Lecture 6

Stock-Market Risk Management

What is Risk-Return Analysis?

The concept of risk-return analysis is integral to the process of investing

and finance. All financial decisions involve risks of varying degrees. You
may expect to earn returns at 15% per annum, from an asset class like
equity, but the risk of not achieving that will always be there.

Return is simply a reward accompanying risks related to investment-

greater the risk, more the returns. Returns are measured by how much
investors' money has grown over the investment period across asset classes
such as equities, mutual funds, and bonds. While you cannot gauge returns
in advance, you can make an educated guess on the kind of returns that you
expect.

Most investment expectations depend on what has happened in the past.

Unfortunately, history doesn’t always repeat itself! Haven't we all seen the
highs of 2007, followed by the lows in 2008?

Even if you are reasonable in your investment expectations for returns,

there is the possibility that actual investing returns turn out different than
expected. You certainly run the risk of losing some or all of your original
investment.

Why is that? It is because of an uncertain future (e.g., the global economic

environment), and uncertainty over the quality and stability of investments.
In general, greater the uncertainty, more the risk. Some familiar sources of
uncertainty (or risks) that we must absorb, while making investments are:
Business and Industry Risk

There might be an industry-wide slowdown or even a global economic

recession. That presents an uncertain future for any business. A company
might see its earnings drop significantly due to management ineptitude or
wrong decisions. A drop in earnings may cause the company's stock prices
to fall, resulting in investment losses for investors.

Inflation Risk
The money you earn today is always worth more than the same amount of
money at a future date. This is because goods and services usually cost
more in the future due to inflation. So, your investment return must beat
the inflation rate.

Market Risk
Market risk is about the uncertainty faced in the stock market, which
primarily invests in equities. Several macro and micro-economic details -
singularly or plurally - can spook the equity market. Even for a well-
managed business growing profitably, its equity stock may drop in value
simply because the overall stock market has fallen.

Liquidity Risk
Sometimes you are not able to get out of your investment conveniently and
at a reasonable price. For example, in 2008, you may have found it tough
to sell your house at a price you wanted. In 2007, however, it was a breeze
to have your home sold.

There can be a phase when the equity market is merely inactive or volatile
to keep investors away. It means you can't sell your investment or get the
price you want if you needed to sell it immediately.
What are Investment vehicles?
An investment vehicle is a product that investors use to generate positive
returns. Investment vehicles can be low-risk (fixed deposits and bonds) or
carry a higher degree of risk as is the case with equity shares, equity
derivatives, options, and futures.
There are a wide variety of investment vehicles, and many investors choose
to hold several types of investment vehicles in their portfolios. This can
enable diversification while minimizing risk.

Organizations' Financial planning

Financial planning is the task of determining how a business will afford to

achieve its strategic goals and objectives through prudent investments in
equity shares, mutual funds and ETFs, among others. Usually, a company
creates a financial plan immediately after the vision and objectives have
been set.

Tasks involved in financial planning:

- Assess the business environment

- Confirm the business vision and objectives
- Identify the types of resources needed to achieve these objectives
- Quantify the amount of resource (labor, equipment, materials)
- Calculate the total cost of each type of resource
- Summarize the costs to create a budget
- Identify any risks and issues with the budget set.

Financial planning is critical to the success of any organization. It provides

the business plan with rigor, by confirming that the objectives set are
achievable from a financial point of view. It also helps the CEO to set
financial targets for the organization, and reward staff for meeting
objectives within the budget set.

Why do traders need Insurance?

A promise of compensation for specific potential future losses in exchange
for a periodic payment. Insurance is designed to protect the financial well-
being of an individual, company or other entity in the case of unexpected
loss. Some forms of insurance are required by law, while others are
optional. Agreeing to the terms of an insurance policy creates a contract
between the insured and the insurer. In exchange for payments from the
insured (called premiums), the insurer agrees to pay the policyholder a sum
of money upon the occurrence of a specific event. In most cases, the
policyholder pays part of the loss (called the deductible), and the insurer
pays the rest. Examples include car insurance, health insurance, disability
insurance, life insurance, and business insurance.

What is risk management?

Basically, risk management is the process of identification, analysis and,
either acceptance or mitigation of uncertainty about the investments.

Essentially, risk management occurs anytime an investor or fund manager

analyses and attempts to quantify the potential for losses in an investment.
This enables the investor to take an appropriate action based on the
investment objectives and risk tolerance.

Inadequate risk management can result in severe consequences for

companies as well as individuals. For example, the recession of 2008 was
largely caused by loose credit risk management of financial firms.

In simpler words, risk management is a two-step process - determining the

risks in an investment and then handling those risks in a way best-suited to
your investment objectives.
Ideally, risk management is done on a prioritization basis, wherein the risks
with the potential of a bigger loss (or impact) are handled first and risks
with lower probability of occurrence (or that can cause a lesser damage)
are handled thereafter.

Methods of risk management:

Usually, methods of risk management consist of some elements which are,
more or less, performed in the following order:
1. Identify, characterize, and assess threats
2. Assess the vulnerability of critical assets to specific threats
3. Determine the risk (i.e. the expected consequences of specific types of
attacks on specific assets)
4. Identify ways to reduce those risks 5. Prioritize risk reduction measures
based on a strategy.

Hedging
Hedging is the process that is used to reduce the risk of incurring losses
due to negative outcomes within the stock market. It is a concept similar to
home insurance, wherein you can protect your assets against negative
outcomes like fire and burglary, by purchasing an insurance policy.

The only difference with hedging is that you are insuring your stocks
against market risks, and you are never fully compensated for your loss.

Hedging is most useful under the following circumstances:

1. If you have commodity investment that is subject to price movements,

you can use hedging as a risk management technique
2. It helps set a price level for purchase or sale of an asset prior to the
transaction.
3. Hedging will also allow you to make profits from any upward price
fluctuations and protect your investments from downward price
movements.

Stop loss
Stop loss is an order of buying or selling shares, once its price rises above
(or drops below) a specified stop loss price. When the specified stop loss
price is reached, the stop loss order is entered as a market order

With a stop loss order, the trader does not have to actively monitor how a
stock is performing. However, since the order is triggered automatically
when the specified price is reached, the stop loss price could be activated
by a short-term fluctuation in a security's price.