INVESTMENT RISKS AND RATES OF RETURNS

TYPES OF RISK
1. BUSINESS RISK
 is the exposure a company or organization has to various factors like competition and consumer preferences
that might lower its profits or lead it to fail.

TYPES OF BUSINESS RISK

 COMPETITIVE RISK
- The risk that your competition will gain advances over you that prevent you from reaching your
goals. For example, competitors that have fundamentally cheaper cost base or better product.
 ECONOMIC RISK
- The possibility that conditions in the economy will increase or reduce your sale.
 OPERATIONAL RISK
- It is the result of insufficient or failed processes; the potential failures related to the day to day
operations of an organization.
 LEGAL RISK
- The chance that new regulations will disrupt your business or that you will incur expenses and
losses due to legal dispute.
 COMPLIANCE RISK
- The chance that you will break laws and regulations.
 STRATEGY RISK
- The risk associated with a particular strategy.
 REPUTATIONAL RISK
- The chance of losses due to declining reputation as a result of practices that are perceived as
dishonest, disrespectful or incompetent.
 PROGRAM RISK
- The risk associated with a particular business program or portfolio of projects.
 PROJECT RISK
- The risk associated with projects.
 INNOVATION RISK
- Risk that applies to innovative areas of your business such as product research.
 COUNTRY RISK
- Exposure to the conditions in the countries in which you operate such as political events and the
economy.
 QUALITY RISK
- The potential that you will fail to meet your quality goals for your products. Services and business
practices.
 CREDIT RISK
- The risk that those who owe you money to fail to pay. This is mostly related to accounts receivable
risk.
 EXCHANGE RATE RISK
- The risk that volatility in foreign exchange rates will impact the value of business transactions and
assets.
 INTEREST RATE RISK
- The risk that changes to interest rates will disrupt your business.
 TAXATION RISK
- The potential for new tax laws or interpretations to result in higher than expected taxation.
  PROCESS RISK
- The business risk associated with a particular process.
 RESOURCE RISK
- The chance that you will fail to meet business goals due to lack of resources such as financing or
the labor of skilled workers.
 POLITICAL RISK
- The potential for political events and outcomes to impede your business.
 SEASONAL RISK
- A business with revenue that’s concentrated in a single season such as ski resort.

2. VOLATILITY RISK
 refers to the risk that a portfolio may experience changes in value due to volatility (price swings) based on
the changes in value of its underlying assets - particularly a stock or group of stocks experiencing volatility
or price fluctuations.
3. INFLATION RISK
 sometimes called purchasing power risk
 is the risk that the cash from an investment won't be worth as much in the future due to inflation
changing its purchasing power.
 Inflation risk is more of a concern for investors who have debt investments like bonds or other cash-
heavy investments.
4. LIQUIDITY RISK
 is involved when assets or securities cannot be liquidated fast enough to ride out an especially volatile
market.
 This kind of risk affects businesses, corporations or individuals in their ability to pay off debts without
suffering losses.
5. REINVESTMENT RISK
 The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond
paying 5%.
 Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments
at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less
than 5%.
 Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at
maturity.
6. HORIZON RISK
 The risk that your investment horizon may be shortened because of an unforeseen event, for example, the
loss of your job.
 This may force you to sell investments that you were expecting to hold for the long term. If you must sell
at a time when the markets are down, you may lose money.
7. LONGEVITY RISK
 The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing
retirement.
8. MARKET RISK
 is a broad term that encompasses the risk that investments or equities will decline in value due to larger
economic or market changes or events.

TYPES OF MARKET RISK

a. EQUITY RISK
o experienced in every investment situation in that it is the risk an equity's share price will drop,
causing a loss
 b. INTEREST RATE RISK
o is the risk that the interest rate of bonds will increase, lowering the value of the bond itself
c. CURRENCY RISK
o applies to foreign investments and the risk of losing money because of a exchange rate.

MEASUREMENT OF RISK
1. BETA
 is a measure of a stock's volatility in relation to the market.
 It measures the exposure of risk a particular stock or sector has in relation to the market.
 If you want to know the systematic risk of your portfolio, you can calculate its beta.

1. A beta of 0 indicates that the portfolio is uncorrelated with the market.

2. A beta less than 0 indicates that it moves in the opposite direction of the market.
3. A beta between 0 and 1 signifies that it moves in the same direction as the market, with less volatility.
4. A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility and is sensitive
to systematic risk.
5. A beta greater than 1 indicates that the portfolio will move in the same direction as the market, with a higher
magnitude, and is very sensitive to systematic risk.

STEPS IN COMPUTING BETA

1. Find the risk-free rate. This is the rate of return an investor could expect on an investment in which his or her
money is not at risk. The risk free-rate is 2%.
2. Determine the respective rates of return for the stock and for the market or appropriate index. These figures
are also expressed as percentages. Usually the rates of return are figured over several months. The stock’s rate of
return is 7% while the market rate of return is 8%.
3. Subtract the risk-free rate from the stock's rate of return. If the stock's rate of return is 7% and the risk-free
rate is 2%, the difference would be 5%.
4. Subtract the risk-free rate from the market (or index) rate of return. If the market or index rate of return is 8%
and the risk-free rate is again 2%, the difference would be 6%.
5. Divide the first difference above by the second difference above. This fraction is the beta figure, typically
expressed as a decimal value. In the example above, the beta would be 5 divided by 6, or 0.833.

HOW TO CALCULATE BETA

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be
known, as well as the variance of the market returns.

𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞
𝐁𝐞𝐭𝐚 =
𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞
where:
Covariance – Measure of a stock’s return relative to that of the market
Variance – Measure of how the market moves relative to its mean

Covariance
 measures how two stocks move together.

 A positive covariance means the stocks tend to move together when their prices go up or down.
 A negative covariance means the stocks move opposite of each other.

Variance
  refers to how far a stock moves relative to its mean.

 Variance is used in measuring the volatility of an individual stock's price over time.
 Covariance is used to measure the correlation in price moves of two different stocks.

Calculating the Beta for Tesla Inc. (TSLA):

Let's assume the investor also wants to calculate the beta of Tesla Motors Inc. (TSLA) in comparison to the SPDR
S&P 500 ETF Trust (SPY). Based on data over the past five years, TSLA and SPY have a covariance of 0.032, and the
variance of SPY is 0.015.

𝟎.𝟎𝟑𝟐
𝐁𝐞𝐭𝐚 𝐨𝐟 𝐓𝐒𝐋𝐀 = 𝟎.𝟎𝟏𝟓 = 2.13

Therefore, TSLA is theoretically 113% more volatile than the SPDR S&P 500 ETF Trust.

2. COEFFICIENCE OF VARIANCE
 Is a statistical measure of the points in a data series around the mean.

𝝈
𝑪𝑽 = 𝒙 𝟏𝟎𝟎
̅
𝒙
Where:
𝝈 − standard deviation
𝐱̅ − mean

3. STANDARD DEVIATION
 measures the dispersion of a data set relative to its mean

where:
∑ - Greek Sigma, means summation
𝐱̅ – x-bar or x-not, means average of x values
N – count of values (or number of numbers)

EXAMPLE:

DEGREE OF OPERATING, FINANCIAL AND TOTAL LEVERAGE

DEGREE OF OPERATING LEVERAGE (DOL)

 Quantifies a company’s operating risk that is a result of the structure of fixed and variable cost.
 Is an indication of how a company’s cost are structured and is used to determine the break-even point for a company.

% ∆𝐄𝐁𝐈𝐓
𝐃𝐎𝐋 =
% ∆𝐒𝐀𝐋𝐄𝐒
EXAMPLE:

COMPANY XYZ (in millions)

2019 2018 % Change

EBIT 14, 358 13, 224 8.58%

 Sales 55, 632 52, 465 6.04%
𝐂𝐔𝐑𝐑𝐄𝐍𝐓 𝐘𝐄𝐀𝐑−𝐏𝐑𝐄𝐕𝐈𝐎𝐔𝐒 𝐘𝐄𝐀𝐑
%∆= 𝐏𝐑𝐄𝐕𝐈𝐎𝐔𝐒 𝐘𝐄𝐀𝐑
Degree of 1.4205
𝟏𝟒,𝟑𝟓𝟖−𝟏𝟑,𝟐𝟐𝟒 Operating
% ∆𝐄𝐁𝐈𝐓 = 𝟏𝟑,𝟐𝟐𝟒
= 8.58% Leverage
𝟓𝟓,𝟔𝟑𝟐−𝟓𝟐,𝟒𝟔𝟓
% ∆𝐒𝐀𝐋𝐄𝐒 = 𝟓𝟐,𝟒𝟔𝟓
= 6.04%

𝟖.𝟓𝟖%
𝐃𝐎𝐋 = 𝟔.𝟎𝟒% =1.4205

DEGREE OF FINANCIAL LEVERAGE (DFL)

 is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its
operating income, as a result of changes in its capital structure.

 DFL is best used to help a company determine an appropriate amount of debt.

 The higher the DFL, the more volatile EPS will be.

𝐄𝐁𝐈𝐓
𝐃𝐅𝐋 =
𝐄𝐁𝐈𝐓 − 𝐈𝐍𝐓𝐄𝐑𝐄𝐒𝐓
where:
EBIT – Earnings before interest and taxes/ operating income
Interest – interest expense

EXAMPLE:
Assume hypothetical company BigBox Inc. has operating income or earnings before interest and taxes (EBIT) of
100 million in Year 1, with interest expense of 10 million, and has 105 million shares outstanding.
EPS for BigBox in Year 1 would thus be:

EBIT – INTEREST EXPENSE

EPS =
NO. OF SHARES
100 million – 10 million
EPS = = 0.86
105 million
100 million
DFL = 100 million −10 million = 1.11

This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.

DEGREE OF TOTAL LEVERAGE (DTL)

 can also be referred to as the “degree of combined leverage” because it considers the effects of both operating
leverage and financial leverage.
 is a ratio that compares the rate of change a company experiences in earnings per share (EPS) to the rate of change
it experiences in revenue from sales.

DTL = DOL x DFL