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Subject COMMERCE

Paper No and Title 14. Security Analysis and Portfolio Management

Module No and Title M30. Risk, Types and Measurement

Module Tag COM_P14_M30

TABLE OF CONTENTS
1. Learning Outcomes

2. Introduction

3. Types/ Elements of Risk

3.1 Systematic Risk
3.2 Unsystematic Risk
4. Measurement of Risk
4.1 Measurement of Systematic Risk
5. Summary

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1. Learning Outcomes
After studying this module, you shall be able to

 Understand the concept of risk

 Explain different types of risk
 Differentiate between systematic and unsystematic risk
 Learn about the measurement of risk
 Calculate systematic risk

2. Introduction
Investment is made with the expectation of making gains in the future. For this, investment
demands sacrifice of current consumption of money value. Also one of the most innate
characteristic of future is the uncertainty involved in it. Since investments are linked to the future,
it also encompasses this element of futurity. The uncertainty induces the risk factor. Risk can be
defined as the probability of loss in the expected returns i.e. the realized returns will be less as
compared to the expected returns. The expected return is the random future return that an investor
expects to earn from the investment he holds. On the contrary, the realized return is the return
actually obtained from that investment at the end of the holding period. The actual return is not
always same to the expected return. This prospective variation of the actual realized return from
the expected return is what we call as risk. The wider the leeway for possible outcomes, the
greater will be the risk. In other words, the instruments whose returns fluctuate significantly are
considered to be high risk investment instruments, e.g. equity shares and the instruments whose
returns are fairly stable are considered to be low risk investment instruments, e.g. government
treasury bills.

3. Types /Elements of Risk

The variations in the expected returns of an investment are caused due to a wide variety of
factors. These factors constitute the elements of risk. These elements of risk may be broadly
classified in two groups or sources.
One such group is composed of factors that are basically attributable to the economy or market.
These factors are external to the companies and uncontrollable in nature. These affect all the
companies and a number of securities simultaneously at large. This group is basically pervasive
in nature. This group of factors induces the systematic risk.
The other group consists of those factors which are internal to companies and specific to
particular security issue. These are controllable to a great extent. The risk produced by this group
of factors is referred to as unsystematic risk.
Thus the total risk of an investment is composed of two components: systematic risk and
unsystematic risk.

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Systematic
Risk
Total Risk
Unsystematic
Risk

Total risk= Systematic risk + Unsystematic Risk

= General Risk + Specific Risk
= Market Risk + Unique Risk

3.1. Systematic Risk:

Systematic risk is the non- diversifiable portion of the total risk. Such risk is attributed to the
overall economy-wide factors that affect the pricing of all securities and companies in general.
These risks are unavoidable and uncontrollable in nature. Systematic risk causes variations in the
return due to movements in the general market. Because the market is inherently unpredictable,
the systematic risk always exists in all investment avenues. This portion of the total risk cannot be
reduced through diversification. This type of risk accounts for most of the risk in a well-
diversified portfolio. The systematic risk can be of different types. A few are listed below:
 Interest Rate Risk
 Market Risk
 Purchasing Power Risk

3.1.1. Interest Rate Risk

Interest rates account for a major part of the systematic risk in investment activities. The
variability in the securities expected rate of return that is caused due to the fluctuations in the
interest rates prevailing in the economy is called as interest rate risk. These changes in the interest
rates are either on account of regulatory framework or market forces. Since the expected return of
an investor rises due to an increase in the general interest rates, the market price of the securities
happens to fall and vice versa. In other words, other things being equal, the security prices move
inversely to the movements in the interest rates. Fluctuations in the interest rates have a more
direct bearing on the bonds and other fixed income securities. Effects on common stocks
(equities) are somewhat indirect.

3.1.2. Market Risk

The market price of shares tends to fluctuate consistently in different time periods. The general
rise and fall in the market share price is commonly referred to as bullish and bearish trends
respectively. These movements can be easily seen in the market indices such as BSE Sensex,
NSE Nifty, and etc. While the phases of ups and downs in the share prices in the long run can be
considered as a result of business cycles, the short term fluctuations are mainly because of
changes in the investors’ psychology. These changes in the investors’ expectations are a result of
their reactions to the tangible and intangible events in the economy such as fall of a government,
sudden change in the monetary policy, emotional instability of the investors collectively leading

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to an overreaction. The variation in the security’s return caused due to stock market volatility is
referred to as market risk.

3.1.3. Purchasing Power Risk

Purchasing power risk or inflation risk is yet another type of systematic risk. The loss in the
purchasing power of money caused due to inflation also affects the returns from holding an
investment. When an investor holds an investment, he makes a sacrifice of the current
consumption of the money value i.e. he postpones his consumption. On the same hand, if there is
inflation in the economy, the price of goods and services would rise leaving the investor with a
reduced purchasing power of the money left with him. Thereby, the investor actually experiences
a decline in the purchasing power of his investment and the return from that investment. The
important types of inflation are the cost push inflation caused due to the rising cost of production
and demand pull inflation that occurs when the demand for goods and services is in excess in
relation to the supply. The purchasing power risk is also related to the interest rate risk as the
interest rate rises when inflation increases.

3.2. Unsystematic Risk

The unsystematic risk represents such component of total risk that arises on account of
companywide factors. These risks are firm specific and are also called as unique risk. These
factors peculiar to a company or industry are for example- labor strike, development of a new
product, management inefficiency, emergence of a new competitor, etc. This risk can either be
reduced or eliminated completely through diversification. In a well-diversified portfolio, the
unique risk of most of the stock tends to cancel each other resulting in minimum non marker risk.
The unsystematic risk can be further classified into the following:
 Business Risk
 Financial Risk

3.2.1. Business Risk

Business risk arises on account of the operating conditions of the company. These operating
conditions include both the internal environment (conditions within the firm) and external
environment (conditions outside the firm). These operating conditions influence the performance
of the company and are reflected in the operating cost of the firm. The operating cost is the
aggregate of fixed cost and variable cost. A large portion of the fixed cost is risky for the firm as
it increases the business risk. In other words, a decline in total revenue of such a company would
result in more than proportionate fall in the operating profits. This is known as operating
leverage. The external environmental conditions which are beyond company’s control such as
changes in government policies, unforeseen market conditions, strategies of competitors, may
cause external business risk. Internal business risk is related to the efficiency with which a
company operates. Some internal business risk factors include raw material scarcity, labor strikes,
fall in production, etc. These are within the company’s control. The business risk is, thus, the
variability in the operating income caused by operating conditions of the company.

3.2.2. Financial Risk

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Financial risk is associated with the financing pattern adopted by the company. The debt
component of capital structure demand fixed payments to be made in the form of interests
irrespective of the fact whether the company makes profit or loss. This fixed interest payment
may cause variations in the earnings per share (EPS) of the equity shareholders. Higher the debt,
higher the degree of financial leverage which may have an unfavorable effect on the EPS. In the
worst cases, it may lead to the capital erosion of the company. Thus, a company with high
financial leverage incorporates high financial risk and vice versa. This risk is, however, within the
controls of the company as the company is independent in its financing decisions i.e. it is free to
finance its activities without resorting to debt. Thus, financial risk is the variability in the EPS due
t presence of debt component in the capital structure of the company.

3.3. Other Risks

In addition to the above major risks, there exists many other risk both controllable ad
uncontrollable. These may vary in form, size and effects. Some of the identifiable risks are listed
below:
 Political Risk: It arises out of the political conditions prevailing in the country. The
variability in the returns of the assets caused due to legislative, judicial and administrative
branches of the government is called political risk. It is also referred to as country risk.
 Management Risk: It is the loss of company caused due to inefficiencies or errors of the
management.
 Default /Insolvency Risk: The variability in the assets return that results from the
financial integrity and creditworthiness of the firm is called as default risk.
 Liquidity Risk: The risk associated with a particular security market in which it is traded
is called liquidity risk. The more the uncertainty about time element and price
concession, the greater the liquidity risks.
 Foreign Exchange/ Currency Risks: Foreign exchange risk or currency risk arises out of
investments made internationally. The prospect of uncertainty in the returns after they
convert their foreign gains back to their own currency is called foreign exchange risk.

4. Measurement Of Risk
Every financial decision involves risk. For making effective financial decisions, it is necessary to
understand the kind of risk likely to be faced, estimate the extent of risk corresponding to
different investment alternatives, and know the effect of risk on the investors’ expected rate of
return. For this we need to measure and quantify the risk associated with each investment
proposal.
Risk is the extent of variation in the expected return. Thus, it is associated with return of an
investment. The risk of an investment in isolation cannot determine the investment decisions.
Another factor influencing the investment decisions is the expected rate of return by an investor.
The return, in turn, depends upon the cash inflows to be received from an investment. It is the
aggregate of yield and the capital appreciation. Thus the return and risk of an investment form the
base for any investment decision.
Suppose that the investors are able to assign probability to each possible return likely to occur
from an investment. A probability distribution can now be drawn for these possible rates of
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Return. A probability distribution is the list of all possible returns form an investment with their
respective probabilities attached with them.

For example: Table 35.1 shows the probability distribution of all possible returns assessed by an
investor that are likely to be received from an investment.

Table 35.1

Returns (𝑹𝒊 ) Probability (𝑷𝒊 )

11% 0.10
12% 0.20
13% 0.40
14% 0.20
15% 0.10

The above probability distribution table can be used to extract two simple statistical measures
(summary statistics) for the purpose of benefiting the investment decision to be made. These
measures are expected return from an investment and the risk of the investment.

 Expected Return

The expected rate of return is given by the weighted average of all possible returns from an
investment, using the probabilities as weight. For the above Table 35.1;

E(R) = (11*0.10) + (12*0.20) + (13*0.40) + (14*0.20) + (15*0.10)

= 1.1 + 2.4 + 0 + 2.8 + 1.5
= 13%

In general, the expected rate of return can be calculated as:

E(R) = 𝑅1 𝑃1 + 𝑅2 𝑃2 + ………………….. + 𝑅𝑛 𝑃𝑛

This can be written as follows:

𝑛

𝐸(𝑅) = ∑ 𝑅𝑖 𝑃𝑖
𝑖=1
…..Equation.1
Where, 𝐸(𝑅) = Expected Return on security i
𝑅𝑖 = Possible return on security i
𝑃𝑖 = Probability /weight

In other words, the expected rate of return is the summation of product of all possible returns with
their respective probabilities. The expected return for the probability distribution in Table 1 is
equal to 13%.

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 Risk

In the above example, the probability of different possible outcomes from an investment itself
depicts the presence of risk in the investment. Had there be a perfect foresight of an investor,
there would have only one possible outcome with no probability distribution. This shows that the
risk is related to the dispersion of distribution. A number of measures of distribution have been
developed by statisticians, such as range, mean absolute deviation and the variance. Among the
most popular and useful is the variance or standard deviation of the probability distribution of
possible returns. Variance is the square of standard deviation (𝛔) and is depicted as (𝜎 2 ). We use
this measure of dispersion to represent the risk of a single investment. The risk of an investment
is the weighted average of the square of each possible return’s deviation from the expected return,
again using the probabilities as weights. For the above example:
𝜎 2 = [(11 − 13)2 ∗ 0.10] + [(12 − 13)2 ∗ 0.20] + [(13 − 13)2 ∗ 0.40] + [(14 − 13)2 ∗ 0.20] +
[(15 − 13)2 ∗ 0.10]
= 1.2
𝛔 = √1.2
= 1.095

In general, variance is calculated as,

𝜎 2 = [{𝑅1 − 𝐸(𝑅1 )}2 ∗ 𝑃1 ] + [{𝑅2 − 𝐸(𝑅2 )}2 ∗ 𝑃2 ] + …………… + [{𝑅𝑛 − 𝐸(𝑅𝑛 )}2 ∗ 𝑃𝑛 ]

This can be written as:

𝑛

𝜎 = ∑[{𝑅𝑖 − 𝐸(𝑅𝑖 )}2 ∗ 𝑃𝑖 ]

2

𝑖=1
…..Equation.2
Where, 𝜎 2 = Variance/ risk on return security i
𝑅𝑖 = Return on security i
𝐸(𝑅𝑖 )= Expected Return on security i
𝑃𝑖 = Probability/ Weight

In the above example, mean measures the expected value and the variance or standard deviation
is used to measures the variability. Thus, this approach of measuring risk is also referred as the
mean-variance approach.

4.1. Measurement of Systematic Risk

The variance or standard deviation measures the total risk of an investment. This total risk is
however composed of two components: systematic and unsystematic risks.
Unsystematic or unique risk is the risk associated with a particular security or company. These
are firm specific and can be reduced or eliminated by combining it with other securities opposite
in nature. This is called diversification. The unsystematic risk can be reduced to zero if the
securities are perfectly negatively correlated. Since, it can be reduced through diversification, it is
considered as irrelevant risk for investors. The investors now need to measure the un-diversifiable
part of the total risk i.e. the unsystematic risk. It is the risk which relates to the economy wide
factors. All the securities are affected by these market changes to some extent or the other. The
greater the variability of security’s return in respect to the market changes, the greater is the

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systematic risk. The measure of systematic risk is beta (β). It is

a measure of the sensitivity of the security’s return to the
movements in the market. The historical data for security’s return and the return of a
representative stock market index are used for calculating beta. Mathematically,

𝑟𝑖𝑚 𝜎𝑖 𝜎𝑚
Beta (β) = ⁄𝜎 2
𝑚
…..Equation.3
Or,
𝐶𝑜𝑣𝑖𝑚
β= ⁄𝜎 2
𝑚
…..Equation.4

Where, 𝑟𝑖𝑚 = coefficient of correlation between return of stock i and return of the market index
𝜎𝑖 = standard deviation of stock i
𝜎𝑚 = standard deviation of the return of market index
2
𝜎𝑚 = variance of the market returns
𝐶𝑜𝑣𝑖𝑚 = covariance of the returns between security i and market index.

5. Summary

 Risk is the probability of loss in the expected return i.e. the realized returns will
be less than the expected returns. It is measured through variance or standard
deviation.
 Total Risk = Systematic Risk + Unsystematic Risk, or
 Total risk = market risk + unique risk
 Systematic risk is the non diversifiable portion of the total risk which is
attributable to the overall economy wide factors affecting pricing of securities and
companies in general.
 Interest rate risks, market risk, purchasing power risk are types of systematic risk.
 Unsystematic risk arises on account of companywide factors/ firm specific
factors. These can be eliminated through the process of diversification.
 Business risk, financial risks are types of unsystematic risk.
 Political risk, management risk, default risk, liquidity risk, foreign exchange risks
are other types of risk.
 Expected return on an investment is the summation of product of all possible
returns with respective probabilities. Mathematically,
𝒏

𝑬(𝑹) = ∑ 𝑹𝒊 𝑷𝒊
𝒊=𝟏

 The risk of an investment is the weighted average of the square of each possible
return’s deviations from their expected return again using the probability as
weights. Mathematically,

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𝝈 = ∑[{𝑹𝒊 − 𝑬(𝑹𝒊 )}𝟐 ∗ 𝑷𝒊 ]

𝟐

𝒊=𝟏

 Mean measures the expected value and the variance or standard deviation
measures the variability. This approach of measuring risk is also known as mean
variance approach.
 Beta (𝜷) is the measure of systematic risk. It measures the sensitivity of the
security’s return to the movements in the market. Mathematically,

𝑟𝑖𝑚 𝜎𝑖 𝜎𝑚
Beta (β) = ⁄𝜎 2
𝑚

Or,
𝐶𝑜𝑣𝑖𝑚
β= ⁄𝜎 2
𝑚

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