Risk

concepts and analysis

Risk
Risk refers to the loss of principal amount of an
investment.
The risk depends on the following factors:
The longer the maturity period, the larger is the risk.
The lower the credit worthiness of the borrower, the
higher is the risk.
The risk varies with the nature of investment.
Investments in ownership securities like equity shares
carry higher risk compared to investments in debt
instruments like debentures and bonds.
The tax provisions would influence the return of risk.
Return
All investments are characterized by the
expectation of a return.
Return = Income (Yield) + Capital Appreciation
Capital appreciation = Sales Price – Purchase Price
The dividend or interest from the investment is the
yield.
Different types of investments promise different
rates of return. The expectation of return from an
investment depends upon the nature of
investment, maturity period, market demand, and
so on.
• Eg:
Let dividend on a share = Rs 25
Face value = Rs 100
Purchase price = Rs 150
Return = 25/150 i.e., 16.6%
Suppose, there is capital appreciation in a year, on purchase price of
Rs 150 = Rs 10, then
Total return = (25 + 10)/150 i.e., 23.3% per annum
Measuring Risk
What is Risk?

Risk is the variability between the expected and actual returns.

An investment whose returns are fairly stable is considered to be a

low-risk investment, whereas an investment whose returns fluctuate
significantly is considered to be a high-risk investment.
Risk and uncertainty
• Risk suggests that the decision-maker knows what there is some
possible consequence of an investment decision.
• Uncertainty involves a situation, where the outcome is not known to
the decision-maker.
• But basically, whether the outcome is known or not, the investments
involve both risk and uncertainty.
What causes the risks?
1) Wrong decision of what to invest in
2) Wrong timing of investments
3) Nature of the instruments invested
4) Creditworthiness of the issuer
5) Maturity period or the length of investment
6) Amount of investment
7) Methods of investment, namely, secured by collateral
or not
8) Terms of lending such as periodicity of servicing,
redemption periods, etc.
9) Nature of the industry or business in which the
company is operating.
10) National and international factors, acts of god, etc.
Risk
Illustrated

The range of total possible returns on

the stock A runs from –30% to more
Probability
than +40%. If the required return on
the stock is 10%, then those outcomes
less than 10% represent risk to the
Outcomes that produce harm

Risk, Return and Portfolio Theory

investor.

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
Differences in Levels of Risk
Illustrated

Outcomes that produce harm The wider the range of probable

outcomes the greater the risk of the
Probability
investment.
B A is a much riskier investment than B

Risk, Return and Portfolio Theory

A

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
Elements of risk
• The total variability in returns of a security represents the total risk of
that security. Systematic risk and unsystematic risk are the two
components of total risk. Thus
Total risk = Systematic risk + Unsystematic risk
Systematic risk
The portion of the variability of return of a security that is caused by
external factors, is called systematic risk.
It is also known as market risk or non-diversifiable risk.
Systematic risks are out of external and uncontrollable factors, arising
out of the market, nature of the industry and the state of the
economy and a host of other factors.
Economic and political instability, economic recession, macro policy
of the government, etc. affect the price of all shares systematically.
Thus the variation of return in shares, which is caused by these
factors, is called systematic risk.
Types of systematic risks
Interest Rate Risk
• Interest-rate risk arises due to variability in the
interest rates from time to time. It particularly
affects debt securities as they carry the fixed rate
of interest.
• It is the risk that an investment’s value will change
as a result of change in interest rates. This risk
affects the value of bonds more directly than
stocks.
• It particularly affect securities like bonds and
debentures.
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.
• Market Risk refers to the variability in returns
resulting from fluctuations in the overall market
conditions.
• 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.
Purchasing power 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.
• It refers to the variation in investor returns caused
by inflation.
E.g.
• Suppose a person lends Rs 100 today at 10%
interest. He would get back Rs 110 after one year. If
during the year, the prices have increased by 8%, Rs
110 received at the end of the year will have a
purchasing power of only Rs. 101.20, i.e. 92% of 110
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.
• The return from a security sometimes varies because
of certain factors affecting only the company issuing
such security. Examples are raw material scarcity,
Labour strike, management efficiency etc.
• When variability of returns occurs because of such
firm-specific factors, it is known as unsystematic risk.
Business risk
• It is a function of the operating conditions faced
by a company and is the variability in operating
income caused by the operating conditions of the
company.
• 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.
• Every company’s operating environment comprises of both
internal and external environment. The impact of these operating
conditions is reflected in the operating costs of the company.
• The operating costs may be fixed costs and variable costs.
Financial 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:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and
surplus.
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.
 Other Risks
Liquidity Risk
 An investment that can be bought or sold quickly without
significant price concession is considered liquid.
The more uncertainty about time element and the price
concession, the greater the liquidity risk.
Foreign Exchange Risk
 When investing in foreign countries one must consider the fact
that currency exchange rates can change the price of the asset as
well. This risk applies to all financial instruments that are in a
currency other than your domestic currency.
Country Risk
 This is also termed political risk, because it is the risk of investing
funds in another country whereby a major change in the political
or economic environment could occur. This could devalue your
investment and reduce its overall return. This type of risk is usually
restricted to emerging or developing countries that do not have
stable economic or political arenas.
 The investor can
only reduce the
“unsystematic
risk” by means
of a diversified
portfolio.
 The “systematic
risk” cannot be
avoided.

 Since the investor takes systematic risk, therefore he should

be compensated for it.z
 Return/Compensation depends on level of risk To measure
the risk, we use the Capital Asset Pricing Model.
What Is Financial Risk?
• The possibility of losing money in a business venture or investment is
referred to as financial risk. In other words, financial risk is a danger
that can translate into the loss of capital.
• In case of a financial risk, there is a possibility that a company’s cash
flow might prove insufficient to satisfy its obligations.
Types of Financial Risks
• Financial risk is caused due to market movements and market
movements can include a host of factors.
• Based on this, financial risk can be classified into various types such as
 Market Risk,
 Credit Risk,
 Liquidity Risk,
 Operational Risk, and
 Legal Risk.
Contd.
• Market Risk:
• This type of risk arises due to the movement in prices of financial instrument.
• Market risk can be classified as Directional Risk and Non-Directional Risk.
• Directional risk is caused due to movement in stock price, interest rates and
more. Non-Directional risk, on the other hand, can be volatility risks.
• Credit Risk:
• This type of risk arises when one fails to fulfill their obligations towards their
counterparties.
• Credit risk can be classified into Sovereign Risk and Settlement Risk.
• Sovereign risk usually arises due to difficult foreign exchange policies. Settlement
risk, on the other hand, arises when one party makes the payment while the
other party fails to fulfill the obligations.
Contd.
• Liquidity Risk:
• This type of risk arises out of an inability to execute transactions.
• Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk.
• Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers against sell
orders and buys orders respectively.
• Operational Risk:
• This type of risk arises out of operational failures such as mismanagement or technical failures.
• Operational risk can be classified into Fraud Risk and Model Risk.
• Fraud risk arises due to the lack of controls and Model risk arises due to incorrect model
application.
• Legal Risk:
• This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company
needs to face financial losses out of legal proceedings, it is a legal risk.
Managing Financial Risk
• Some commonly used methods to analyze financial risks associated
with long-term investments are as follows:
• Fundamental analysis: Measures a security’s intrinsic value. It
evaluates all aspects of the underlying business, such as the firm’s
earnings and assets.
• Technical analysis: Evaluates securities via statistics. It considers
historical returns, share prices, trade volumes, and other
performance data.
• Quantitative analysis: Evaluates a company’s historical
performance using specific financial ratio calculations.
• Statistical and numerical analysis: Identifies potential risks using
statistical methods.
What Is Risk Management?
• Risk management is the process of identification, analysis, and
acceptance or mitigation of uncertainty in investment decisions.
• Risk is inseparable from return in the investment world.
• A variety of tactics exist to ascertain risk; one of the most common is
standard deviation, a statistical measure of dispersion around a central
tendency.
• Beta, also known as market risk, is a measure of the volatility, or
systematic risk, of an individual stock in comparison to the entire market.
• Alpha is a measure of excess return; money managers who employ active
strategies to beat the market are subject to alpha risk.
Need for Risk Management Process
• Improve all resource planning by predicting future costs
• Improve how companies track project costs
• Improve the accuracy of estimates of ROI
• A more flexible response to all future challenges
Identifying the Risk
• The first step in a successful risk management process is to identify
the type of risk the organization is currently dealing with or could deal
with in the future.
• These risks can be noted down manually but if there is a risk
management platform implemented in the organization, the risk
identification process becomes a lot simpler.
• The gathered information is directly inserted into the system.
Analyzing the Risk
• The risk analysis should answer the following questions:
• What is the likelihood of these risks occurring?
• What will be the consequences of these risks to the organization?
• During the risk analysis process, teams estimate the probability of each
risk occurring and its fallout to prioritize the identified risks.
• The factors that companies consider when prioritizing the risks include:
• Potential financial loss
• Time lost
• The severity of the impact
• Availability of resources to manage the risk
Evaluating the Risk
• After completing a thorough analysis of risks, they need to be ranked
in order of severity and then prioritized.
• When organizations use risk management platforms, they can help in
identifying different workable solutions for each risk that the
enterprise could face. This way all the projects in the organization and
processes can go on uninterrupted and without any delay.
Treating the Risk
• One aspect of effectively treating the risk is the efficient usage of
resources without losing the progress made in the active projects.
• Some of the common ways of mitigating risk include:
• Accepting the risk of the project, which means understanding the risk it poses
but realizing that the benefits outweigh the negative outcomes of the risk
• Avoiding the risk in the project, where team members simply do not
participate in an activity that could lead to potential risk
• Controlling the risk, where team members mitigate the risk by reducing the
likelihood of its occurrence to reduce the impact beforehand
• Transferring the risk, where organizations get a third party involved (such as
insurance) to take responsibility for the risk in case it occurs
Monitoring and Reviewing the Risk
• Organizations will notice over time that there will be some risks that
cannot be eliminated and will be omnipresent. These continuous risks
can include external risks such as market risks and environmental risks.
They need to be continuously monitored to make the mitigation process
more effective.

• When companies employ risk management solutions, the system

becomes responsible for monitoring the organization’s complete risk
framework. If there is any change, all relevant parties get notified
immediately. This also ensures continuity. When employees are
properly trained in the processes, they can use the system efficiently.
Risk management strategies
• There are four main risk management strategies
1. Risk acceptance, in which executives decide to accept a risk without taking
any actions to mitigate them;
2. Risk avoidance, in which the organization seeks to eliminate the potential
risk and the potential for damages and financial consequences of a
threatening event;
3. Risk reduction, in which the organization puts in policies and procedures
aimed at limiting a risk from harming the enterprise and/or limiting the
harm done by the risk; and
4. Risk transfer, in which the organization contracts with a third party that
assumes the risk and its consequences on behalf of the enterprise.
Risk Avoidance
• Risk avoidance deals with eliminating any exposure to risk that poses
a potential loss.
• Risk avoidance is not performing any activity that may carry risk.
• A risk avoidance methodology attempts to minimize vulnerabilities
that can pose a threat.
• Risk avoidance and mitigation can be achieved through policy and
procedure, training and education, and technology implementations.
Risk Reduction
• Risk reduction deals with reducing the likelihood and severity of a
possible loss.
• Risk reduction deals with mitigating potential losses through more of
a staggered approach.
Risk Avoidance vs. Risk Reduction

Risk Avoidance Risk Reduction

• Safely guarantees that returns • Seeks a "best of both worlds"
will not be lost or jeopardized approach to mitigating risk, while
exposing yourself to potentially high
• Closes the door on opportunities returns
for future gains, especially
• Can be riskier financially, if risks
potentially higher returns on come to fruition
investment
• Requires a more complex approach
• Simple way to focus on steady to investing, including full
streams of income understanding of your liabilities
Risk Management Information System
(RMIS)
• A Risk Management Information System (RMIS) is an integrated
computer information system used to aggregate risk data and to help
decision makers evaluate business risks.
• This information includes risk exposure, protection measures and risk
management.
• Like other computerized information systems, a RMIS SYSTEM is easy
to access from different locations and on different devices. It is
flexible and agile, able to allow for the changing needs of a modern
workplace. At the same time, it is tailored to support your business’
risk concerns, exposures, protection measures and risk management.
Why do organizations invest in a RMIS?
• Some of the most important reasons to consider investing in a RMIS include:
• Expanding responsibilities. Risk managers no longer play a supporting role on the finance team. Today, they are
valued C-level executives, responsible for presenting to boards and other stakeholders on a regular basis. Their
ability to access and manage the data is directly tied to their success in speeding up processes and assisting in
decision making.

• Stricter governance regulations and more insecurity. Today’s world is litigious and uncertain. The cost of
mistakes grows higher in an unsteady economy with a growing population and number of natural disasters.
There’s more at risk.
• Brand reputation. With a global economy and easy access to social media, every organization’s reputation is on
the line every minute of the day. An organization’s ability to manage its reputation – and potential damage to
that reputation – is also a marker of its success.

• More data than ever before. Information is all around, and therefore, aggregating risk data has become more
important than ever. It is nearly impossible to manage all the information efficiently via disjointed spreadsheets
anymore. Through the use of technology, however, the information becomes not only manageable but useful.
Measuring Risk
Ex post Standard Deviation

n _

 i
( r  r ) 2

[8-7] Ex post   i 1

n1

Variance = (σ 2)

Where :
  the standard deviation
_
r  the average return
ri  the return in year i
n  the number of observatio ns

Risk, Return and Portfolio Theory

Criticism of variance (and standard deviation)
as a measure of risk
Variance considers all deviations, negative as well as
positive. Investors, however, do not view positive
deviations unfavourably – in fact, they welcome it.
Hence some researchers have argued that only
negative deviations should be considered while
measuring risk. Markowitz, recognised this limitation
and suggested a measure of downside risk called
semi-variance and it considers only negative
deviations.
When the probability distribution is not symmetrical
around its expected value, variance alone does not
suffice. In addition to variance, the skewness of the
distribution should also be used. Markowitz does not
consider skewness in developing portfolio theory.
 Coefficient of Variation

The ratio of the standard deviation of a distribution to the

mean of that distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
Determining Standard
Deviation (Risk Measure)

n
s = S ( Ri - R )2
i=1
(n)

Note, this is for a continuous distribution

where the distribution is for a population.
R represents the population mean in this
example.
Example: Variance and Standard Deviation
of an Investment
 Given the following data for Newco's stock, calculate the stock's variance and standard
deviation.
Expected
Scenario Probability Return
Return
Worst Case 10% 10% 0.01
Base Case 80% 14% 0.112
Best Case 10% 18% 0.018

Answer:
σ2 = (0.10)(0.10 - 0.14)2 + (0.80)(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2 = 0.0003

The variance for Newco's stock is 0.0003.

Measurement of Systematic Risk
• Systematic risk is the variability in security returns caused by changes
in the economy or the market.
• 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 (β).
• 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, viz,
• Correlation method
• Regression method
Calculation of β by using Correlation Method
• β can be calculated from the historical data of returns by the following
formula:

• Where
rim = Correlation coefficient between the returns of stock i and the
returns of the market index.
σi = Standard deviation of returns of stock i.
σm= Standard deviation of returns of the market index.
σ2m = Variance of the market returns
Calculation of β by using Regression Method
• This model postulates a linear relationship between a dependent
variable and an independent variable.
• The model helps to calculate the values of two constants, namely 
and β.
• β measures the change in the dependent variable in response to unit
change in the independent variable, while  measures the value of the
dependent variable even when the independent variable has zero value.
The form of the regression equation is as follows:
Y =  + βX
Where
Y = Dependent variable
X = Independent variable
 and β are constants.
• The formula used for the calculation of  and β are given below

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 return of the individual security is
taken as the dependent variable, and the return of the market index is
taken as the independent variable.
• The regression equation is represented as follows:

Where
Ri = Return of the individual security
Rm = Return of the market index
 = Estimated return of the security when the market is stationary
βi = 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.