MODULE 2

RETURN & RISK CONCEPTS

RISK:
 Risk in investment analysis means that future returns from an investment are
unpredictable. The concept of risk may be defined as the possibility that the actual
return may not be same as expected. In other words, risk refers to the chance that
the actual outcome (return)from an investment will differ from an expected outcome.
 With reference to a firm, risk may be defined as the possibility that the actual
outcome of a financial decision may not be same as estimated.
 The risk may be considered as a chance of variation in return. Investments having
greater chances of variations are considered more risky than those with lesser
chances of variations. Between equity shares and corporate bonds, the former is
riskier than latter.
 If the corporate bonds are held till maturity, then the annual interest inflows and
maturity repayment. Investment management is a game of money in which we have to
balance the risk and return.

The risks associated with investment are:-

1. Inflation risk : Due to inflation, the purchasing power of money gets reduced.
2. Interest rate risk : Due to an economic situation prevailing in the country, the interest rate
may change.
3. Default risk : The risk of not getting investment back. That is, the principal amount
invested and / or interest.
4. Business risk : The risk of depression and other uncertainties ofbusiness.
5. Socio-political risk : The risk of changes in government, government policies, social
attitudes, etc.

RETURN:

 Return: the return is the basic motivating force and the principal reward in the
investment process. The return may be defined in terms of
(i) realized return, i.e., the return which has been earned, and
(ii) expected return, i.e., the return which the investor anticipates to earn over some
future investment period.
 The expected return is a predicted or estimated return and may or maynot occur.
 The realized returns in the past allow an investor to estimate cash inflows in terms of
dividends, interest, bonus, capital gains, etc, available to the holder of the investment.
 The return can be measured as the total gain or loss to the holder over a given period
of time and may be defined as a percentage return on the initial amount invested. With
reference to investment in equity shares, return is consisting of the dividends and the
capital gain or loss at the time of sale of these shares.

Prof. Ningambika G Meti Dept of MBA, SVIT

The returns on investment usually come in the following forms:-

1. The safety of the principal amount invested. Investment Management.

2. Regular and timely payment of interest or dividend.
3. Liquidity of investment. This facilitates premature encashment, loan facilities,
marketability of investment, etc.
4. Chances of capital appreciation, where the market price of the investment is higher, due
to issue of bonus shares, right issue at a lower premium, etc.
5. Problem-free transactions like easy buying and selling of the investment, encashment of
interest or dividend warrants, etc.

The simple rule of investment management is that:-

1. The higher the risk, the greater will be the returns.
2. Similarly, lesser the risk, the lower will be the returns.
This rule of investment management is depicted in the following diagram:-
The above diagram showing risk and return indicates that:-
a) Low risk instruments such as small savings, and bank deposits bring low returns.
b) Medium risk instruments such as company deposits and non-convertible debentures will
earn medium returns.
c) High-risk securities like equity shares and convertible debentures will earn higher returns.
Every investment opportunity carries some risks or the other.

In some investments, a certain type of risk may be predominant, and others not so
significant. A full understanding of the various important risks is essential for taking
calculated risks and making sensible investment decisions.

Prof. Ningambika G Meti Dept of MBA, SVIT

SOURCES OF RISK:

Seven major risks are present in varying degrees in different types of investments.
The main sources of risk are
1. Interest Rate Risk
2. Market Risk
3. Inflation Risk
4. Business Risk
5. Financial Risk
6. Liquidity Risk.

1. Interest rate risk

In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent
impact on investment values and yields. Interest rate risk affects fixed income securities and
refers to the risk of a change in the value of your investment as a result of movement in
interest rates.

Suppose you have invested in a security yielding 8 per cent p.a. for 3 years. If the interest
rates move up to 9 per cent one year down the line, a similar security can then be issued only
at 9 per cent. Due to the lower yield, the value of your security gets reduced.

2. Market risk

Market risk is the risk of movement in security prices due to factors that affect the market as
a whole. Natural disasters can be one such factor. The most important of these factors is the
phase (bearish or bullish) the markets are going through. Stock markets and bond markets are
affected by rising and falling prices due to alternating bullish and bearish periods: Thus:

 Bearish stock markets usually precede economic recessions.

 Bearish bond markets result generally from high market interest rates, which, in turn,
are pushed by high rates of inflation.

 Bullish stock markets are witnessed during economic recovery and boom periods.

 Bullish bond markets result from low interest rates and low rates of inflation.

3. Business risk

The market value of your investment in equity shares depends upon the performance of the
company you invest in. If a company's business suffers and the company does not perform
well, the market value of your share can go down sharply.

This invariably happens in the case of shares of companies which hit the IPO market with
issues at high premiums when the economy is in a good condition and the stock markets are

Prof. Ningambika G Meti Dept of MBA, SVIT

bullish. Then if these companies could not deliver upon their promises, their share prices fall
drastically.

When you invest money in commercial, industrial and business enterprises, there is always
the possibility of failure of that business; and you may then get nothing, or very little, on a
pro-rata basis in case of the firm's bankruptcy.

The greatest risk of buying shares in many budding enterprises is the promoter himself, who
by overstretching or swindling may ruin the business.

4. Financial Risk

Financial risk arises when companies resort to financial leverage or the use of debt financing.
The more the company resorts to debt financing, the greater the financial risk as it creates
fixed interest payments due to debt or fixed dividend payments on preference stock thereby
causing the amount of residual earnings available for common stock dividends to be more
variable than if no interest payments were required. It is avoidable to the extent
that management has the freedom to decide whether to borrow or not to borrow funds.

5. Liquidity risk

This risk is associated with the secondary market in which the particular security is traded in.
A security that can be bought or sold quickly without significant price concession is
considered liquid. The greater the uncertainty about the true element and the price
concession, the greater the liquidity risk. Securities that have ready markets like treasury
bills have lesser liquidity risk.

The relative liquidity of different investments is highlighted in Table 1.

Prof. Ningambika G Meti Dept of MBA, SVIT

6. Purchasing power risk, or inflation risk

Inflation means being broke with a lot of money in your pocket. When prices shoot up, the
purchasing power of your money goes down. Some economists consider inflation to be a
disguised tax.

Given the present rates of inflation, it may sound surprising but among developing countries,
India is often given good marks for effective management of inflation. The average rate of
inflation in India has been less than 8% p.a. during the last two decades.

This risk is associated with the secondary market in which the particular security is traded in.
A security that can be bought or sold quickly without significant price concession is
considered liquid. The greater the uncertainty about the true element and the price
concession, the greater the liquidity risk. Securities that have ready markets like treasury
bills have lesser liquidity risk.

7. Political risk

The government has extraordinary powers to affect the economy; it may introduce legislation
affecting some industries or companies in which you have invested, or it may introduce
legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.

One government may go and another come with a totally different set of political and
economic ideologies. In the process, the fortunes of many industries and companies undergo
a drastic change. Change in government policies is one reason for political risk.

Whenever there is a threat of war, financial markets become panicky. Nervous selling begins.
Security prices plummet. In case a war actually breaks out, it often leads to sheer
pandemonium in the financial markets. Similarly, markets become hesitant whenever
elections are round the corner. The market prefers to wait and watch, rather than gamble on
poll predictions.

International political developments also have an impact on the domestic scene, what with
markets becoming globalized. This was amply demonstrated by the aftermath of 9/11 events
in the USA and in the countdown to the Iraq war early in 2003. Through increased world
trade, India is likely to become much more prone to political events in its trading partner-
countries.

8. Default risk

This is the most frightening of all investment risks. The risk of non-payment refers to both
the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes,
company deposits, etc., this risk is very high. Since there is no security attached, you can do
nothing except, of course, go to a court when there is a default in refund of capital or payment
of accrued interest.

Prof. Ningambika G Meti Dept of MBA, SVIT

Given the present circumstances of enormous delays in our legal systems, even if you do go
to court and even win the case, you will still be left wondering who ended up being better off
you, the borrower, or your lawyer!

So, do look at the CRISIL / ICRA credit ratings for the company before you invest in
company deposits or debentures.

SYSTEMATIC RISK:

 Systematic risk is due to the influence of external factors on an organization. Such

factors are normally uncontrollable from an organization's point of view.
 It is a macro in nature as it affects a large number of organizations operating under a
similar stream or same domain. It cannot be planned by the organization. The types of
systematic risk are depicted and listed below.

 Also called un diversifiable risk or market risk. A good example of a systematic risk is
market r i A risk that is carried by an entire class of assets and/or liabilities. systematic
risk may apply to a certain country or industry, or to the entire global economy. It is

Prof. Ningambika G Meti Dept of MBA, SVIT

 impossible to reduce systematic risk for the global economy (complete global
shutdown is always theoretically possible), bu t one may mitigate other forms of
systematic risk by buying different kinds of securities and/or by buying in different
industries. For example, oil companies have the systematic risk that they
 The degree to which the stock moves with the overall market is called the systematic
riskand denoted as beta.
 Systematic risk is due to the influence of external factors on an organization. Such
factors arenormally uncontrollable from an organization's point of view.
 It is a macro in nature as it affects a large number of organizations operating under a
similarstream or same domain. It cannot be planned by the organization.
 The types of systematic risk are depicted and listed below.

The types of systematic risk are depicted and listed below.

1. Interest rate risk

 Interest-rate risk arises due to variability in the interest rates from time to time.
 It particularlyaffects debt securities as they carry the fixed rate of interest.
The types of interest-rate risk are depicted and listed below.

The meaning of price and reinvestment rate risk is as follows:

1. Price risk arises due to the possibility that the price of the shares, commodity,
investment, etc. may decline or fall in the future.

Prof. Ningambika G Meti Dept of MBA, SVIT

 2. Reinvestment rate risk results from fact that the interest or dividend earned
from an investment can't be reinvested with the same rate of return as it was
acquiring earlier.
2. Market risk
 Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is, it arises due to rise or fall in the trading price of
listed shares or securities in the stock market.
 The types of market risk are depicted and listed below.

 Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty
percentage chance of getting a head and vice-versa.
 Relative risk is the assessment or evaluation of risk at different levels of business
functions. For e.g. a relative-risk from a foreign exchange fluctuation may be higher if
the maximum sales accounted by an organization are of export sales.
 Directional risks are those risks where the loss arises from an exposure to the
particular assets of a market. For e.g. an investor holding some shares experience a
loss when the market price of those shares falls down.
 Non-Directional risk arises where the method of trading is not consistently followed
by the trader. For e.g. the dealer will buy and sell the share simultaneously to
mitigate the risk
 Basis risk is due to the possibility of loss arising from imperfectly matched risks.
For the risks which are in offsetting positions in two related but non-identical markets.
 Volatility risk is of a change in the price of securities as a result of changes in the
volatility of a risk-factor. For e.g. it applies to the portfolios of derivative
instruments, where the volatility of its underlying is a major influence of prices.

3. Purchasing power or inflationary risk:

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates)
from the fact that it affects a purchasing power adversely. It is not desirable to invest in
securities during an inflationary period.

The types of power or inflationary risk are depicted and listed below.

Prof. Ningambika G Meti Dept of MBA, SVIT

 Demand inflation risk arises due to increase in price, which result from an excess of
demand over supply. It occurs when supply fails to cope with the demand and hence
cannot expand anymore. In other words, demand inflation occurs when production
factors are under maximum utilization.
 Cost inflation risk arises due to sustained increase in the prices of goods and services .It
is actually caused by higher production cost. A high cost of production inflates the final
price of finished goods consumed by people.

UNSYSTEMATIC RISK:
 Unsystematic risk is due to the influence of internal factors prevailing within an
organization. Such factors are normally controllable from an organization's point of view.
 It is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the
risk.

Business Or Liquidity Risk:

 Business risk is also known as liquidity risk. It is so, since it emanates (originates) from
the sale and purchase of securities affected by business cycles, technological changes,
etc.

 The types of business or liquidity risk are depicted and listed below.

Prof. Ningambika G Meti Dept of MBA, SVIT

Asset liquidity risk & Funding liquidity risk:

 Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or
near, their carrying value when needed. For e.g. assets sold at a lesser value than their
book value.

 Funding liquidity risk exists for not having an access to the sufficient-funds to make a
payment on time. For e.g. when commitments made to customers are not fulfilled as
discussed in the SLA (service level agreements).

Financial or credit risk:

 Financial risk is also known as credit risk. It arises due to change in the capital structure
of the organization. The capital structure mainly comprises of three ways by which funds
are sourced for the projects. These are as follows:

o Owned funds. For e.g. share capital.

o Borrowed funds. For e.g. loan funds.

o Retained earnings. For e.g. reserve and surplus.

 The types of financial or credit risk are depicted and listed below.

 Exchange rate risk is also called as exposure rate risk. It is a form of financial risk
that arises from a potential change seen in the exchange rate of one country's currency
in relation to another country's currency and vice-versa. For e.g. investors or
businesses face it either when they have assets or operations across national borders,
or if they have loans or borrowings in a foreign currency.

 Recovery rate risk is an often neglected aspect of a credit-risk analysis. The recovery
rate is normally needed to be evaluated. For e.g. the expected recovery rate of the
funds tendered (given) as a loan to the customers by banks, non-banking financial
companies (NBFC), etc.

 Credit event risk refers to the risk that a borrower or issuer of debt instruments will
fail to meet its obligations, resulting in a negative impact on the value of the debt
securities held by investors.

Prof. Ningambika G Meti Dept of MBA, SVIT

  Non-directional risk refers to the risk associated with market movements that are not
dependent on the overall direction of the market. Unlike directional risk, which is tied
to the general trend of the market (upward or downward), non-directional risk is more
specific to factors such as volatility, changes in interest rates, or other market
dynamics that may impact an investment regardless of whether the overall market is
moving up or down.

 Sovereign risk is associated with the government. Here, a government is unable to

meet its loan obligations, reneging (to break a promise) on loans it guarantees, etc.

 Settlement risk exists when counterparty does not deliver a security or its value in
cash as per the agreement of trade or business.

Operational risk:

 Operational risks are the business process risks failing due to human errors. This risk
will change from industry to industry. It occurs due to breakdowns in the internal
procedures, people, policies and systems.

 The types of operational risk are depicted and listed below.

 Model risk is involved in using various models to value financial securities. It is due
to probability of loss resulting from the weaknesses in the financial-model used in
assessing and managing a risk.

 People risk arises when people do not follow the organization’s procedures, practices
and/or rules. That is, they deviate from their expected behavior.

 Legal risk arises when parties are not lawfully competent to enter an agreement
among themselves. Furthermore, this relates to the regulatory-risk, where a
transaction could conflict with a government policy or particular legislation (law)
might be amended in the future with retrospective effect.

 Political risk occurs due to changes in government policies. Such changes may have
an unfavorable impact on an investor. It is especially prevalent in the third-world
countries.

Prof. Ningambika G Meti Dept of MBA, SVIT

INSOLVENCY RISK:

 Insolvency risk refers to the risk that a company or individual may become insolvent,
meaning that their liabilities exceed their assets, and they are unable to meet their
financial obligations.

 In the context of corporate finance, insolvency risk is particularly relevant to creditors

and investors who are concerned about the financial health and stability of the
companies in which they have invested or to which they have extended credit.

RISK-RETURN RELATIONSHIP

 The risk-return relationship is a fundamental concept in finance that describes the

correlation between the level of risk associated with an investment and the
potential return or reward that investment might generate.
 In general, the relationship suggests that higher potential returns are usually
accompanied by higher levels of risk, and lower-risk investments tend to offer lower
potential returns.
 The risk-return relationship is essential for investors to make informed decisions
aligned with their financial objectives and risk tolerance. It also serves as a foundation
for portfolio construction and risk management strategies in the world of finance.

Risk:

 Volatility: Risk is often measured in terms of volatility or the degree of variation in

the returns of an investment. High volatility indicates higher risk, while low volatility
suggests lower risk.

 Uncertainty: Risk is associated with the uncertainty of future returns. Investments

with higher risk are more unpredictable, and there is a greater chance of experiencing
losses.

Return:

 Profit Potential: Return refers to the potential gain or profit that an investor may earn
from an investment. It is expressed as a percentage of the initial investment or as a
monetary amount.

 Yield: Return can come in various forms, including capital appreciation, interest,
dividends, or a combination of these. Different investments offer different types of
returns.

Risk-Return Trade-off:

 The risk-return trade-off implies that investors must weigh the potential for higher
returns against the increased level of risk. In other words, there is no "free lunch" in
investing, and higher returns usually come with higher levels of risk.

Prof. Ningambika G Meti Dept of MBA, SVIT

  Investors with a higher risk tolerance may be willing to accept more volatility in
pursuit of potentially higher returns, while those with a lower risk tolerance may
prefer lower-risk investments with more predictable returns.

Diversifiable Risk (Unsystematic Risk):

 Diversifiable risk, also known as unsystematic risk or company-specific risk, and non-
diversifiable risk, also known as systematic risk or market risk, are two components
that make up the total risk associated with an investment portfolio.

 Understanding the distinction between these two types of risk is crucial for investors
in managing their portfolios effectively.

 Definition: Diversifiable risk is the portion of an investment's risk that can be

eliminated through diversification. It is specific to individual assets or companies and
is not related to broader market factors.

 Causes: Diversifiable risk can arise from factors such as company management,
industry conditions, competitive pressures, regulatory changes, and other company-
specific events.

 Reducibility: By holding a well-diversified portfolio that includes a mix of different

assets, sectors, and industries, investors can reduce or eliminate diversifiable risk. The
idea is that the positive performance of some investments may offset the negative
performance of others.

Non-Diversifiable Risk (Systematic Risk):

 Definition: Non-diversifiable risk is the portion of an investment's risk that cannot be

eliminated through diversification. It is associated with broader economic, market,
or systemic factors that affect all investments to some extent.

 Causes: Non-diversifiable risk can result from factors such as interest rate changes,
inflation, economic recessions, geopolitical events, and overall market trends.

 Market Sensitivity: All investments are subject to non-diversifiable risk, and it is

inherent in the overall market. It is the risk that remains even in a well-diversified
portfolio because it is related to factors that affect the entire market.

 Risk Factors: Examples of non-diversifiable risk factors include market risk, interest rate
risk, and currency risk.

Relationship between Diversifiable risk and non-diversifiable:

 Diversifiable risk and non-diversifiable risk are complementary components that together
make up the total risk of an investment.
 Diversifiable risk is specific to individual investments and can be managed through
diversification strategies.

Prof. Ningambika G Meti Dept of MBA, SVIT

 Non-diversifiable risk is systemic and affects all investments to some degree, regardless
of diversification.
 diversifiable risk is specific to individual assets and can be mitigated through
diversification, while non-diversifiable risk is inherent in the overall market and cannot
be eliminated through diversification. Both types of risk contribute to the total risk of an
investment, and understanding their distinctions is essential for effective portfolio
management and risk assessment.

RISK MEASUREMENT:

 Risk measurement refers to evaluating and quantifying potential loss associated with a
decision, action, or investment. It aims at prioritizing the severity of potential
consequences of any action and accordingly planning the resource allocation for
maximizing return while taking a calculative risk.
 Risk measures are statistical measures that are historical predictors of investment risk and
volatility.
 Risk measures are also major components in modern portfolio theory (MPT), a standard
financial methodology for assessing investment performance.

Types of risk measurement:

 Ex-post Risk: The term ex-post risk refers to a risk measurement technique that uses
historic returns to predict future risks associated with an investment. This type of
risk manages risks associated with investment returns after the fact.

 Ex-ante Risk: Ex-ante risk refers to any of the returns that an investment earns before
that risk actually takes place. This kind of analysis looks at the risk of current
portfolio holdings and estimates future return streams and their projected variability
based upon statistical assumptions.

PORTFOLIO RISK MANAGEMENT:

 Portfolio risk is a term used to describe the potential loss of value or decline in the
performance of an investment portfolio due to various factors, including market volatility,
credit defaults, interest rate changes, and currency fluctuations.
 Portfolio risk management is the process of identifying, assessing, and mitigating the
various risks associated with an investment portfolio. It involves implementing strategies
to optimize the balance between risk and return, ensuring that the portfolio aligns with the
investor's financial goals and risk tolerance.

Prof. Ningambika G Meti Dept of MBA, SVIT

IMPORTANT QUESTION:

1. What is Risk? 3m
2. Explain systematic and unsystematic risk? 7m/10m
3. Discuss the types of risk? 7m/10m
4. What is sovereign risk? 3m
5. Discuss sources of Risk? 7m
6. Explain the relationship between risk and return? 7m
7. Describe the risk measurement in detail. 7m

Prof. Ningambika G Meti Dept of MBA, SVIT