Every investment is characterised by return and risk.

Risk is defined as the possibility of loss or injury; the degree or probability of such loss. Risk may also defined as probability of loss in a financial transaction . It is the potential for variability in returns. Possibility of variation of actual return from the expected return term as risk.

 Returns represents the reward for undertaking the investment .It is the primary motivating force that derives investment. It may be expected return or realised return. Expected return-uncertain future return that an investor expected to get from his investment. Realised return-certain return that an investor actually obtain from his investment.

Elements of Risk
The essence of risk in an investment is the variation in its returns. Variation in risk in an investment is variation in returns caused by various factors. The first group include factors that are external to company affect a large number securities(uncontrollable).

 Second group include those factor that are internal to companies ,affect only those particular company (controllable to great extent). Total risk =Systematic + unsystematic.

Return
Investment is about returns, management of realised (historical) return is necessary to assess how well the investment manager has done. Historical returns are often used as an important input in estimating future (prospective)returns.

Returns of an investment is consists of two components: Current Return-Return that occur in periodic cash flow (income) such as dividend/interest ,generated by the investment. Capital Return-Return is reflected in the price change i.e, Price appreciation Beginning price of asset Total Return=current return + capital return

Systematic Risk
It affects entire market by bear hug and bull grip. As society is dynamic, changes occur in economic , political and social system. Impact of economic ,political and social changes is system wide and that portion of total variability in security returns caused by such system wide factors is referred as Systematic Risk

Unsystematic Risk
It is unique and peculiar to a firm/an industry .Eg.raw material scarcity,labour strike,management inefficiency,changes in consumer preference. When variability of returns occurs because of specific factors,known as Unsystematic Risk

Systematic Risk
It comprises of the factors external to the corporate. It is Uncontrollable. It is unavoidable. Economic, political and social changes causes systematic risk. It affects the whole market.

Unsystematic Risk

It comprises of the factors internal to the corporate. It is controllable. It is avoidable. It is factor specific to particular corporate. It affect specific corporate.

Sources of Risk
Types of Systematic risk 1.Interest Rate Risk 2.Market Risk 3.Purchasing Power Risk Types of Unsystematic risk 1.Business Risk 2.Financial Risk

1.Market Risk
It is the type of risk affect shares. Market price of share moves up and down consistently for some period.A general rise in share price(bullish trend) & fall in share price (bearish trend). Forces affect the stock market are political uncertainty , fall in the value of currency, war, earthquake.

Causes:Economic sanctions Atomic explosion LPG policies Recession PROTECTION Study price behaviour of stock Standard deviation indicate the volatility of stock (risk factor) Careful regarding timing of purchase and sell of stock

2.Interest rate Risk

It is the variation in the single period rates of return caused by fluctuations in the market interest rate. It affects debt security like bond & debt(fixed coupon rate of interest). Company pays interest to bond holders at this coupon rate. Fluctuating in interest rates are caused by changes in government policy and changes that occur in interest rate (TB & Govt. sector)

 Increase in interest rate make investor switch from private to public. variation in bond price caused due to variation in interest rate is called as interest rate risk. Causes: 1.Business environment of the economy. 2.Borrowing 3.It adversely affect individual returns.

 Protection 1.Hold till maturity. 2.Preference to guaranteed bond. 3.Invest in bond having different maturity dates and diversified in various sector.

3.Purchasing Power Risk

Variation in investor returns caused by inflation. Inflation results in lowering of purchasing power of money. Variation in returns caused by loss of purchasing power. Inflation may be demand pull(the demand for goods and services are in excess of their supply) /cost push(rise in price caused by increase in cost).

Protection against inflation

High yield bond with low risk factor , provide hedge against the inflation. To avoid risk invest in short term security. Diversification

1.Business Risk
Risk caused by operating environment of the business. It arises from inability of a firm to maintain its competitive edge and growth/stability of the earning. Business risk concerned with difference between revenue and EBIT. It is of two types : External and internal Business Risk

Internal Business Risk

It is associated with the operational efficiency of firm. Efficiency of operation is reflected on companys achievement in pre-set goals and fulfillment of the promises to its investors. a)Fluctuations in the sales : Competitions Loss of customer lead to operation incomes loss. Wide customer through diversification channels. Diversified sales force.

B) Research and development: Overcome the problem of obsolescence. New product should be produce to replace the old one. Measurable cutting of R&D budget reduce operational efficiency. C)Personnel Management: Frequently strike and lock outs ,results in loss of production and increase capital cost. Productivity suffer. Encourage and boost Morale.

D)Fixed Cost:
Enhance risk if fixed cost is increase in the cost component of the company. During recession /low demand for product, company cannot reduce fixed cost (burden to firm). Fixed cost component has to keep always in a reasonable size ,so not to affect profitability. E) Single product: Producing single product may cause problem if demand decrease.

External Risk:
External risk result of operating conditions imposed on firm by circumstances beyond its control. The external factors are social and regulatory factors, Monetary and Fiscal policies of government ,business cycle etc.

 A)Social and regulatory factors. B)Political factors. C)Business Cycle.

2.Financial Risk
It refers to as variability of income to equity capital due to debt capital. It is associated with the capital structure (equity and borrowed funds) of the company. The use of debt with the owned funds to increase the return to the shareholder is known as financial leverage. Financial risk is an avoidable risk because it is the management who has to decide, how much to be funded with equity capital and borrowed capital.

 As long as the earning of a company are higher than the cost of borrowed funds, shareholders earning are increased . At the same time when earning is low , it may lead to bankruptcy to equity holders. The financial risk considers the difference between EBIT and EBT. The Business risk considers the difference between revenue and EBIT.

Protection against business and financial risk

Investor has to analyse strength and weakness of company. Analysing the profitability trend and capital structure of the company .

1. The supply funds from savers, primarily households 2. The demand for funds from businesses 3. The governments net supply or demand for funds as modified by actions of RBI.

 The growth rate of the money is known as Nominal rates of interest Suppose FD amount = 10000

FD rate of interest(Nominal)(R) = 10%

According to Nominal rates of Interest, interest amount received is 1000.

 The growth rate of the purchasing power is called real interest rate. Suppose rate of inflation (i) = 6%
Nominal rate of interest ( R) = 10%

Real rate (r) = 10 6

= 4%

 1+r=1+R 1+i

1 + 0.04 = 1 + 0.10 1 + 0.06 Growth factor of purchasing power equals to the growth factor of money divided by the new price level

Credit Risk
The risk of a trading partner not fulfilling his obligations in full on due date or at any time thereafter is a risk that affects all aspects of business. With traditional instruments such as loans, bonds or currency trading, the amount which the counterparty is obliged to repay is the amount of Credit Risk. In derivatives credit risk is equals to the amount due or margin money in case the trader default to pay back.

Sources of Risk
1. Competitive Risk The earning and cash flow of the stock may be affected by unanticipated actions of competitors

Sources of Risk
2. Industry-specific Risk Unexpected technological developments and regulatory changes of Industry may have impact on stock price 3. Market Risk Unanticipated changes in macroeconomic factors like the GDP growth rate, interest rate and inflation

Sources of Risk
4. International Risk In case of foreign investment, earnings may be affected due to exchange rate risk or political risk. 5. Inflation, Frauds, Insolvency risk etc.

Historical Rate of Return

The records of past rates of return is one possible source of information about risk premium and standard deviation.

Historical Rate of Return

The formula for historical variance 2 = Sum total ( rt r)2 n rt = each years outcome r = Historical average n = Probability

=Square root of 54.3 =7.4% ANSWER Average rate of return = 3.4% Variance = 54.3 SD = 7.4%

Expected Rate of Return

The expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities

Expected Rate of Return

E(R) = Sum total of PiRi E (R) = Expected Return Pi = Probability of outcome Ri = Rate of Return

Expected return
The expected rate of return [E(R)] is the sum of the product of each outcome (return) and its associated probability. Risk associated with a security can be calculated from its expected returns by the following formula:

P r -E(r)
1 i=1

Expected Rate of Return

State of Economy Probability of growth Rate of Return

Boom

0.25

35

Normal Growth

0.50

20

Recession

0.25

10

E(R) = 8.75 + 10 + 2.5 = 21.25

 Q-1.A portfolio manager and have to advise your client between the securities of two companies the returns on the securities are given below:
Probability 0.5 0.4 0.1 Security A 4 2 0 Security B 0 3 3

On the basis of risk and return which security will you choose?

Solution
Security A is to be chosen. Reason:
Security A 1.326 2.8 Security B 1.5 1.5

Risk () Expected Return

Measure of Systematic Risk

The systematic risk is calculated by (beta), a measure of the volatility of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.

R j k e R f (R m R f ) j
where; Rj = Return on security j Ke = Cost of equity (i.e. of security j) Rf = Risk free rate of return Rm= Market rate of return j = Beta or the systematic risk of security j

Measure of Systematic Risk

The security return is calculated as
Todays price Yesterdays Price

Todays security return =

X 100 Yesterdays price

Todays index Yesterdays Todays market return = index Yesterdays index

X 100

and the return on security is given by: Ri= i+ i Rm + ei Where R

i

= Return on stock i

i = Intercept i = Slope (beta) of stock i Rm = Return of the market index ei = The error term

Calculation of
n XY (X)(Y) nX2 - (X)2

=yx

Example
Date October 5 October 6 October 7 October 8 October 9 October12 October13 October14 October15 October16 NSE index (x) 904.95 845.75 874.24 847.95 849.10 835.80 816.75 843.55 835.55 839.50 Bajaj Auto (y) 597.80 570.80 582.95 559.85 554.60 545.10 519.15 560.70 560.95 597.40

Calculate the .

Solution
Index Return (X) -6.54 3.37 -3.01 0.14 -1.57 -2.28 3.28 -0.95 0.47 Total -7.09 X2 Bajaj Auto Stock Return (Y) 42.77 11.36 9.06 0.02 2.46 5.20 10.76 0.90 0.22 82.75 -4.52 2.13 -3.96 -0.94 -1.71 -4.76 8.00 0.04 6.50 0.78 XY

29.56 7.18 11.92 -0.13 2.68 10.85 26.24 -0.04 3.06 91.32

Investors and Risk

Risk averse investors are willing to consider only risk-free or speculative prospects with positive risk premium. Risk neutral investors judge risky prospects solely by their expected rates of returns.

Investors and Risk

Risk Lover is willing to engage in fair games and gambles; this investor adjusts the expected return upward to take into account the fun of confronting the prospects risk.

Value at Risk
Valuation of a stock is based on its expected future cash flow and the equilibrium price is set so as to yield a fair expected return appropriate with its risk.

Value at Risk
Professional investors extensively use a risk measure that highlights the potential loss from extreme negative returns called value at risk denoted by VaR.

Power of Diversification
Diversification into many more securities, continues to spread out exposure to firm-specific factors and portfolio volatility should continue to fall.

Power of Diversification
Portfolio risk does fall with diversification. However even extensive diversification cannot eliminate risk.