RISK AND RETURN ANALYSIS

RISK: DICTIONARY MEANING OF RISK IS THE POSSIBILITY OF LOSS OR INJURY, THE DEGREE AND PROBABILITY OF SUCH LOSS.

1. SYSTEMATIC RISKS- UNAVOIDABLE RISKS LIKE POLITICAL UNCERTAINTY, GLOBAL DEPRESSION, WAR, EARTHQUAKE (WHICH AFFECTS THE WHOLE MARKET)

2. UNSYSTEMATIC RISKS- RELATED TO SOME FIRM OR INDUSTRY

UNSYSTEMATIC RISK CAN BE CATEGORISED INTO BUSINESS RISKS AND FINANCIAL RISKS.

BUSINESS R ISK

A. MANAGERIAL INEFFICIENCYB. TECHNOLOGICAL CHANGE IN

PRODUCTION PROCESSC. AVAILABILITY OF RAW MATERIALSD. CHANGE IN CONSUMER PREFERENCEE.LABOUR PROBLEMS

FINANCIAL RISK

A. DEBT EQUITY MIX

RISK MEASUREMENT

IT IS THE EXPRESSION OF RISK IN QUANTITATIVE TERMS

1. STANDARD DEVIATION METHOD-EXAMPLE

2. CHARACTERISTIC REGRESSION LINE-EXAMPLE

3. CORRELATION METHOD-EXAMPLE

BOND VALUATION

A BOND IS A CONTRACT THAT REQUIRES THE BORROWER TO PAY the INTEREST INCOME TO THE LENDER. IT RESEMBLES THE PROMISSORY NOTE AND ISSUED BY GOVERNMENT AND COROPORATE.

THE PAR VALUE OF THE BOND INDICATES THE FACE VALUE OF BOND I.E THE VALUE STATED ON THE BOND PAPER.

GENERALLY THE FACE VALUE OF THE BOND IS IN RS 1000,2000,5000 ETC.

MOST OF THE BONDS MAKE FIXED INTEREST PAYMENT TILL MATURITY PERIOD.

THE SPECIFIC RATE OF INTEEREST IS KNOWN AS COUPON RATE.

IN USA, BONDS ARE SECURED BY TANGIBLE PHYSICAL ASSETS OF THE COMPANY AND DEBENTURES ARE SECURED ONLY BY CREDITWORTHINESS OF THE COMPANY.

BUT IN INDIA AND UK NO SUCH DISCUSSION IS MADE AND THEY ARE USED INTERCHANGEABLY.

TYPES OF DEBENTURES AND BONDS

1. SIMPLE, NAKED OR UNSECURED DEBENTURESTHESE DEBENTURES ARE NOT GIVEN ANY SECURITY ON ASSETS. THEY HAVE TO NO PRIORITY AS COMPARED TO OTHER CREDITORS. THEY ARE TREATED ALONG

WITH UNSECURED CREDITORS AT THE TIME OF WINDING UP OF COMPANY

2. SECURED OR MORTGAGED DEBENTURESTHESE DEBENTURTES ARE GIVEN SECURITY ON ASSETS OF THE COMPANY

3. BEARER DEBENTURES:THESE DEBENTURES ARE EASILY TRANSFERABLE. THEY ARE JUST LIKE NEGOTIABLE INSTRUMENTS.

4. REGISTERED DEBENTURES:REQUIREMENT OF FOLLOW UP OF PROCEDURE FOR TRANSFER

5. REDEEMABLE DEBENTURES

6. IRREDEEMABLE DEBENTURES7. CONVERTIBLE DEBENTURES8. ZERO INTEREST BONDS/DEBENTURES:

RECENTLY INTRODUCED CONVERTIBLE DEBENTURE WHICH

YIELDS NO INTEREST. THE INVESTOR IN A ZERO INTEREST

BOND IS COMPENSATED FOR THE LOSS OF INTEREST THROUGH CONVERSION OF SUCH BOND INTO EQUITY SHARES.

9. DEEP DISCOUNT BONDS:THESE BONDS DOESN’T CARRY ANY INTEREST BUT IT IS SOLD BY THE ISSUER COMPANY AT A DEEP DISCOUNT FROM ITS EVENTUAL MATURITY VALUE.

FEATURES: FIXED RATE OF INTEREST FIXED MATURITY INCOME CERTAINTY LOW RISK OF CAPITAL CLAIMS ON INCOME CONTROL CALL OPTION( WHEN MARKET RATE

IS LOWER THAN INTEREST ON DEBENTURE)

BOND RISKS

INTEREST RATE RISK:

VARIABILITY IN THE RETURN FROM THE DEBT INSTRUMENTS TO INVESTORS IS CAUSED BY THE CHANGES IN THE MARKET INTEREST RATE.

PRICE OF BOND IS INVERSLY PROPORTIONAL TO MARKET INTEREST RATE.

E.G FOR A 14.5% BOND, IF THE MARKET INTEREST RATE FALLS FROM 14 % TO 13%, BOND VALUE WILL BE HIGHER.

DEFAULT RISK:

THE FAILURE TO PAY THE AGREED VALUE OF THE DEBT INSTRUMENTS BY THE ISSUER IN FULL OR ON TIME.

MARKETABILITY RISK:

VARIABILITY IN RETURN CAUSED BY DIFFICULTY IN SELLING THE BONDS QUICKLY WITHOUT MAKING ANY SUBSTANTIAL PRICE CONCESSIONS. THE MARKETABILITY OR

LIQUIDITY OF THE PARTICULAR BOND DEPENDS ON THE CORPORATE WHO ISSUES THE BOND.

CALLABILITY RISK:

THE UNCERTAINTY CREATED IN THE INVESTORS RETURN BY THE ISSUERS ABILITY TO CALL THE BOND. IF CALL OPTION IS THERE.

BOND RETURN

HOLDING PERIOD RETURN:

AN INVETSOR BUYS A BOND AND SELLS IT AFTER HOLDING FOR A PERIOD. THE RATE OF RETURN IN THAT HOLDING PERIOD IS:

HPR= PRICE GAIN/LOSS DURING HOLDING PERIOD+COUPON INT RATE IF ANY(PAYMENT)/PRICE AT THE BEGINNING OF THE HOLDING PERIOD

CALLED AS ONE PERIOD RATE OF RETURN IF THE FALL IN THE BOND PRICE IS GREATER THAN

COUPON PAYMENT, HPR WILL BE NEGATIVE.

EXAMPLE

CURRENT YIELD:

IT IS THE COUPON PAYMENT AS A PERCENTAGE OF CURRENT MARKET PRICE

CURRENT YIELD=ANNUAL COUPON PAYMENT/CURRENT MARKET PRICE

BY THIS MEASURE INVESTORS CAN FIND OUT THE RATE OF CASH FLOW WHICH THEY ARE GETTING BECAUSE OF INCREASE/DECREASE IN MARKET PRICE.

DIFFERENT FROM COUPON RATE COUPON RATE IS BASED ON FACE VALUE CY IS BASED ON MARKET PRICE

YIELD TO MATURITY(YTM)

MOST WIDELY TOOL IN BOND INVESTMENT MANAGEMENT

YTM IS THE SINGLE DISCOUNT FACTOR THAT MAKES PRESENT VALUE OF FUTURE CASH FLOWS FROM A BOND IS EQUAL TO THE CURRENT PRICE OF THE BOND

BASICALLY YTM IS THE RATE OF RETURN WHICH AN INVESTOR CAN EXPECT TO EARN IF THE BOND IS HELD TILL MATURITY.

BASED ON PRESENT VALUE CONCEPT

EXAMPLES

ASSUMPTIONS:

1. THERE SHOULD NOT BE ANY DEFAULT COUPON AND PRINCIPAL AMOUNT SHOULD BE PAID AS PER SCHEDULE

2. THE INVESTOR HAS TO HOLD THE BOND TILL MATURITY

3. ALL THE COUPON PAYMENTS SHOULD BE REINVESTED IMMEDIATELY AT THE SAME INTEREST RATE AT THE SAME YIELD TO MATURITY OF THE BOND

BOND VALUE THEORMSVALUE OF BONS DEPENDS UPON THREE FACTORS NAMELY:1. COUPON RATE2. YEARS TO MATURITY3. EXPECTED YIELD TO MATURITY

ON THE BASIS OF THIS CERTAIN THEORMS HAVE BEEN PROPOUNDED:

THEOREM 1

IF THE MARKET PRICE OR SELLING PRICE OF THE BOND INCREASES, THE YIELD WOULD DECLINE AND VICE VERSA

EXAMPLE

THEOREM 2

IF THE BOND YIELD REMAINS THE SAME OVER ITS LIFE, THE DISCOUNT OR PREMIUM DEPENDS UPON MATURITY PERIOD

EXAMPLE

THEOREM 3

BOND PRICE IS INVERSLY PROPORTIONAL TO YIELD. THIS RELATION IS NOT LINEAR ALSO.

A RAISE IN THE BOND’S PRICE FOR A DECLINE IN BOND’S YIELD IS GREATER THAN THE FALL IN THE BOND’S PRICE FOR A RAISE IN YIELD

EXAMPLE

THEOREM 4

THE CHANGE IN PRICE WILL BE LESSER FOR A PERCENTAGE CHANGE IN BOND’S YIELD IF ITS COUPON RATE IS HIGHER.