RISK & RETURN

RISK: Risk can be defined as the probability that the expected return from the security will not
materialize.

Types of Investment Risk: The risk consists of two components i.e. systematic risk and unsystematic
risk. The systematic risk can be caused by factors external to a particular company and
uncontrollable by the company.

The unsystematic risk is caused by specific, unique, related factors to the particular industry or
company.

Systematic Risk: An investor can construct a diversified portfolio and eliminate part of the total risk,
the diversifiable or non market part. The leftover part is systematic risk.

Variability in a securities total return that is directly associated with overall movements in the
general market or economy is called systematic risk.

The systematic risk is further sub divided in to:

1. Market Risk: The variability in a securities return resulting from fluctuation in the aggregate
market is known as market risk. All securities are exposed to market risk including recession ,
wars, structural changes in the economy.Sometimes market risk is used synonymously with
systematic risk.

2. Interest Rate Risk: The variability in a securities return resulting from changes in the level of
interest rates is referred to as interest rate risk.

3. Such changes affect the security inversly. Interest rate risk affects the bond more directly
than the common stock. As interest rate change, bond prices change in the opposite
direction.

4. Purchasing Power Risk: A factor affecting all securities is purchasing power risk, also known
as inflation risk. This is the possibility that the purchasing power of invested dollars will
decline. Increase in inflation decreases the purchasing power & vice versa

5. Unsystematic Risk: is that portion of total risk that is unique to the firm/ industry. Factors
such as management capability, consumer preferences, labour strikes causes systematic
variability of returns in a firm.

Diversification reduces the risk when returns of the securities do not exactly vary in the
same direction.

Elements of Unsystematic Risk:

1. Business Risk : is a function of operating condition faced by a firm.eg. Changes in profit

costs, scale of production & market strategy .

2. Financial Risk: is associated with the way the company finances its activities. Financial risk arises
because of presence of debt in the capital structure of the firm.
Risk Measurement: Risk is the uncertainity of future outcome. The anticipated return for some
future is known as the expected return. The actual return over past period is known as the realised
return. Statistical tools are used to measure the risk. These are:

1. Standard deviation: It is the measure of the values around mean or it is the square root of the
sum of the squared deviation from the mean divided by the no of observations. The arithematic
mean of the returns may be same for two companies but returns may vary widely.

2. The Characteristic regression line: is the simple linear regression model estimated for a particular
stock against the market index return to measure its diversifiable and undiversifiable risk. This model
is:

Ri = ai + BiRm + ei

Ri = Return of the ith stock

Ai = Intercept

Bi = Slope of the ith stock

Rm = Return of market index

Ei = error term

The security return is

Today’s Security return= Today’s price- yesterdays price

_________________________x100

Yesterday’s Price

Today’s Market Return = Today’s index- Yesterday’s index

___________________________x100

Yesterday’s Index

Measurement of systematic Risk

Beta Coefficient: Beta is a technique to measure systematic risk. It reflects how the prices of a
security respond to market forces. The more responsive the price of a security to the market
changes, the higher will be its beta.

It is calculated by relating the returns on a security with the return for the market as a whole.
Market return is measured by the average return of a large sample of stocks . The beta for overall
market is equal to 1. Beta describes the relationship between the stock ‘s return and index return.

a) Beta = + 1.0

One percent change in market index return causes exactly one percent change in the stock
return. It indicates that the stock moves in tandem with the market.
b) Beta = + 0.5

One percent change in the market index return causes 0.5 percent change in the stock return. The
stock is less volatile compared to the market.

c) Beta = + 2.0

One percent change in the market index return causes 2% change in the stock return.The stock
return is more volatile. When there is a decline of 10% in the market

return, the stock with a beta of 2 would give a negative return of 20%. The stock with more than 1
beta value is considered to be risky.

d) Negative beta value indicates that the stock return moves in the opposite direction to the market
return. A stock with a negative beta of -1 would provide a return of 10%, if the market return
declines by 10% and vice- versa.

Alpha: It indicates that the stock return is independent of the market return. A +ve value of alpha is
a healthy sign. Positive alpha value would yield profitable return. In a well diversified portfolio the
average value of alpha of all stocks turns out to be zero.

Correlation: The correlation coefficient measures the nature and the extent of relationship between
the stock market index return and the stock return in particular period.

The square of the correlation co-efficient is the co-efficient of determination. It gives the percentage
of the variation in the stock’s return.

FUNDAMENTAL ANALYSIS

ECONOMY

INDUSTRY

COMPANYE ANALYSIS
ECONOMY ANALYSIS: The level of economic activity has an impact on investment in many ways. If
economy grows, industry also shows a rapid growth & vice versa. When level of economic activity is
low ,stock prices are also low & vice versa.

The analysis of macro economic environment is essential to understand the behaviour of stock
prices. The commonly analysed macro economic factors are:

1. Gross domestic product: GDP represents the value of goods and services produced in the
economy. It consists of personal consumption expenditure, gross private domestic
investment and government expenditure on goods and services and net export of goods and
services. The higher growth rate is more favorable for the economy.

2. Savings and Investment: pattern of the public affect the stock to a great extent.

3. Inflation: A mild level of inflation is good for the stock market but high rate of inflation is
harmful for the stock market.

4. Interest Rates: Interest rates affects the cost of financing to the firm. A decrease in
interest rate means lower cost of financing and more profitability. More money is available
at a lower interest rate for the brokers who are doing business with borrowed money.
Availability of cheap funds, encourages speculation and rise in the price of shares.

5. Budget: A deficit in budget means high inflation and high cost of production. A balanced
budget is highly favourable to the stock market. Surplus budget may result in deflation.

6. The tax structure: The type of tax exemption has impact on the profitability of the
industry.

7. The balance of payment: The volatility of foreign exchange rate affects the investment of
FII’s in the stock market. A favorable BOP renders positive effect on the stock market..

8. Monsoon and agriculture: A good monsoon, good demand for input and good crop which gives
bounce to stock market & vice versa.

9. Infrastructure facilities: Good infrastructure facilities affect the stock market favourably.

10. Demographic Factors

ECONOMIC FORECASTING: Techniques:

1. Economic Indicators are the factors that indicate the present status, progress, slow down of the
economy. They are capital investment, business profits, money supply,

GNP, interest rate, unemployment etc.The economic indicators are grouped in to leading,
coincidental and lagging indicators.The indicators are selected on the basis of following criteria

- Economic significance
 - Statistical adequacy

- Timing

- Conformity

The leading indicator indicate what is going to happen in the economy &help in predicting the path
of the economy.

The popular indicators are the fiscal policy, monetary policy, productivity, rainfall, capital
investment and stock indices.

The coincidental indicators indicate what economy is. They are GNP, industrial production, interest
rates and reserve funds.

The changes occuring in leading and coincidental indicators are reflected in lagging indicators.

2. Diffusion Index: is a composite or consensus index. It consists of all three indicators and difficult
to calculate.

Econometric Model Building: Relationship between dependent and independent variable is

analysed mathematically for forecasting.

INDUSTRY ANALYSIS

Industries can be classified as:

Growth Industry eg. Healthcare industry, infrastructure, technology, financial services industry etc.

Cyclical Industry eg. Fridge, washing machine, kitchen range etc.

Defensive Industry- defines the movement of the business cycle. Eg. Food industry

Cyclical Growth Industry eg. Automobile industry. The changes in technology & introduction of new
models help the industry to resume their growth path.

Industry life cycle:

1. Pioneering stage

2. Rapid growth stage

3. Maturity & Stabilization stage

4. Decline Stage

Factors to be considered

Apart from industry life cycle investor has to analyse the following factors:

1. Growth of the industry

2. Cost structure and profitability

 3. Nature of the product

4. Nature of competition

5. Government policy

6. Labour

7. Research & Development

8. Pollution standard

9. SWOT Analysis

COMPANY ANALYSIS

1. Competitive edge of the company

- Market share

- The growth of annual sales

- The stability of annual Sales

- Sales Forecast

2. Earnings of the company

- Change in Sales

- Change in cost

- Depreciation method adopted

- Depletion of resources in the case of oil, mining, forest products, gas etc.

- Inventory accounting method.

- Replacement cost of inventories

- Wages, Salaries and Fringe benefits

- Income taxes and other taxes

3. Capital Structure

4. Management

- Ability to get along with the people

- Leadership

- Analytical competence
 - Industry

- Judgement

- Ability to get things done

5. Operating Efficiency

6. Operating Leverage

7. Financial Analysis

- The profit and loss account

- Analysis of Financial Statement

- Comparative Financial Statement

- Trend Analysis

- Common Size Statement

- Fund Flow Analysis

- Cash Flow Analysis

- Ratio Analysis

PORTFOLIO ANALYSIS: RISK AND RETURN

Portfolio analysis begins where the security analysis ends & this fact has important
consequences for the investors.

Portfolios which are combinations of securities may or may not take on the aggregate
characteristics of individual parts. Portfolio analysis considers the determination of future risk &
return in holding various blends of individual securities. Portfolio expected return is a weighted
average of securities but portfolio variance can something less than a weighted average of security
variances.

As a result an investor can sometime reduce portfolio risk by adding another security in the
portfolio. This seemingly curious result occurs because risk depends greatly on civariance among
individuals of securities.

A portfolio is a collection of securities having different risk & return. Since, it is rarely
desirable to invest the entire funds of an individual or an institution in a single security, it is essential
that every security be viewed in a portfolio context.

Thus, it seems logical that the expected return of portfolio should depend on the expected
return of each security contained in the portfolio.
Since portfolios expected return is a weighted average of the expected return of its securities, the
contribution of each security to the portfolios expected return depends on its expected return & its
proportionate share of the initial portfolios market value.

Eg, Portfolio % of total investment(‘000) Return %

HLL 30 20

RIL 20 25

TELCO 10 30

WIPRO 40 35

------

100

Risk Analysis: Of all possible questions which an investor may ask, the most important one is
concerned with the probability of actual return being less than zero i.e. with the probability of loss.
This is the essence of risk.

A useful measure of risk should somehow taken in to account both the probability of various
possible outcomes & their associated magnitudes.

Instead of measuring the probability of a no of different outcomes, the measure of risk should some
how estimate the extent to which the actual outcome is likely to diverse from the expected.

Two measures are used for this purpose:

1. The average absolute deviation

2. The standard deviation

In order to estimate the total risk of a portfolio of assets several estimates are needed. The
variance of each individual assets under consideration for inclusion in the portfolio & the
covariance or correlation coefficient of each asset with each of the other asset.

Portfolio Selection Model: Markowitz Model

Dr. H.M. Markowitz is credited with the developing the first modern portfolio analysis model.
Since the basic elements of modern portfolio theory emanate from a series of propositions
concerning rational investor behaviour set forth by Markowitz.

Markowitz used mathematical programming & statistical analysis in order to arrange for optimum
allocation of assets within portfolio. To reach this objective Markowitz generated a portfolio
within a reward risk context.

In other words, he considered the variance in the expected return from investment & the
relationship to each other in constructing portfolios. Markowitz model is a theoretical framework
for the analysis of risk & return choices. Decisions are based on the concept of efficient portfolios.
If portfolio is efficient ,when it is expected to yield the highest return for the level of risk accepted
or alternatively the smallest portfolio risk for the specified level of expected return.

To build an efficient portfolio, an expected return level is chosen & assets are substituted until the
portfolio combination with the smallest variance at the return level is found. As this process is
repeated for other expected return, set of efficient portfolio is generated.

ASSUMPTIONS: The Markowitz model is based on several assumptions regarding investors

behaviour.

1. Investors consider each investment alternative as being represented by a probability

distribution of expected return over some holding period.

2. Investors maximize one period expected utility curve, which demonstrates diminishing
marginal utility of wealth.

3. Individual estimate risk on the basis of variability of expected returns.

4. Investors base decisions solely on expected returns only.

5. For a given risk level investors prefer high return to lower returns.

Similarly for a given level of expected return investors prefer less risk to more risk.

Under these assumptions a single asset or portfolio of assets offer higher expected returns
with the same or higher expected returns.
A geographical representation of mean variance criterion is presented in the figure, the vertical axis
denotes expected return & Standard deviation, any investment option can be represented by point
on such a plane & the set of all potential option can be encoded by an area such as shown in figure.
The efficient frontier given by arc PW is boundary of attainable set. In figure the shaded area
represents the attainable set of portfolio considerations with their own risk & expected return( Two
different portfolios may have the same expected return & risk). Any point inside the shaded area is
not efficient as a corresponding point on the efficient frontier- the arc PW.

For Instance point X1 offers the same expected return as X2 but has smaller standard deviation. Any
point below X1 such as X3, has the same standard deviation as X1, but a smaller expected return.
The portfolios on the efficient frontier representing all possible portfolios.

After the efficient set is defined an investor can maximize the expected return or minimise a risk by
selecting a portfolio from the set. Any other portfolio would not either maximize the expected return
for a presented level of expected return. Again an efficient portfolio is one compared to which no
other portfolio has the same return & a lower risk or the same risk & a high return.

Selection of Optimal Portfolio

In order to know which portfolio & efficient frontier is suitable to an investor, the preference in
terms of his/her risk tolerance should be taken in to account.

In general investors are averse, though the degree of risk tolerance may vary. The risk tolerance can
be well depicted by an indifference curve.

An indifference curve represents the investors trade off between risk & return.

One particular indifference curve indicated that all points lying on the curve provide the same level
of utility to investor & a no. of indifference curve can be drawn on the basis of investor’s preference
for risk & return.

Investors are generally risk averse i.e. they will select the portfolio with smaller standard
deviation but the degree of risk aversion differ from investor to investor. Thus, it is clear that
different investors will have different maps of indifference curve that may be classified in to four
categories.

1. Highly Risk Averse Investors

2. Moderately Risk averse Investor

3. Slightly Risk Averse investors

4. Risk Neutral investors

Therefore it is clear that

 a) All portfolios that lies on a given indifference curve are equally desirable to the investor.

b) All other portfolio would not meet the investors objective.

So, an investor will find any portfolio that is lying on an indifference curve to be more
desirable than any other portfolio lying on the indifference curve.

Conclusion: Portfolio Selection process explains four basic steps.

1. Identifying the asset to be considered for portfolio construction.

2. Generating the necessary input data to portfolio selection. This involves estimating the
expected returns variance & covariance for all the assets considered.

3. 3. Determining the efficient portfolios.

4. 4. Selecting the optimal portfolio in terms of the assets to be held & the proportion of
available funds to be allocated to each with reference to given level of risk tolerance of an
investor.

Beta Coefficient

Beta is a technique for measuring systematic risk. It reflects how the price of a security
responds to market forces. The more responsible the price of a security to the market
changes, the higher will be its beta. It is computed by relating returns on a security with
the return for the market as a whole.

Market return is measured by the average return of a large sample

of stocks. The beta for the overall market is equal to 1. & other betas are evaluated in
relation to this variable.

It is very helpful for investors in assessing the systematic risk of a security. The investor can
evaluate the impact of market movements over the return expected from a share.

Beta of a particular security is calculated on the basis of past performance. Beta under good
situations shows higher returns & vice- versa.

The higher the beta of a security, the higher will be the varability of returns.

The lower the beta of a security, the lower will be the variability of returns.

Risk averse investors will prefer to have a security with lower returns & vice versa.

Sharpe Single Index Model of Portfolio Analysis

Sharpe assumed that the return on a security could be regarded as being linearly related to a single
index like market index.

The market index should consists of all the securities trading on the stock market.

William Sharpe developed a simple model called as Market Model.

 He said portfolio risk declines to some extent but to an extent. The part of risk which can not be
reduced through diversification is systematic risk. The undiversifiable risk is attributed to systematic
factors principally operated at a given market.

If one includes all the traded securities in a market in his portfolio, that portfolio reduces the risk to
the extent of market influences.

Rit + αi + βmtRm + eit

Rit = Return on ith security during t holding period

Βmt = Market beta or market sensitivity of a given stock.

αi = Constant term

Rm = Rate of return on market index.

e = error term

β= 1 indicates that if the market portfolio’s excess return is 1% larger than expected, then the best
guess is that the security’s excess return is also likely to be 1% larger than expected.

β= 2 indicates that if the market portfolio’s excess return is larger than expected, then the best guess
is that the security’s excess return is also likely to be 2% larger than expected.

β= 0.5 indicates that if the market portfolio’s excess return is 1% larger than expected, then the best
guess is that the security’s excess return is also likely to be ½ of 1% larger than expected.

Securities with β value greater then one are termed as aggressive securities.In up market their
prices tend to rise at a faster rate than the average security & in down market they tend to fall at a
faster rate .

Securities with β value less than one are termed as defensive securities. In up market their
prices tend to rise at a slower rate than the average security & in down market they tend to fall at a
slower rate.

Error term= represents the uncertain portion of market.

Corner Portfolios: A no. of portfolios on the efficient frontier are corner portfolios. These are the
portfolios which are calculated where a security either enters or leaves the protfolio. Corner
portfolio 1 is a one stock portfolio.It contains the stock with the greatest return (& risk) from the set.

As the no of stocks increases in the portfolio, the corner portfolio would be the one with
lowest return & risk combination.

Sharpe Optimal Portfolio:

Ri – R f / β i