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Notes on security analysis and portfolio management
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Nandini MishraCopyright
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/ 33
is .d risk. The concept of risk is intuitively
i t is characterised by return an e co _of isi veh
aoe ae py KIveStOS- in general, it refers to the possibility of incurring a loss in
financial rardoction But risk involves much more than that. The word ‘risk’ has a definite
financial meaning
MEANING OF RISK
A person making an investment expects to get some return from the investment in the
fature. But, as future is uncertain, so is the future expected return. It is this uncertainty
associated with the returns from an investment that introduces risk into an investment.
ed return from an
We can distinguish between the expected return and the realis¢
investment. The expected return is the uncertain future return that an investor expects to
get from his investment. The realised return, on the contrary, is the certain return that an
= a * y
investor has actually obtained from his investment at the end of the holding period. The
investor makes the investment decision based on the expected return from the investment
The actual retum realised from the investment may not correspond to the expected return.
vii possibility of variation of the actual return from the expected return is termed risk.
a realisations correspond to expectations exactly, there would be no risk. Risk arise
oe oe ee sibility of variation between expectations and realisations with regard
wean, apne be defined in terms of variability of returns. “Risk is the potential for
a we inveainent aN investment whose returns are fairly stable is considered to b¢
considered to be a high-risk inves an investment whose returns fluctuate significantly ©
widely are considered risky inestmnan Equity shares whose returns are likely to fuctity
ents. Government securities whose returns are /aitlY
stable are considered to possess low risk.
54 449 | al
eye
LEMENTS OF RISK Risk §5
B
essence of risk in an inv '
The ted by a number of factone 8 YAtialion in its ret ni
is caused factors. These factory ey Fluns. This variation in retums
from an investment constitute the lene joel Produce variations in the returns
Let us consider the risk in holding soe no
ing securitie:
ments of risk may be broad S| les, such as shares, el
ea that are terial toacom i Pssitied into two Broups. The ‘es pei res
are mostly uncontrollable mg tee large number of ecu simultaneous
These ly ollable in nature, The second fc ies simultaneously.
are internal to companies and affect onl 8roup includes those factors which
th !
to a great extent. The risk produced by the fret ou Sopantes,-Theseare controllable
risk, and that produced by the second group is
The total variability in returns of a security
systematic risk and ungystematic tisk Tepresents the total risk of that security.
are the two components of total risk. Thus,
Total risk = Systematic risk + Unsystematic risk
Systematic Risk
As the society is dynamic, changes occur in the economic, political and social systems
constantly. These changes have an influence on the performance of companies and thereby
on their stock prices. But these changes affect all companies and all securities in varying
degrees. For example, economic and political instability adversely affects all industries
and companies. When an economy moves into recession, corporate profits will shift
downwards and stock prices of most companies may decline. Thus, the impact of economic,
political and social changes is system-wide and that portion of total variability in security
retus caused by such system-wide factors is referred to as systematic risk. Systematic
risk is further subdivided into interest rate risk, market risk, and purchasing
power risk.
Interest Rate Risk
Interest rate risk is a type of systematic risk that particularly affects debt securities like
bonds and debentures. A bond or debenture normally has a fixed coupon rate of interest.
The issuing company pays interest to the bond holder at this coupon rate. A bond is
normally issued with a coupon rate which is equal to the interest rate prevailing in the
market at the time of issue. Subsequent to the issue, the market interest rate may change
but the coupon rate remains constant till the maturity of the instrument. The change in
market interest rate relative to the coupon rale of a bond causes changes in its market
rice.
: £ Rs, 100 issued with a coupon rate of ten per cent when
A bond having a face value 0
i i bsequent
the market i ie algo ten per cent will have a market price of Rs. 100. If, subseqi
Be ee mare p to 12.5 per cent, no investor will buy the
to the issue, the market interest rate moves ¥ t
bond with ten per ie coupon interest rate unless the holder of the bond reduces the price
to Rs. 80. When the price is reduced to Rs. 80, the purchaser of the bond gets interest of | eB
56 Secunty Analysis and Portfolio Management
Rs, ten on an investment of Rs. 80 which is equivalent to a return of 12.5 per cent Whig
ili interest rate.
the same as the prevailing market interes ;
Thus, we see that as the market interest rate moves up in relation to the coy
interest rate, the market price of the bond declines. Similarly, the market price of the
would move up when there is a drop in market interest rate compared to the coupon, ta
In other words, the market price of bonds and debentures is inversely related tg
market interest rates. As a result, the market price of debt securities fluctuates in respon
to variations in the market interest rates. This variation in bond prices caused due jg th
Variations in interest rates is known as interest rate risk. e
‘The interest rate variations have an indirect impact on stock prices also. Speculator
often resort to margin trading, i.e. purchasing stock on margin using borrowed funds. a,
interest rates increase, margin trading becomes less attractive. The lower demand 4
speculators may push down stock prices. The opposite happens when interest rates fa,
Many companies use borrowed funds to finance their operation. When interest rates
move up, companies using borrowed funds have to make higher interest payments, This
leads to lower earnings, dividends and share prices. On the contrary, lower interest rates
may push up earnings and prices. Thus, we see that variations in interest rates may
indirectly influence stock prices. Interest rate risk is a systematic risk which affects bonds
directly and shares indirectly.
Market Risk
Market risk is a type of systematic risk that affects shares. Market prices of shares move
up or down consistently for some time periods. A general rise in share prices is referred
to asa buillish trend, whereas a general fall in share prices is referred to as a bearish trend.
In other words, thé share market alternates between the bullish phase and the bearish
phase. The alternating movements can be easily seen in the movement of share price
indices such as the BSE Sensitive Index, BSE National Index, NSE Index, etc)
Business cycles are considered to be a major determinant of the timing and extent of
the bull and bear phases of the market. This would suggest that the ups and downs in
share markets would follow the expansion and recession phase of the economy. This may
be true in the long run, but it does not sufficieritly explain the short-term movements in
the market.
The short-term volatility in the stock market is caused by sweeping changes in investor
expectations which are the result of investor reactions to certain tangible as well as intangible
events. The basis of the reaction may be a set of real tangible events, political, economi¢
or social, such as the fall of a government, drastic change in monetary policy, etc. The
change in investor expectations is usually initiated by the reaction to real events. But the
reaction is often aggravated by the intangible factor of emotional instability of investors:
They tend to act collectively and irrationally, leading to an overreaction.
The stock market is seen to be volatile. This volatility leads to variations in the returns
of investors in shares. The variation in returns caused by the volatility of the stock market
is referred to as the market risk.
hy
Pon,
bong Risk 57
purchasing Power Risk
Another type of systematic risk is the urchasi ‘
investor returns caused by inflation Purchasing power risk. It refers to the variation in
Inflation results in lowering of the i
. a Purchasing power of moni i
ey. When an investor
saris fs poatperng Ne ee CPP EH io buy some goods or sevice, other
words, me eee aide He consumption. Meanwhile, if there is inflation in the economy,
the prices « e aan Services Would increase and thereby the investor actually experiences
a decline in the purchasing power of his investments and the return from the seecteent
Let us consider a simple example. Suppose a person lends Rs. 100 today at ter per cent
interest. He would get back Rs. 110 afte ’
; T one year. If during the year, the prices have
increased by eight per cent, Rs. 110 received at the end of the year will have 2 purchasing
power of only Rs. 101.20, i.e. 92 per cent of Rs. 110. Thus, inflation causes a variation i
the purchasing power of the returns from an investment. This is known as purchasing
power risk and its impact is uniformly felt on all securities in the market and as such, is
a systematic risk.
The two important sources of inflation are rising costs of production and excess demand
for goods and_services_in relation to_theit_supply. They are known as Gost-push and
demand-
ation respectively. When demand is increasing but supply cannot be
increased, price of the goods increases thereby forcing out some of the excess demand and
bringing the demand and supply into equilibrium. This phenomenon is known as demand,
pull inflation. Cost push inflation occurs when the cost of production increases and this
increase in cost iS passed on to the consumers by the producers through higher prices of
ods.
ar an inflationary economy, rational investors would include an allowance for the
purchasing power risk in their estimate of the expected rate of return from an investment.
In other words, the expected rate of return would be adjusted upwards by the estimated
annual rate of inflation.
Unsystematic Risk
the company issuing such security. Examples are raw material scaftity, labour strike,
management inefficiency{ When variability of returns occurs because of such Firm—specific
factors, it is known as unsystematic risk.\This risk is unique or peculiar to a company or
industry and affects it if addition to the systematic risk affecting all securities.
The unsystematic or unique risk affecting specific securities arises from two sources:
(a) the operating environment of the company, and (b) the financing pattern adopted by
the company. These two types of unsystematic risk are referred to as business risk and
financial risk respectively.
The returns from a security may sometimes vary because of a sae ou only
Business Risk
Every company operates within a particular operating environment. This operating
environment comprises both internal environment within the firm and external environment
outside the firm. The impact of these operating conditions is reflected in the operating "| EE
58 Security Analysis and Portfolio Management
costs of the company. The operating costs can be segregated into fixed costs and Varia
oats. A larger proportion of fixed costs is disadvantageous to a company. TE the tog
sevenue of such a company declines due to some reason of the other, there would be
yore than proportionate decline in its operaing profits because it would be unable 1,
reduce its fixed costs. Such a firm is said to face a larger business risk.
Business risk is thus a function of the operating conditions faced by a company ang
is the variability in operating income caused by the operating conditions of the company,
Financial Risk
Financial risk is a function of financial leverage which is the use of debt in the capitay
structure. The presence of debt in the capital structure creates fixed payments in the form,
of interest which is a compulsory payment to be made whether the company makes prof,
or loss. This fixed interest payment creates more variability in the earnings per share (EPs)
available to equity share holders. For example, ifthe rate of return or operating profit rato
is higher than the interest rate payable on the debt, EPS would increase. On the contrary,
if the operating profit ratio is lower than the interest rate, EPS would be depressed. The
increase or decrease in EPS in response to changes in operating profit would be much
wider in the case of a levered firm (a company having debt in its capital structure) than
in the case of an unlevered firm.
This variability in EPS due to the presence of debt in the capital structure of a company
is referred to as financial risk. This is specific to each company and forms part of its
tuncystematic risk. Financial risk is an avoidable risk in so far as a company is free to
finance its activities without resorting to debt.
MEASUREMENT OF RISK
An intelligent investor would attempt to anticipate the kind of risk that he is likely to face.
He would also attempt to estimate the extent of risk associated with different investment
| proposals. In other words, he tries to measure or quantify the risk of each investment that
he considers before making the final selection. The quantification of risk is thus necessary
for investment analysis.
Risk in investment is associated with return. The risk of an investment cannot be
measured without reference to return. The return, in turn, depends on the cash inflows t0
be received from the investment. Let us consider the purchase of a share. While purchasing
an equity share, an investor expects to receive future dividends declared by the company:
In addition, he expects to receive the selling price when the share is finally sold.
| Suppose a share is currently selling at Rs. 120. An investor who is interested in the
share anticipates that the company will pay a dividend of Rs. 5 in the next year. Moreover”
he expects to sell the share at Rs. 175 after one year. The expected return from this investment
can be calculated as follows: Risk 59
Forecasted dividend + Forecasted end of the
or riod stock price
Tnitial investment re
z
Rs. 5 + Rs. 175
= BE aao — ~ 1= 05 or 50 per cent
w36246
In this case the investor expects to get a return of 50 per cent in the future. But the
future is uncertain. The dividend declared by the company may turn out to be either more
or less than the figure anticipated by the investor. Similarly, the selling price of the stock
may be less than the price anticipated by the investor at the time of investment. It may
sometimes be even more, Thus, there is a possibility that the future return may be more
than 50 per cent or less than 50 per cent. Since the future is uncertain the investor has to
consider the probability of several other possible returns. The expected returns may be 30
per cent, 40 per cent, 50 per cent, 60 per cent or 70 per cent. The investor now has to assign
the probability of occurrence of these possible alternative returns. An example is given
below:
Possible returns (in per cent)
Probability of occurrence
x, Xd =
30 a0, Bes
40 oa
50 04d *
60 0.10'
7” aio NBRARS
This table gives the probability distribution of possible returns from an investment in
shares. Such a distribution can be developed by the investor by studying the past data and
modifying it appropriately for the changes he expects to occur in the future.
. The information contained in the probability distribution has to be reduced to two
simple statistical measures in order to aid investment decision-making. These measures
are summary statistics. One measure would indicate the expected return from the investment
and the other measure would indicate the risk of the investment. 658")
Expected Return
The expected return of the investment is the probability weighted average of all the possible
elurns. If the possible returns are denoted by X, and the related probabilities are p(X), tie
“*pected return may be represented as X and can be calculated as:
Xp z X,p(X))
Itis the sum of the products of possible returns with their respective probabilities.
follows, ©xpected return of the share in the example given above can be calculated as im
Calculation of Expected Retui
0 Security Analysis and Portfolio Managoment
: —
Probability Xi p(X)
Posies >)
% a0 120
0.30
“0 oo 20.0
3 0.10 So
PY 0.10 7.0
a
z XiplX;) = 48.0
a
Here, the expected return is 48 per cent.
a isic kin The’ risk aspect should
considered. The most popular, serion mak varince cranes deviation get
Te cnet, denoted by and ts calculated by the following formula:
1" =
=> (x, - XP P(X;)]
; Mat a
The table below provides the required calculations in the case of our
example.
Possible Probability Deviation Deviation Product
return PAX;) (%- X) squared % ~ XP pry
xX (X%- XR
= 0.10 -18 324 32.4
0.30 ~8 64 19.2
50. 0.40 2 4
60 0.10 1 7
bi on 2 144 44
22 484 48.4
= 1160
Variance = 116 per
cent
Standard deviation j
saard d is the square Toot of
eviation in our example is 116 = 10. nm erate and is “Presented 88 0. The standard
Variance and standar
expected na in Pars measure the extent Of variability of possible
jation have ee Mal at measures such as Tange, semi-variance and
‘© Measure fi i
Y accepted measure, ure tisk, but standard deviation has been oo
4
Go i gucieaac. Risk 64
In the method described above, the prob
investment proposal is used to estimate the
variability. The mean gives the expe
gives the variabilily. This widely use
variance approach.
The standard deviation or variance, however, provides a measure of the total risk
associated with a security. Total risk comprises of two components, namely systematic risk
and unsystematic risk. Unsystematic risk is risk which is specific ot unique to a company.
Unsystematic risk associated with the security o
stemalic ris f a particular company can be reduced by
combining it with another security having opposite characteristics. This process is known
as diversification of investment. As a result of diversification, the investment is spread
over a group of securities with different characteristics. This Sroup of securities is called
a portfolio.
As far as an investor is concerned, the uns
be reduced or eliminated through diversifica
relevant in investment decision-making is the
Hence, the investor seeks to measure the syst
ability distribution of possible returns from an
© expected return from the investment and its
ted value and the variance or standard deviation
' procedure for assessing risk is know
the mean-
ystematic risk is not very important as it can
tion. It is an irrelevant risk. The risk that is
systematic risk because it is undiversifiable.
tematic risk of a security.
Measurement of Systematic Risk
Systematic risk is the variability in security returns caused by changes in the economy or
the market. All securities are affected by such changes to some extent, but some securities
t greater variability in response to market changes. Such securities are said to have
higher systematic risk. The average effect of a change in the economy can be represented
by the change in the stock market index. The systematic risk of a security can be measured
by relating that security's variability with the variability in the stock market index. A
higher variability would indicate higher systematic risk and vice versa.
The systematic risk of a security is measured by a statistical measure called Beta. The
input data required for the calculation of beta are the historical data of returns of the
individual security as well as the returns of a representative stock market index. Two
statistical methods may be used for the calculation of Beta, namely the correlation method
or the regression method.
Using the correlation method, beta can be calculated from the historical data of returns
by the following formula:
a
where
Tim = Cortelation coefficient between the returns of stock i and the returns of the market
index.
= Standard deviation of returns of stock i.
tandard deviation of returns of the market index.
Variance of the market returns.
moda S¢°0nd method of calculating beta is by using the regression metho. The regression
el postulates a linear relationship between a dependent variable and an independent
G
on
oe
ee 62. Security Analysis and Portfolio Management
en th
lows;
Y=a+ px
where
Y = Dependent variable.
X = Independent variable.
@ and B are constants.
The formula used for the calculation of @and B are given below.
a=¥-px
_ REXY -(ExyEY)
n&X? - (EXP
where
n= Number of items.
¥ = Mean value of the dependent variable scores,
Mean value of independent variable scores,
Y = Dependent variable scores.
X= Independent variable scores.
For the calculation of beta, the retum of the individual Security is taken as the dependent
Variable, and the return of the market index is taken as the independent variable. The
Tegression equation is represented as follows:
R= a+ BRy
where
Ry = Retum of the individual security.
Ry, = Retum of the market index,
a = Estimated return of the security when the market is stationary.
B, = Change in the return of the individual security in response to unit change in the
return of the market index. It is, thus, the measure of systematic risk of a security.
A security can have betas that are Positive, negative or zero,
“The beta of an asset, i, is a measure of the variability of that asset relative to te
variability of the market as a whole. Beta is an index of the systematic risk of an asset.”
As beta measures the vola tility of a security's returns relative to the market, the larger
the beta, the more volatile the security. A beta of 1.0 indicates a security of average risk.
4 stock with beta reater than 1.0 has above average risk. Its returns would be more
volatile than the market returns. For example, when market returns move up by five per
ent, a stock with beta of 1.5 would find its returns moving up by 7.5 per cent (ie. 5 x 1.5)-
‘imilarly, decline in market returns by five per cent would produce a decline of 7.5 per cent
a the return of the individual security. A stock with beta less than 1.0 would
have below average ri ‘ability in i
i isk. Variability in its
returns sou be compari lesser than the market variability: Beta can also be ae
implying that the stock returns move in a direction opposite to that of the market returns.
Beta is calculated from historical data
security. It is a historical measure of s Of returns to measure the systematic risk of a
decision-making, the investor is assuming that the rela
and market variability will continue to remain the
To conchide, risk is the possibility of vari
factors contribute to this variability in returns. Some of these factors are system-wide and
affect all securities, while some are unique and affect only specific securities. Total variability
or risk of a security can be measured by calculating the standard deviation or variance of
the security's returns. Beta measures the systematic risk of a security.
tionship between the security variability
same in future also,
lation in returns from an investment. Many
Example 1 A share is currently selling at Rs. 50. It is expected that a dividend of Rs. 2
per share would be paid during the year and the share could be sold at Rs. 54 at the end
of the year. Calculate the expected return from the share.
Solution
Forecasted dividend + Forecasted end of the period stock price
R =
Tnitial investment
R 2454 -1=0.12 or 12 percent
Alternatively,
R
where
D = Dividend.
P, = End of period stock price.
Py = Initial strick price.
2, 54-50
R= yt
Example 2 Calculate the expected return and the standard deviation of returns for a
stock having the following probability distribution of returns.
=0.04 +0.08=0.12 or 12 percent.
Possible returns (in per cent) Probability of occurrence
= (0.05
-10 0.10
0 0.10
15 0.15
20 0.25
30 0.20
35 0.15 64 Security Analysis and Portlolio Management
Solution
Calculation of Expected Return
Product
Possible returns Probability
x W(X) Xp (Xi)
m5 0.05 7125
-10 0.10 1.00
0 0.10 0.00
15 0.15 2.25
20 0.25 5.00
30 0.20 6.00
35 0.5 5.25
16.25
X= ¥ Xip(X)) = 16.25 per cent 6a
Ai 1b
fe 4a
Calculation of Standard Deviation of Return 7
| Possible returns Probability, Deviation Deviation Product
7 squared =
| x; PX) &-X) OG - XP OX - X Pox)
| -25 0.05 41.25 1701.56 85.08
-10 0.10 26.25 689.06 68.91
0 0.10 16.25 264.06 26.41
15 0.15 1.25 156 023
20 0.25 375 14.06 3.52
30 0.20 13.75 189.06 3781
35 0.15 18.75 351.56 52.73
o = 274.69
Variance, 0 = )[(X; ~ X)*p(X,)] = 274.69 per cent
a
Standard deviation, o = J274.69 = 16.57 per cent
Example 3A stock costing Rs. 120 pays no dividends. The possible prices that the stock
might sell for at the end of the year with the respective Probabilities as follows: a Risk 65
Price (Rs.) = P
— robabilily
120 or
125 i
130 ts
135 02
ee ee
1. Calculate the expected return.
2. Calculate the standard deviation of returns,
Solution Here, the probable returns have to be calculated using the formula
D
Rap
Calculation of Probable Returns
Possible prices (Py) Py Po U(P;~ Po/Pol x 100
Rs. Rs. Return (per cent)
us 5 -4.17
120 0 0.00
125 5 4.17
10 10 8.33
135 15 12.50
140 20 16.67
Calculation of Expected Return
Probable return Probability Product
Xp p(X) Xi p(X)
4.17 0 -0417
000 oi 0.000
417 02 0.838
2.33 03 ed
1250 02 2a)
1667 ot 1.667
X = 7.083
Expected return, % = 7.08 per cent dj
66 Secunty Analysis and Portfolio Management
Calculation of Standard Deviation of Returns S
~Protabie return Probability Deviation Deviation Protne
x r(X) (x, - X) (X,- XP (X)~ Povey
-417 01 =11.25 126.56 Des
0.00 01 7.08 50.13 5.01
4.7 02 291 8.47 169
8x3 03 1.25 1.56 047
12S 0.2 5.42 29.38 5.88
16.67 01 9.59 91.97 9.20
o = 34.91
Variance, o” = 34.91 per cent
L. Standard deviation, ¢= 34.97 = 5.91 per cent
ample 4 An investor has analysed a share for a one-year holding period. The share ig
currently selling for Rs. 43 but pays no dividends and there is a fifty-fifty chance that the
share will sell for either Rs. 55 or Rs. 60 by the year end. What is the expected return and
| risk if 250 shares are acquired with 80 per cent borrowed funds? Assume the cost of
| borrowed funds to be 12 per cent. (Ignore commissions and taxes).
Solution
Calculation of Probable Returns
Year-end prices (P;) (P, - Pp) Return (per cent)
(Rs) (Rs.) [Py ~ Po)/Pol x 100
55 2 2791
60 v7 39.53
Calculation of Expected Return
Probable return Probability Product
(per cent) (Xi) PX) XplX)
291 0.50 13.955
39.53 0.50 19.765
X = 33.720 =
Fisk 67
Calculation of Standard Deviation
Probable return Probability Deviation Deviation squared Product
x; p(X) (X;- X) (X= XP (X%,-X)?p(X)
WI 05 5.81 33.76 16.88
3953 0s 581 33.76 16.88
o = 33.76
variance, 0? = 33.76
Return and risk of buying 250 shares
Investment in 250 shares = 250 x Rs. 43
= Rs. 10,750
Borrowed funds (80 per cent) = Rs. 8,600
Expected return from 250 shares:
10,750 x 33.72 _
Gross return = 3,624.90
Less: Interest at the rate of 12 per cent on. borrowed funds
8600 x 12
=—0 = 1,032.00
Net returns = 2,592.90
Risk in investing in 250 shares
10,750 x 5.81 _
= OT a Rs. 624.58
hcwple 5 Monthly return data (in per cent) are presented below for ITC stock and BSE
™ National Index for a 12 month period.
Month ITC BSE National Index
1 943 7AL
2 0.00 5.33
3 -431 7.35
4 -18.92 -14.64
5 -6.67 158
6 2657 15.19
? 20.00 5.11
. 2.93 0.76
2s 5.25 -0.97
i 21.45 10.44
u 23.13 1747
2 32.83 2015
Calculate beta of ITC stock. 68 Security Analysis and Portfolio Management
Solution Correlation coefficient is calculated with the following formula:
n&XY ~ (EX) (ZY)
"ex? (Ex yey? - (EY
One data series (Ry).
Other data series (R,).
n = Number of items.
where
Calculation of Correlation Coefficient
ITC returns BSE Index return
YR) X(R,) ye xt xy
9.43 7A 88.92 54.91 69.88
0.00 5.33 00.00 28.41 00.00
-431 -735 1858 54.02 31.68
-18.92 14.64 357.97 214.33 276.99
6.67 158 4449 2.50 10.54
2657 15.19 705.96 230.74 403.60
20.00 5.1 400.00 26.11 102.20
293 0.76 8.58 058 223
5.25 -0.97 27.56 0.94 5.09
21.45 10.44 460.10 108.99 223.94
3.13 17.47 535.00 305.20 404.08
32.83 20.15 1077.81 406.02 661.52
111.69 49.82 3724.97 + 1432.75 2160.49
. (12 x 2160.49) — (49.82 x 111.69)
Fe ee Se
| [12 x 1432.75) - (49.82)? (12 x 3724.97) - (111.69)?
| 25,925.88 — 5564.40
*fi7193 — 2482.03 [44, 699.64 — 12, 474.66
. 20,361.48 0,361.48
14,710.97 x 32,224.98 21,772.94
.935
Standard deviation and variance can be calculated by using the following formula:
2 _osxy
Variance, o?= NEX_— (EX) Risk 69
Standard deviation, o =
we
whe? = Original data.
N= Number of items.
rd deviation of ITC returns From the above _ the following data are availabl
Standa
ER; = 111.69 pe = 372497, N=12 ry
a” or = AG
[eax 3724.97) - (111.69) __ [44,699.64 — 12,474.66 or
es rs ee
= \2B78 =14.96
Variance and standard deviation of BSE Index returns From the above table, the following
data are available:
ER, = 49.82 ERy, = 1432.75 N=12
go? 2% 1432.75) — (49.82)"
e T2x12
17,193 - 2482.03 _ 14,710.97 _
= et
= Vi0z16 = 10.11 ~ i A724
Beta
Tin |
a j
{
_(0.936)(14.96 10.11) _ 14141 ee
— 102.16 = 702.16 4) oe ae
fais 2 Qe wee
Example 6 With the data given in example 5, calculate beta of ITC stock, using the
regression model. als G - 95
Solution
Dependent variable Y = R;
Independent variable X = Rn
From the table prepared for solving the problem in e
values:
xample 5, we have the following
EXY = 2160.49 EX = 49.82 LY = 111.69
= 1432.75 n= 12 Li
g
70 Security Analysis and P¢
rttolio Management
|
Example 7 Monthly return data (in per cen!
5 EY _ 11.69 931
Yeu -
_ EX _ 49.82 _
xe Bea 24.15
nEXY - (EX)(EY)
Be —aEx? = (EX)
(12 2160.49) ~ (49.82x111.69)
(12x 1432.75) - (49.82)
25,925.88 - 5564.40
17, 193 = 2482.03
20,361.48
= 74,710.97
B= 1.384
a= ¥ -pXx
= 931 - 5.74 = 3.57
31 — (1.384 x 4.15)
1) for ONGC stock and the NSE index for
12 month period are presented below:
‘Month ‘ONGC NSE Index
1 =0.75 -0.35
2 545 -049
3 3.05 1.03
4 341 1.64
5 943 6.67
6 2.36 113
7 0.42 0.72
8 551 0.84
° 6.80 4.05
4 2.60 121
z “361 0.29
2 -191 196
b Calculate alpha and beta for the ONGC stock.
. Suppose NSE index is expected to move up by 15 per cent next month. How
much retum would you expect from ONGC?
bie Risk 71
Solution Since alpha and beta of the stock are to be calculated, the regression model may
be used.
Calculation of « and fi of stock
ONGC returns NSE Index return 7
Y(R) X (Ry) " a
=0.75 =035 oar nae
545 ~049 0.24 -267
3.05 103 1.06 314
341 1.64 2.69 5.59
9.13 6.67 4449 0.90
2.36 113 128 267
0.42 07 052 030
551 084 on 463
6.80 4.05 1640 2754
2.60 121 146 3.15
-381 029 0.08 -110
-191 -196 3.84 374
25.32 12.72 72.89 107.55
nEXY - (ZX)(ZY)
= (12x 107.55) - (12.72 x 25.32)
(1272.89) — (12.72?
= 1290.60 -322.07 _ 968.53
874.68 - 161.80 712.88
B= 1.359
a= ¥-px
25.32 12.72
= SH 0.389)
= 2.11 ~ (1.359) (1.06) = 2.11 - 1.44 = 0.67
The expected return from ONGC stock when NSE index moves up by 15 per cent can
be calculated from the regression equation which is
R= 0.67 + 1359 Ry
Substituting the value of Ry, as 15 in the equation, we get
Ry = 0.67 + 1.359 (15) = 0.67 + 20.385 = 21.055 \
UNIT 3_ RISK AND RETURN
Objectives
es of this Unit are to:
The objec
+ Explain the concepts of Risk and Retum
* Describe the genesis of total Investment Risk.
* Distinguish between ‘Systematic’ and ‘Unsystematic’ Risk.
* Identify the factors that affect Risk in Investment in Equity Shares,
Structure
3.1 Concept of Investment Risk
3.2 Evolution of Risk Connotations
3.3, Sources of Risk
3.4 Types of Risk
3.5. Measuring historical retum,
3.6 Measuring historical risk.
3.7 Measuring expected return and risk,
3.8 Summary
3.9 Key Words
3.10 Self-Assessment Questions/Exercises
3.11 Further Readings
3.1__ CONCEPT OF INVESTMENT RISK
‘The term ‘risk’ is commonly used in the investment sector. In everyday life, the
word risk frequently connotes an unexpected negative outcome. When you sey
itis risk to drive on a certain route, you are implying that driving on that route
could result in an accident. The term risk in the context of investments. on the
other hand, has a different meaning. It not only denotes the possibility of a
s0 the likelihood of a less positive outcome.
negative outcome but
AS you are aware risk and retum are interrelated. A person purchases a
financial asset with the intent of receiving a profit. The investment decision
would be based on an ‘anticipated return,’ which may be realized ot not. The
tisk associated with an investment decision is the possibility of an
“unexpected” negative or "adverse" return.
Almost every decision involves some level of risk. When a manufacturing
manager chooses equipment, a marketing manager creates an ad campaign, of
a finance manager manages a portfolio of assets, they are all dealing with
uncertain cash flows. The financial analysis includes assessing risks and
incorporating their likely effect into financial decisions. The variability in
retum from security is deseribed as a risk in theory. On the other hand,
Security that generates consistent retums over time and the returns are assured
37 based on some type of guarantee usually sovereign guaranteg ign”
a “risk-less security" or "risk-free security," whereas security they
inconsistent returns over time is referred to as a "risky asset," Takes s
the following options, for example:
os
* Rs.1000, 12% 2020 Government of India Loan.
‘erat,
Ook ay
Rs.100, 14.5% 2005 TISCO Non-Convertible Debentures.
The Government Loan would have zero tisk because the government system
does not collapse, and interest and principal repayments are guaranteed. In
the case of TISCO debentures, here are protective covers in the shape of
corporate assets and sustained solid financial performance, but there is a risk
of poor performance and default,
For many investors, investment risk is a major source of anxiety. When a
secondary market fails to respond to rational expectations, the risk
component of such markets is rather large, and most investors are unaware of
the true risk involved in the investment Process. Risk aversion is a
characteristic that many small investors have in the secondary market. Small
investors, in particular, look to the market for a certain return, and when their
expectations are not satisfied, it has a detrimental impact on their morale. As
a result, these investors prefer to put their money into assets that will give
them a small return on average rather than securities that may give them a
large return on average but fluctuate wildly.
There are also risk-taking investors in the financial system. Speculators are
risk-takers who choose to invest in securities that provide large returns even
though the certainty of such returns is relatively low. In the market, they are
also known as risk-takers. A secondary market requires both risk-takers and
risk-averse investors.
In figure-3.1(i), an investor given the following investment none petd
surely pick investment ‘B* over investment ‘A’. Whereas in figure i,
Investment “A° provides a predictable income stream. Comparing Figures 31
(i) and 3.1 Gi), we find Investment “BY is preditable in the igure 3.1() but
jable in figure 3.1 (ii). The risk of a security is defined as the volatility in
tee low of income to investors. Despite the danger in the second ease, the
in are reference would still be for investment *B” because it provides @
beneeyaree t every time, This can be interpreted as the investor is
Beton return, om? har entien for taking greater risk, Wisk and Return
Investment
Investment
3.1 Gi) Fluct
Activity 3.1
a) Define
3.2__| EVOLUTION OF RISK CONNOTATIONS
In the twenty-first century, analysts would utilize financial statement data to
assess the risk of a company's securities. They utilized the quantity of debt
held by the company as a broad indication. Their rule was that the bigger the
amount of debt, the riskier the securities. In the 1962 edition of their seminal
work titled "Security Analysis," Graham Dodd and Cottle, who are
considered pioneers of "security analysis" as a field, emphasized "margin of
safety" as a measure of risk. They believed that security analysis: should
compute a security's "intrinsic worth," which is independent of its market
price. “The intrinsic worth of an asset would be the security analyst's own
opinion based on its earning power and financial attributes, without reference
they claim, The margin of safety was defined as the
to its market price, 0 Financial
‘Management
‘An Overview
difference between “intinsic value” and market price.” ang yy,
assessment criterion was "ihe bigger the margin of safety, the lower the Tisk
Other thon the standard deviation, IneasUrEMents Such as range, sem.
Honus and mean absolute deviation have been employed t0 assess righ
However, the standard deviation i Widely accepted since it alloys
Probability statements for a wide ange of distributions. This “total ic
decomposed into multiple components by the investment risk, which can be
done in two ways. The fist is te divide total risk into systematic and
Unsystematic risk, and the second is to divide total tisk into components, each
Of which has a causal force as ite source,
his projected rate of return the investor wout
risk factor.
Sbligations, This type of risk ig not taken into account when ¢
alculating the
paPecled or needed rate of retum by
seause it can be mitigated with a diverse
aware of the following:
1) What makes investment risky?
fi) What are the various ele
‘Ments OF sources of risk that the investments are
exposed to?
Variations in investment return ean be tributed to a variety of factor, Rach
of these sources carries a certain for Tan of danger. We have mentioned
above that there are various causes for future returns difteriny from Predicted
Tetums. Now, let us focus on understanding distinet tisk sources The
i) Market Risk
Even though the company’s earnings do not change, market prices of
‘ivestmens, patcularly equity shares, may Nuctuate in short period
ee een, ‘ne causes for this pricii *
ae) equities conahante a could be several, Investors! attitudes
a changesin farket'price ae a result of one or more factors, leading !©
the market price, This tote return on investment varies depending on
wvarietion: in. ‘return’ caused ferred to as market risk, Market risk is the
investment and arises as i" by changes in the market price of an
ca seen. "Prscoudon: a result of investors’ reactions to various key
of social, political, eco prices of equity shares are affected by variety
that influences water amie, end firm-specific events. Another aspect
oar phases 1g bull periods, while prices tend to fall during
Business cycles have been discovered to be a primary driver of the
timing and extent of bull and bear market periods. This would imply that
ik market correspond to the economy's
the ups and downs in the stoc
expansion and contraction cycles. Pessimism i triggered by a bear
‘on a large scale, Although there may be
market, and prices plummet
exceptions, empirical evidence sugees|
avoid losing money in down markets. As stated earlier, market risk can
be characterized as systematic or non-systematic. When 2 number of
systematic forces cause the majority of stocks to rise during bull
market and decrease during a bear market, it is said to be a market
ematic market risk.
stors to
ts that it is difficult for inv
situation called syst
centage of securities would be negatively
et trend. For example firms which have
been granted a valuable patent for gaining a profitable additional market
share, may sec their share prices rise despite the market's general gloom
Such unsystematic price ‘swings are diversifiable, and the securities that
are exposed to them can be managed with other shares, resulting ina
diversified portfolio.
‘As is stated earlier, a small per
associated with the current mark
ji) Interest-Rate Risk.
The interest rate influences the return on securities in a variety of ways.
Because investors always compare risk-free return with expected return
ted or required rate of return.
on investment, it has an impact on the expe:
t rate rises, the expected or needed rate of return on
When the interest
other assets rises as well. Thus, the interest rates ‘on risk-free
(government) securities and the general rate of interest are linked. The
ccurities rises or falls in tune with the risk~
rate of interest On other bond se
rest rate risk refers to the variation in return
free rate of interest. Inte!
induced by market price changes in fixed income products, such as
bonds and debentures. The price ora security (bonds and debentures) is
inversely proportional to the level of interest rates. Existing securities’
prices decline when the interest rate rises, and vice versa. Changes in
bond and debenture prices, as well
Prrerest rates have a direct impact ob
swan indirect impact on equity share values. i) Inflation Risk.
1.
f an asse'
ing power O|
i urchasing PO’ to the
Inflation risk is the variability in the total P' Thus, it refers
pected from an
investment.
sing general price level.
I arises from the rising general m of cash flows ox
unpredictability of the buying powel ion affects an k
inflation or deflation on stoc!
investment. It depicts how inflation vvell as dividend rates ral
Interest rates on bonds and debentures, as wel terms, and if the gene ‘
and preference shares, are expressed in mye sing power of cas!
mice level kes in the ture, the pure money rate of return
interesv/dividend income will certainly drop. If the pero rate of return.
is equal to the rate of inflation, the investor obtains a z: rte
spite inflation, they will be better off i
Many investors feel that, despite inflation,
market prices of their finan ets ri
they
After all, money is ine
argue. This is nothing more than a monetary delusion. ae an
example, a circumstance in which the market price of security y« 7
doubles and the overall price level quadruples. Would you consider
you to be wealthier just because your control over money has
doubled as a result of selling the security? True, you get more money
than before, but you can only buy so much with it. You cannot deny that,
as a result of a four-fold increase in pricing in general, your control over
Seods and services (which is the ultimate goal of all investment
decisions) has eroded. Thus, the
tisk of inflation originates from the
uncertainty of the purchasing power of the money to be gained from
future investments,
iv) Business Risk.
, Which
ge in goverment policy on
fertilizer subsidies, for example, could harm a group of fertilizer
companies. Similatly, a competitor's conduct, whether domestic or
foreign, might have an impact on other businesses. While
aforementioned changes in
the
the environment are the result
entities, several other elemey
Of specific
‘nts alter the operational environm,
hot be traced to a particular sources. For exam
affected by the business eye!
from one year to the next,
ent but can
ple, many businesses are
le, and their earnings fluctuate dramatically
Portfolio of assets from se:
can help to mitigate such
Portfoli
, Would be vulnerable t
sectors of the
Portfolio are affected by environmental changes.
¥) Financial Risk.
When the company capital structure includes debt,
Debt creates a fixed liability, which incrense:
financial risk occurs,
available to equity stockholders and it is not al
s the income variability
Ways a negative thing, It vi)
Profitability yw
ny cive nye the company performs well, and stock
CAUSE OF the figeq ahs Tetum than would otherwise be available
company fais 4g . ility, debt causes problems in poor times. If the
SPENE a significant tS Mbt obligations, the managers will have to
delayed payment enum OF time convincing lenders to accept a
: » Wasting valuable managerial time in the proce
he ene
an thecal Spreads negative information about the orga jon,
unable te ota iot i Plagued by problems on multiple Fronts. I may be
cant ain financing from suppliers, and some of its best
Ployees may depart. Customers will also favor organizations with
Strong financials to minimize supply disruptions. However, until the loan
'S completely secured, too much debt causes challenges for even current
debt security holders. Even in such circumstances, due to the lengthy
legal process, seizing assets and selling them to fulfill theit liabilities is
challenging,
Management Risk:
Management risk is the portion of total retum variability caused by
managerial actions in companies where the owners are not the managers.
Regardless of how experienced the Management team is, there is always
the risk of making a mistake or making the wrong decision. Owners-
investors are rightfully enraged when executives are paid large salaries
and bonuses and are given ego-boosting non-income spendings such as
fancy automobiles and lavishly equipped offices, but their poor decisions
put the company in serious trouble.
Management errors are the primary causes of the management risk
component of overall investor risk. There are so many of them that it is
difficult to keep track of them all, let alone classify them. Nonetheless,
certain potential managerial blunders can be identified. Ignoring product
obsolescence is one of the biggest mistakes that management can make.
In reality, adequate R&D expenditures must be made, and alternative
products must be promoted before the old ones’ life cycle ends. Firms
with a single product line will be more vulnerable to this risk than those
with a diverse product range.
‘A company's reliance on a single large customer also may cause this
risk, Many software firms are now dealing with this issue and are
attempting to diversify their customer base as well as their geographic
exposure. Another example of management mistakes could be how a
correct choice is handled when it is unfairly criticized and even litigated
in court. For example, a vehicle company produces a fuel-efficient tiny
car well ahead of its time. Some zealous consumer advocacy group files
‘a lawsuit because they perceive that user safety is being jeopardized. The
company then announces the product's discontinuation, leaving investors
to endure the loss of their capital as well as future revenue losses. Please
keep in mind that these examples are merely examples, and the list might
go on indefinitely
“
Risk and Return 3.4 _ TYPES OF RISK
The first three
tisk, es of tisk in investments, namely market risk, interest rate
ieee tisk, are external to the firm and therefore cannot be
si caela aa all pervasive and have an impact OH all businesses, The
business and financial cs, on the other hand, are controlled and internal to a
Corporation, Based on this analysis, the risk may be classified into
Systematic and unsystematic risk.
i) Systematic Risk.
The portion of return variability induced by factors impacting all
enterprises is referred to as systematic risk, Diversification will not be
able to mitigate such a risk. The following are some examples of
systemic risk:
> The government changes the interest rate policy.
> The corporate tax rate is increased.
> The government resorts to massive deficit financing,
> The inflation rate increased.
‘The Central Bank of the Country promulgates @ restrictive credit
policy.
> Government fails to attract FIIs.
v
ii) Unsystematic Risk.
‘The unsystematic risk is the variation in the retum of an investment
owing to factors that are specific to the firm and not to the market as a
sole. Unsystematic, or unique risk, is a type of risk that ean be
Completely mitigated through diversification. The following are some
‘examples of unsystematie risk:
v
Workers declare a strike in a company,
‘The R&D expert of the company leaves.
vv
‘A formidable competitor enters the market.
The company loses a big contract in a bid.
‘The company makes a breakthrough in process of innovation.
vvv
‘The government increases custom duty on the material used by the
company.
> The company is not able to obtain an adequate quantity of rar
material used by the company.
Total risk is equal to systematic risk + non-systematic risk because the "vo
components are additive. In most cases, systemic risk is calculated by
comparing the stock’s performance to the market's performance undet various
ene For example, if the stock appreciates more than other stocks in the
gnarket during a good period and depreciates more than other stocks in the ee Rises)
market during a poor period, the stock's systematic risk is more than the
market risk.
The market's systematic risk is one, and systematic risk of all stocks is stated
in terms of the market index's systematic risk. This is accomplished by
‘measuring a value known as beta, When stock returns are regressed on
market-index returns, the beta of the stock equals the beta of the regression
coefficient. Ifa stock's beta is 1.50, it is likely to see a price increase of 1.5
Limes as compared to market return of 1. At the same time, if the market falls
by a certain percentage in a terrible period, the stock is predicted to fall 1.5
times as much as the market.
Risk Vs. Uncertainty:
Although the terms risk and uncertainty are sometimes used interchangeably,
their perceptions differ. Risk implies that a decision-maker is aware of the
probable outcomes of a decision and its associated probabilities. Uncertainty
refers to a scenario in which the likelihood of a particular occurrence is
unknown, Investors strive to maximize Expected Returns while staying
within their risk tolerance, The degree of risk depends upon the basis of the
features of assets, investment instruments, and the mode of investment,
Causes of Risk:
Some factors, which can be stated to cause risk in the investment arena, are
given below:
> Wrong method of investment,
> Wrong period of investment,
> Wrong quantity of investment,
> Interest rate risk,
> Nature of investment instruments,
> Nature of industry,
> Nature of business in which investment is made,
> National and international factors,
> Nature calamities etc
3.5__ MEASURING HISTORICAL RETURN
The total return on investment for a given period is:
Cash Payment received Price change over
during period + the period,
Total return
Price of the investment at the beginning
The amount received throughout the period could be positive or negative
The difference between the ending price and the initial price is the rupee
price change over time, This might be positive (the ending price is higher
47 Fanagement -
An Overview
48
than the beginning price), zero (the ending price 'S the same as the beginning
price), or negative (the ending price is lower than the beginning price).
C#(Pe-Pa)
R
Pa
total return over the period
C= cash payment received during the period
Py
Py= beginning price
riding price of the investment
formation for an equity stock:
0.00
To illustrate, consider the following 1"!
Prive atthe beginning of the year: RS.7|
> Dividend paid at the end of this years Rs.5.00
> Price at the end of the year: Rs.80.00
“The total return on this stock is ealeulated as follows:
5.00 + (80-70)
= = 0.214 oF 21.4%
70
3.6 _ MEASURING HISTORICAL RISK
Risle refers to the possibility that the actual outcome of an investment will
differ from the expected outcome. Alternatively, risk refers to variability or
dispersion. If an asset’s return has no variability, itis riskless. Suppose You
arevalyeing the total return of an equity stock aver some time, Apart from
Knowing the mean return, you would also like to know about the variability
in returns.
Variance and Standard Deviation:
‘The most commonly used measures of risk in finance are the Variance or its
square root; the Standard Deviation. The variance and the stancdarc deviation
of a historical risk are defined as follows:
Standard deviation = WVartence
a
o
ile-a)
nal
o
Where, o?= Variance of Return
y= return from the stock in peri
oom tock in petiod I 1,....4n)
rate of return or me:
n= number of periods mean of the returns
= standard deviation
‘To illustrate, consider initial rate of re
stock over 6 years period are: return is 16% and the returns from a Ri=16%, R=12%, R: 10%, Ry = -13%, Rs =15%, Re = 10%
The variance and Standard deviation of returns are calculated as below:
Period Retum Deviation Square of deviation
RR R_RY
! 16 16-10= 6 36
2 12 12-10= 2 4
3 2 20-10= 10 100
4 “13 713-10= 23 529
5 15 15-10=5 25
6
10 10-10=0 0
By a h38.8
6-1
= V138.8 = 11.78
Variance = 138.8 and Standard deviation = i388 = 11.78
Looking at the above calculations, we find that:
expressed in the same units, allowing them to be compared directly,
3.7 MEASURING EXPECTED RETURN AND
RISK
We have just looked at historical (ex facto) return and risk so far. Now we
will discuss the predicted (ex-ante) return and risk
i) Probability Distribution:
When you buy a stock, you understand that the return on your investment
might be anything, For example, it could be 59%, 15%, or even 35%.
Furthermore, the probability of these possible retums vatiee Asa result, you
should consider probability distributions,
The likelihood of an event's occurrence is represented by its probability,
Assume there is 80% possibility that the market price of stock A wil climb in
the following two weeks. This means that there is 80% likelihood that the
Price of stock A will raise in the next two weeks, and a 20% chnge that it
will remain unchanged. 50
Outcome
Probability,
Stock price will rise 0.80
Stock price will not rise 0.20
Another illustration of the concept of probability distribution could be
presented.
Consider the stock of Bharat Foods and the stock of Oriental Shipping. Based
on the status of the economy, Bharat Foods stock could produce a return of
16%, 11%, oF 06%, with certain probability associated with each Based on
the status of the economy, the second stock, Oriental Shipping stock, which
js more volatile, might achieve a return of 40%, 10%, oF -20% with the same
‘odds, The following Exhibit shows the probability distributions of the returns
for these two stocks:
State of
Economy
Probability of Rate of Return (%)
‘Occurrence Bharat Foods] Oriental
Shipping
16 40,
i
06
Recession
You can compute two crucial parameters, the expected rate of retum and the
standard deviation of the rate ‘of return, using the probability distribution of
the rate of retu™.
Expected Rate of Return:
‘The expected rate of revurn is he weighted average of all possible Feu
multiplied by their respective probabilities. In symbols
E(R)= SRR
Where,
(R)
