates
Risk is how we characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is
the degree of uncertainty.
The chance that some unfavorable event will occur.
Stand-Alone Risk
The risk an investor would face if he or she held only one asset.
In financing and investment decisions there are many types of risk we must consider. These include:
■ Cash flow risk
1. Business risk
Sales risk
Operating risk
2. Financial risk
3. Default risk/Credit Risk
■ Reinvestment risk
1. Prepayment risk
2. Call risk
■ Interest rate risk
■ Purchasing power risk
■ Currency risk
■ Portfolio risk
1. Diversifiable risk
2. Non diversifiable risk
Cash Flow Risk
Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any investment,
the risk that cash flows may not be as expected—in timing, amount, or both—is related to the investment’s
business risk.
Business Risk
1
,Business risk is the risk associated with operating cash flows. Operating cash flows are not certain because neither
do the revenues nor the expenditures comprise the cash flows.
Revenues: depending on economic conditions and the actions of competitors, prices or quantity of sales
(or both) may be different from what is expected. This is sales risk.
Expenditures: operating costs are comprised of fixed costs and variable costs. The greater the fixed
component of operating costs, the less easily a company can adjust its operating costs to changes in sales.
We refer to the risk that comes about from the mix of fixed and variable costs as operating risk. The greater the
fixed operating costs relative to variable operating costs, the greater the operating risk.
Let’s take a look at how operating risk affects cash flow risk. Remember back in economics when you learned
about elasticity? That’s a measure of the sensitivity of changes in one item to changes in another. We can look at
how sensitive a firm’s operating cash flows are to changes in demand, as measured by unit sales. We’ll calculate
the operating cash flow elasticity, which we call the degree of operating
Leverage (DOL).
The degree of operating leverage is the ratio of the percentage change in operating cash flows to the percentage
change in units sold. Let’s simplify things and assume that we sell all that we produce in the same period. Then,
Example
Suppose the price per unit is Ksh300, the variable cost per unit is Ksh200, and the total fixed costs are Ksh50, 000.
If we go from selling 1,000 units to selling 1,500 units, an increase of 50% of the units sold, operating cash flows
change from:
Operating Cash flow = Sales - (Variable Cost + Fixed cost)
Solution: Class activity
How much do operating cash flows change when the number of units sold changes? It changes by the difference
between the price per unit and the variable cost per unit—called the contribution margin—times the change in
units sold. The percentage change in operating cash flows for a given change in units sold is:
Class Activity: Calculate the DOL for 1,000 units and interpret the results
Confirm Answer: 2
A DOL of 2.0 means that a 1% change in units sold results in a 1% X 2.0 = 2% change in operating cash flow.
2
, Financial risk
~ is the risk associated with how a company finances its operations. If a company finances with debt, it is a legally
obligated to pay the amounts comprising its debts when due.
The more fixed-cost obligations (i.e., debt) incurred by the firm, the greater its financial risk. We can quantify this
risk somewhat in the same way we did for operating risk, looking at the sensitivity of the cash flows available to
owners when operating cash flows change. This sensitivity, which we refer to as the degree of financial leverage
(DFL), is:
Default Risk/Credit Risk
When you invest in a bond, you expect interest to be paid (usually semiannually) and the principal to be paid at the
maturity date. However, the more burdened a firm is with debt—required interest and principal payments—the
more likely it is that payments promised to bondholders will not be made and that there will be nothing left for the
owners. We refer to the cash flow risk of a debt security as default risk or credit risk.
Technically, default risk on a debt security depends on the specific obligations comprising the debt. Default may
result from:
■ Failure to make an interest payment when promised (or within a specified period).
■ Failure to make the principal payment as promised.
■ Failure to make sinking fund payments (that is, amounts set aside to pay off the obligation), if these payments
are required.
■ Failure to meet any other condition of the loan.
■ Bankruptcy.
Q &A Why do financial managers need to worry about default risk?
Because they invest their firm’s funds in the debt securities of other firms; because they are concerned about how
investors perceive the risk of their own debt securities; and because the greater the perceived default risk of a
firm’s securities, the greater the firm’s cost of financing.
Default risk is affected by both business risk—which includes sales risk and operating risk—and financial risk.
Interest Rate Risk
Interest rate risk is the sensitivity of the change in an asset’s value to changes in market interest rates. And, you
should remember that market interest rates determine the rate we must use to discount a future value to a
present value. The value of any investment depends on the rate used to discount its cash flows to the present. If
the discount rate changes, the investment’s value changes.
INTEREST RATE HEDGING
Class activity
Forward rate agreement (FRA) hedge against risks by fixing the interest rate on future borrowing.
Terminology:
a) 5.75-5.70 means that you fix borrowing rate at 5.75%
b) A ‘3-6’ forward rate agreement is one that starts in three months and lasts for three months.
c) A basis point is 0.01%
Illustration:
It is 30th June. Suraya ltd will need kshs10Million 6 month fixed rate from October. Suraya wants to hedge using
an FRA. The relevant FRA rate is 6% on 30th June.
a) Determine the FRA is required.
3
