Risk and Return-gv

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Risk and Return

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Risk in holding securities is generally associated with possibility that

realized returns will be less than the expected returns.OR

Risk can be defined as the probability that the expected return from the

security will not materialize.

Every investment involves uncertainties that make future investmentreturns risk-prone. Risk could be categorized depending on whether it

affects the market as whole, or just a particular industry.

Types of Investment Risk

Systematic Risk

Unsystematic Risk

Risk is the potential for variability in returns. Total variability in returns of

a security represents the total risk of that security.

Total Risk = Systematic Risk + Unsystematic Risk

RISK


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Risk Classification

Total Risk

SystematicRisk

Market RiskInterest Rate

RiskPurchasingPower Risk

UnsystematicRisk

BusinessRisk

FinancialRisk


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Systematic risk refers to that portion of total

variability in return caused by factors affecting the

prices of all securities. Economic, political, and social

changes are sources of systematic risk.

Systematic Risk is further subdivided into:

Market Risk (variation in returns caused by the volatility of

stock market)

Interest Rate Risk (Variation in bond prices due to change

in interest rate)

Purchasing Power Risk (Inflation results in lowering of

the purchasing power of money)

Systematic Risk


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Unsystematic risk is the portion oftotal risks that is unique to a firm

or industry. Factors such as management capability, consumer

preferences, raw material scarcity and labour strikes cause

unsystematic variability of returns in a firm. Unsystematic factors are

largely independent of factors affecting securities markets in general.Unsystematic Risk is further subdivided into:

(Operating Environment, and Financing Pattern)

Business Risk (Variability in Operation Income caused by

Operating Conditions)

Financial Risk (Variability in EPS due to the presence of

debt in Capital Structure)

Unsystematic Risk


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Risk and Expected Return

The risk involved in investment depends on various factors such as:

i) The length of the maturity period - longer maturity periods impart

greater risk to investments.

ii) The credit-worthiness of the issuer of securities - the ability of the

borrower to make periodical interest payments and pay back the

principal amount will impart safety to the investment and this reduces

risk.

iii) The nature of the instrument or security also determines the risk.

Generally, government securities and fixed deposits with banks

tend to be riskless or least risky; corporate debt instruments like

debentures tend to be riskier than government bonds and ownership

instruments like equity shares tend to be the riskiest. The relative

ranking of instruments by risk is once again connected to the safety of

the investment.


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iv) Equity shares are considered to be the most risky

investment on account of the variability of the rates of

returns and also because the residual risk of bankruptcy

has to be borne by the equity holders.

v) The liquidity of an investment also determines the risk

involved in that investment. Liquidity of an asset refers to

its quick salability without a loss or with a minimum of

loss.

vi) In addition to the aforesaid factors, there are also various

others such as the economic, industry and firm specific

factors that affect the risk an investment.


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Sources of Risk

Business Risk The risk that the companys profit margin may be lower than expected

due to inefficient management, bad trading policies and changes affecting

that industry

Financial Risk

The risk of partial or complete loss of invested capital in the event of thefailure of a company or scheme due to an unsound financial structure

Market Risk/Volatility

It is caused by market cycles and movements in the market.

It can mean the value of capital can vary, both positively and negatively.

These variations can be daily or less frequently They can vary significantly or not much at all

They can be sudden and unexpected or it can be slow and predicted


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Sources of Risk(Contd)

Market Timing Risk Economists often use economic cycles

To try and predict when a market will rise or fall

However, this is extremely difficult, as economic cycles are never exactly

the same with the same timing

Economic Risk Risk relating to changes in inflation rates, interest rates, etc..

Political Risk

Changes in government and government policies

Interest rate risk

Some investors attempt to avoid volatility by investing in fixed rateinvestments.

Than they face the risk that when the investment matures the money

may have to be reinvested and interest rates could be significantly lower

Thus , relying on interest as income - this income could dramatically

decrease


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Sources of Risk(Contd) Credit Risk

When money is places with banks and companies through term deposits

and debentures they use it in their businesses and pay an interest rate for

doing so.

The risk here is the financial ability of those institutions to be able to

pay the interest and/or repay the capital on the due date Mismatch risk

This risk means that although a chosen investment may be considered

a good investment for certain investors, it may be a poor one if it does

not suit the needs and circumstances of the investor.

Inflation risk

Whether inflation is high or low , the cost of goods has always increased

over time.

If the chosen investment does not at least grow at the same rate then the

real purchasing power of the money is being eroded.


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Sources of Risk(Contd)

Liquidity Risk

Considerable problems can occur if money is required for

unexpected expenses and the investments cannot be turned

into cash quickly or without costs

Legislative Risk Long-term investment strategies can be selected based on current

tax laws and regulations.

If these should be changed later then the result required could be

badly affected.

Risk of not diversifying

Diversifying investment means spreading the capital across various

areas


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Unsystemat ic Risk

Volatility may be described as the range of

movement (or price fluctuation) from the expected level of

return. The variance and standard deviation measure

the extent of variability of possible returns from expected

return.

Measurement of Risk


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Systematic Risk

Beta is a measure of the systematic risk of a security that cannot be

avoided through diversification.

Correlat ion Method

i = rimi * m / 2m

Regressio n Method

= n XY- (X) * (Y) / {nX2(X)2}

Ri = + * Rm

Measurement of Risk


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Returns Return is a reward for and a motivating force behind

in investment, the objective of which is usually to

maximize return. The return from the stock

includes both current income and capital gain

caused by the appreciation of the price. Theincome and capital gain are expressed as a percentage

of money invested in the beginning.

Realized return: (History) The Return that was

earned

Expected return: (Future/Predicted) The Return

from an asset that investors expect they will earn

over some future period


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Elements in return

Return on typical investment consist of twocomponents

1. Basic Component:

Periodic cash receipts on investment Either in form of interest or dividend

Yield refers to the income component in

relation to some price for security2. Change in the price of the asset

Capital gain/loss


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Factors Determinants of return:

The time preference risk- free real rate. The expected rate of inflation

The risk associated with the investment,

which is unique to the investor.

Components of return

Yield: the interest or dividend received is called

yield.

Capital appreciation: the difference between the

sale price and the purchased price is the capital

appreciation


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Return Measurement

Total Return = Cash payment Received+

Price Change Over the Period

Purchase Price of Assets

Total return for a given holding period

relates all the cash flows received by an

investor during any designated time period

to the amount of money invested in theasset.

Risk and Return-gv

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