Security Analysis and Portfolio Management - Lesson 5 - Risk Management, Concept, Sources & Types of...

7/29/2019 Security Analysis and Portfolio Management - Lesson 5 - Risk Management, Concept, Sources & Types of Risk

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Copy Right: Rai University

11.621.3 25

the current holder market down t he price. As the rate on

USGs advances, they become relatively more attractive and other

securities become less attractive. Consequently, bo nd purchasers

will buy governments instead of corporates. This will cause the

price of corporates to fall and th e rate on corp orates to rise.

Rising corp orate b ond rates will evnetually cause preferred- and

common -stock prices to adjust down woard as the chain

reaction is felt through out the system of security yields. (The

exact nature and extent of t his mark down process and th e

relationsh ips between rates, prices, and m aturity will be

exploraed in Chaper 9.)

Thus, a rational, highly interconnected structure o f security

yeilds exists. Shifts in the pure cost of money will ripple

through the structure. the d irect effect on increases in thelevel ofinterest rates is to cause security prices to fall across a wide span

of investment vehicles. similarly, falling interest rates precipitate

prices markups on outstanding securities.

In addition to thedirect, systematic effect on bonds, there are

indirect effects on com mon stocks. First, lower or higher

interest rates make the purchase of stocks on margin (using

borrowed funds) more or less attractive. Higher interest rates,for example, may lead to lower p rices because of a diminished

demand fo r equities by speculators who use margin. Eb ulient

stock markets are at times pr opelled to som e excesses by marginbuying when interest rates are relatively low.

Second, many firms suchas pub lic utilities finance th eir opera-

tions quite heavily with borrowed funds. Others, suchasfinancial institutions, are p rincipally in the b usiness of lend ing

money. As interest rates advance, firms with heavy doses of

borrowed capital find that more of their income goes toward

paying interest on borrowed money. This may lead to lower

earnings, dividends, and share prices. Advancing interest rates

can bring higher earnings to lending institutions whose

principal revenue sources is interest received on loans. Fo r these

firms, higher earnings could lead to increased dividends and

stock prices.

Purcha sing-Pow er Risk

Market risk and interest-rate risk can be definded in terms of

uncertainties as to the amount of current dollars to be received

by an investor. Purchasing-power risk is the uncertainityof the

purchasing power of the amo unts to be received. In more

everyday terms, purchasing-power risk refers to th e impact of

inclation or d eflation on an investment.

If we think of investment as thepostpo nement of consump -

tion, we can see that when a person purchses a stock, he has

foregone the opp portunity to buy some good or service for as

long as he owns th e stock. If, during the ho lding period, good

or services rise, the investor actually loses pu rchasing power.

Rising prices on goods and services are no rmally associated withwhat is referred to as inflation. Falling prices on goo ds and

services are term ed deflation. Both inflation an d deflation are

covered in the all-encom passing term purch asing power risk.

G enerally, purchasing-power risk has come t o be ident ified with

inflation (rising prices); the incidence of declining prices in mostcountries has been slight.

Rational investors should include in their estimate of expectedreturn an allowance for purchasing-power risk, in the form of

an expected annual percentage change in prices. If a cost-of-

living index begins the year at 100 and ends at 103, we say that

therate o f increase (inflation) is 3 percent [(1030100)/ 100]. If

from the second to thethird year, the index changes from 103 to

109, the rate is about 5.8 percent [109-103/ 103].

Just as changes in interest rates h ave a systematic influence on

the prices of all securities, both bon ds and stocks, so too do

anticipated puchasing-power changes manifest themselves. If

annual changes in the consumer price index of other measure

of p urchsaing power h ave been averaging steadily around 3.5

percent and prices will apparently spurt ahead by 4.5 percentover th e next year, required rates of return will adjust upward.

This pro cess will affect government and corpo rate bon ds as well

as common stocks.

Market, purchasing-power and interest-rate risk are the principle

sources of systematic risk in securites; but we should also

consider another important category of security risk a unsystem-atic risks.

Unsys t em at ic Risk Unsystematic risk is the po rtion of total risk that is unique or

peculiar to a firm or an industry, above and beyond that

affecting securites markets in general. Factors such as manage-

ment capability, consum der preferences, and labor strikes can

cause unsystematic variability of returns for a comp anys sto ck.

Because these factors affect one industry and/ or one firm, theymustbeexamined separately for each comp any.

The uncertainty surroundings the abilityof t heissuer to make

payments on securities stems from two sources: (1) theoperating environment o f the b usiness, and (2) the financing

of the firm. These risks are referred to as business risk and

financial risk, respectively. They are strictly a function of the

operating conditions of the firm a and they way in which it

chooses to finance its operations. O ur intention here will bedirected to the bro ad aspects and implications of b usiness and

financial risk. In-depth treatment will be the principal goal of

later chapters on analysis of the economy, the industry, and the

firm.

Business Risk

Business risk is a function of the operating conditions faced by

a firm and th e variability these cond itions inject into operating

income and expected to increase 10 percent per year over the

foreseeable future, business riskwould behigher if operating

earnings could grow as much as 14 percen t or as little as 6

percent than if the range were from a high of 11 percent to a

low of 9 percent. The degree of variation from the expected

trend wo uld measure business risk.

Business risk can bed ivided into two b road categories: external

and intern al. Internal business risk is largely asociated with th e

efficiency with wh ich a firm conduct s its operations with in the

broader operating environm ent imposed upo n it. Each firmhas its own set of internal risks, and the degree to which it is

successful in coping with them is reflectedin operating efficienty.

To large extent, external business riskis the result of op erating

conditions imposes upon the firm by circumstances beyond its

contro l. Each frim also faces its own set o f external risks,

depending upon the specific operating environmental factors

with which it must deal. The external factors, from cost ofmon ey to defense-budget cuts to higher traffs to a down swing

in the b usiness cycle, are far too n umero us to list in detail, but

the m ost p ervasive external risk factor is pro bably the business


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cycle. The sales of some industries (steel, autos) tend to move

in tandem with the business cycle, while the sales of others

move countrycyclically (housing). D emographic considerations

can also influence revenues through ch anges in th e birth rate or

the geographical distribution of th e pop ulation by age, group,

race, and so on. Political Policies are a part of external business

risk; government policies with regard to mon etary and fiscal

matters can affect revenues through th e effect on the cost and

availability of funds. If money is more expenseive, consumers

who buy on credit may postpo ne purchases, and municipal

governments may not sell bonds to finance a water-treatmentplant. The impact upon retail stores, telelvision manufacturers,

of water-purification systems is clear.

Fina ncial Risk

Financial risk is associated with the way in which a co mpany

finaces its act ivities. We usually gauge finacial risk by looking at

the capital structure of a firm. The presence of borrowed

mon ey of debt in th e capital structure creates fixed payment in

the form of interest that must be sustained by the firm. The

presence of these interest commitments fixed interest payments

due to debt of fixed-dividend p ayments o n p referred stock

causes the amount of rasidual earnings available for common-

stock dividends to be more variable than if no interestpayments were requ ired. Financial risk is avoidable risk to th e

extent that managements have the freedom to d ecide to bo rrow

or not to bo rrow funds. A firm with no d ebt financing has no

financial risk.

By engaging in debt financing, the firm changes the characteristic

of the earnings stream avaialbel to the common-stock holders.

Speciafically, the reliance on debt financing, called financial

leverage, has at three important effects on comm on-stock

holders. D ebt financing (1) increases th e variability of th eir

returns, (2) affects their expectations con cerning their returns,

and (3) increases their risk of b eing ruined.

Assign ing Risk Allow an ces (Prem iums)

One way of quantifying risk and building a required rate ofreturn (r), would be to express the required rate as comprising

ariskless rate plus co mpen sation for individual risk factors

previously enuciated, or as:

r = i + p + b + f + m + o

Whrere:

i = real interest rate (riskless rate)

p = purchasing-power-risk allowance

b = business-risk allowance

f = financial-risk allowance

m = market-risk allowance

o = allowance for oth er risks

The first step would to determine a suitable risk less rate of

interest. Unfort unately, no investment is risk-free. The return

on U.S. Treasury bills or an insured savings account, which ever

is relevant to an individual investor, can be used as an appro xi-

mate risk less rate. Savings account s possess p urchasing-power

risk and are subject to interest-rate risk of income but not

principal. U.S. governmen t b ills are subject to interest-risk of

principal. Th e risk less rate might by 8 p ercent.

Using the rate on U.S. government bills and assuming that

interest-rate-and-risk comp ensation is already included in the

U.S. governm ent bill rate, we see in Figure 3-1 the process o f

building required rate of return for alternative investments.

To qu antify the separate effects of each type of systematic and

unsystematic risk is difficult because of overlapping effects and

the sheer complexity involved. In the remainder of the chapter,

we will examine som e pro xies for packaging into a single

measure of risk all those q ualitative risk factors t aken togetherthat perhaps cannot b e measured separately.

Can w e Red uce t he Risk Expo sure ?Every investor wants to guard himself from the risk. This can

be don e by understanding the nature of th e risk and careful

planning. Lets see how can we protect ou rselves as an investor

from the different types of risks.

Market Risk Protection

a. The investor has to study the price behaviour of the stock.

Usually history repeats itself even th ough it is no t in p erfect

form. The stock that sho ws a growth pattern m ay continue

to do so fo r some more period. The In dian stock market

expects the growth pattern to continue for some more time

in information technology stock and depressing conditionsto continue in the textile related stock. Some stocks may be

cyclical stocks. It is better to avoid such type of stocks. The

standard deviation and beta indicate the volatility of the

stock.

b. The standard deviation and beta are available for the stocks

that are included in the indices. The N ational Stock

Exchange N ews bulletin provides this information.

Looking at th e beta values, the investor can gauge the risk

factor and make wise decision according to h is risk

tolerance.c. Further, the investor sh ould be prepared to hold

the stock for a period of time to reap the benefits of the

rising trends in the market. He should be careful in the

timings of th e purchase and sale of the stock. H e should

purchase it at t he lower level and sh ould exit at a higher

level.

Prot ection Aga inst Int ere st Rate Risk

a. O ften suggested solution for this is to hold the investment

sells it in the middle due to fall in the interest rate, the

capital invested would experience tolerance.

b. The investors can also buy treasury bills and bonds of short

maturity. The portfo lio man ager can invest in the treasury

bills and the money can be reinvested in the market to suit

the prevailing interest rate.

c. Another suggested solution is to invest in bonds withdifferent m aturity dates. When the b onds m ature in

different dates, reinvestment can be done according to the

changes in th e investment climate. Maturity diversification

can yield the best r esults.

Protection Against Inflation

a. The general opinion is that the bonds or debentures with

fixed return cannot solve the problem. If the bond yield is

13 to 15 % with low risk factor, they would provide hedge

against the inflation .


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b. Another way to avoid the risk is to have investment in

short-term securities and to avoid long term

investment.The rising consumer price index may wipe off

the real rate of interest in the long term.

c. Investment diversification can also solve this problem to a

certain extent. Th e investor has to d iversify his investment

in real estates, precious metals, arts and antiques along with

the investment in securities. One cannot assure that

different types of investments would provide a perfect

hedge against inflation. It can minimise the loss due to thefall in the purchasing power.

Prote ction Aga inst Busine ss an d Fina ncial Risk

a. To guard against the business risk, the investor has to

analyse the strength and weakness of the industry to which

the com pany belongs. If weakness of the industry is too

much of government interference in the way of rules and

regulations, it is better to avoid it.

b. Analysing the profitability trend of the company is

essential. The calculation o f stand ard deviation wo uld yield

the variability of the return. If there is inconsistency in the

earnings, it is better to avoid it. The investor has to choose a

stock of consistent track record.

c. The financial risk should be m inimised by analysing the

capital structure of the company. If the debt equity ratio is

higher, the investor should have a sense of caution. Along

with th e capital structure analysis,. he shou ld also take into

account of the interest payment. In a boo m period, the

investor can select a highly levered compan y but no t in a

recession.

Notes

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