CHAPTER 7 in the stock market, is trying to trace the m the 20,000 mark in October 2007. It took only 10 trading days t the index crossed the 19,000-mark on 15 October. The major driv ues such as Larsen and Toubro, Reliance Industries, ICICI Bank, the BSE Sensex went into free fall. It hit the lower circuit breaker in = Opened at 10 a.m. Trading was suspended for an hour, On r the market saw its biggest intra-day fall, and hit a low of 15,332, It was ever, after a reassurance from the finance minister, the market ret 730. Yet, it had lost 875 points. The Indian stock market found mention among the: ss the world in 2011 and suffered a loss of 25 per cent. ‘ zis are creating panic in Mohan and giving rise to many questions in his mir ‘smoothly? Why are there these ups and downs? What are the fi How can I assess the volatility? Have ail stocks moved along with the index? preward their investors even when the market seems to be doing reasonably we CHAPTER OBJECTIVES © Tounderstand the concept of risk * To distinguish between systematic and unsystematic risk * To know how to measure risk Mr Mohan should accept the fact that equity investment is the most risky investment in all financial markets, Any rational investor, before investing his or her investible wealth in a stock, analyses the risks ‘associated with it. The actual return he receives from a stock may vary from his expected return, and the risk is expressed in terms of variability of return. The downside risk may be caused by several factors, either common to all stocks or specific to a stock. Investors like to analyse the risk factors because a thorough knowledge of the risk helps them plan their portfolios to minimize risk.Analysis and Portfolio Management DEFINITION OF RISK or The dictionary meaning of risk is the possibility of loss of injury Peat 0 Risk is defined as variability in return or volatility in return. Risk is O° 8 return, Thus, risk means any deviation from exPeN 4, Probability thatthe returns trom any asset will differ from the expected! We asset, In risk assessment, the probable outcomes of all the possible eventt Re tts For era listed subjectively, the derived probabilities can be assigned to the entire PORE TTT Ny investor can analyse and find out the possible range of returns from his Investec subjective probability to his returns, such as 50 per cent of the time there j 4 share as dividend and 50 per cent of the time the possible dividend mi babi interchangeably with uncertainty. In uncertainty, the possible events and the probabWnes A Rt are not known. Hence, risk and uncertainty are different from each other. components: * Systematic risk - External factors cause unsystematic risk to a company: control this risk, Systematic risk affects the market as a whole. ; Unsystematic risk ~ Here, the factors are specific, unique and related to the industry or company, SYSTEMATIC RISK 4 wh Systematic risk affects the entire market. Often we read in the newspaper that the stock market is: bear hug or is in a bull grip. This indicates that the entire market is moving in a direction either ‘or upwards. Economic conditions, the political situation or sociological changes affect the securities mark A recession can affect the profit prospects of the industry and the stock market. The recession experienced by developed and developing countries in 2008 affected stock markets ‘over the world. The economic crisis in the US affected the stock markets worldwide, These factors ae ‘The company is not beyond the control of the corporation or the investor. They cannot be entirely avoided by the investor. means, systematic risk is unavoidable. Systematic risk is further sub-divided into the following: © Market risk © Interest rate risk © Purchasing power risk Market Risk ee defined market risk as that portion of total variability of return that is caused b alternating of the bull and bear phases. Both tangible and intangible events can During and bear phases more than 80 per cent of the securities’ prices rise or fall along stock market indices. When the security index moves upward haltingly for a significant period, the market is known as market. In a bull market, the index moves from a low level to its peak. A bull market tends to be: with rising investor confidence and expectations of further capital gains. A bear market is just the reverse of a bull market; the index declines haltingly from the p Jow point called the trough for a significant period. A bear market is typified by falling stockRisk 125 Sensex closed above the 20,000 mark. It was Supported by foreign institutional investors (PII) investment in ; the inflow was & 69,731.10 cro ore for the calendar year till 10 December. On 21 Jamuary 2008, the Sensex 1,408.35 points. The rising number of defaults in the US sub-prime market affected the US stock markets. led to the failure of many leading financial institutions, including the Lehman Brothers. These events ly affected the Indian markets, Sub-prime credit refers to high-interest, high-risk debt given to those Poor credit records or ratings. Flls' investment and fuilure of financial institutions are tangible events ible events Intangible events are tel However, ward, lated to dharkat Psychology. Such psychology is affected by real Fractions to tangible events become over-reactions and push the market either upward or ‘Thus, any untoward political or economic event can lead toa fall in the price of the security which can be + cceentuated by the over-reactions and herd-like behaviour of investors, If some financial institutions disposing of their stocks, it can cause fear that Spreads to investors. This will then result in a rush to the stocks, The actions of the financial institutions would have a snowballing effect. This type of over- tion affects the market adversely, and the scrips’ prices can fall below their intrinsic values. This is the control of the corporations, Figure 7.1 illustrates some of the events that have created the bull and bear run in the Indian stock market. {nfo of Fil Investment Ian, slowdown of GO ae | ‘lobal recession See <> Gebalnarial sis 0 SS $f pSietiea eo 9. Sane, ee wy ey a ef y SF of ee eee Figure 7.1 Movement of the BSE Sensex 2097-11 Ny, aypleat k “ for Votdew Qyrdotdel st Rate Risk hy lal ; rate risk is the m Mada dts dud ly, interest rate risk affects the followir ke Lend Py LOU Feturn Fluctuations in interest rates are caused by changes in the government's moneti that occur in the interest rates of treasury bills and government bonds, These cause Price and its return, which in turn lead to changes in investment patterns, These are sum Bond return Cost of borrowing 4)126 Security Analysis and Porttolo Management ‘When interest rates rise, new issues will approach the market with securities. Hence, the prices of the latter go down. * When interest rates decline, new bond issues come 10 making those older, higher-yielding ones worth more. Hence, * If the government, to tide over the deficit in the budget, floats interest, an investor would like to switch his investments from private-sector DT Likewise, if the stock market is depressed, investors would like oe oa most of the initial wo a Al have an assured rate of return, The best example is that of Apri and IFC bonds were ub offerings of many companies remained undersubscribed but [DBI A The assured rate of return attracted investors from the stock market to the bond market. of borrowing. This affects stock tr Cost of borrowing The rise or fall in interest rate affects the cost ‘and corporate bodies in the following ways: ; e Most stock traders trade inthe stock market with borrowed funds. The increase in the cost of m affects the profitability of the traders. This dampens the spirit of the speculative traders who use funds. The fall in the demand for securities leads to a fall in the value of the stock index. Interest rates not only affect the security traders but also corporate bodies that carry on their business with borrowed funds. The cost of borrowing increases; a heavy outflow of profit takes place in the form of interest on the capital borrowed. This leads to a reduction in the earnings per share and a consequent fall in the price of the share. Purchasing Power Risk Variations in returns are caused also by the loss of purchasing power of the currency. Purchasing power risk is the probable loss in the purchasing power of the returns to be received. Inflation is the reason behind the loss of purchasing power. Inflation, defined as a persistent increase in prices, is a serious risk for any long-term investor. The level of inflation proceeds faster than the increase in capital value. The rise in price penalizes the returns to the investor, and every potential rise in price is a risk to the investor. Broadly inflation is classified as: © Demand-pull © = Cost-push ‘Demand-pull inflation In the demand-pull inflation, the demand for goods and services exceeds supply. At full employment level of factors of production, the economy would not be able to supp in un, and the demand for products pushes the price upwards. The supply cannot be incre unless an expansion of labour force or machinery for production. The equilibrium bi sd ply i anna as igh Price level. a inflation Cost-push inflation, as the name indicates, refers to the tise ts. The increase in the cost of raw material, labour and equi in high price level. The producer tries to pass theRisk 127 wholesale price index also is used to measure inflation, The real return of any investment can be calculated in the following way. For example, if an investor gets a return of 12 per cent on his investment and the inflation rate is 0.068, then the real value would be 10+ r Lo+m | Where, IR = Inflation rate; r = return _ 10 +012 ~ 1.0 + 0.068 \Real rate of return = ~ 1 = 1,0486 - 1 = 0.0486 = 4.86% This shows that his actual rate of return is only 4.86 per cent, The purchasing power has not increased by 12 per cent according to his earnings. If he really wants to protect himself from inflation, and earn a 12 per cent real rate of return, then his rate of return should be 19.6 per cent. tic, 10+ R lt+r = 0.12 +1 = ——_ = 1,1961-1 = 0.196 = 1 1.0 + 0.068 ia Tf the investor earns a 5 per cent return from his investment in stocks, even though it gives an illusion of earning, his earning is actually negative. The following calculation explains it. 10+r 1.0 + JR a 1.0 + 0.05 © 1.068 - 1 = -0.0169 = -1.69% The investor’s income has increased by 5 per cent. However, his real rate of return has declined by 1,69 per cent. His investment has a negative real rate of return. Thus, the changes that occur in the purchasing power also cause variations in the expected return and the actual return, To tide over the purchasing power risk, the investor should try to ensure that the nominal rate of return is greater than the inflation ratc prevailing in the economy. Thus, purchasing power risk affects returns from bonds, debentures, and stocks. UNSYSTEMATIC RISK Unsystematic risk is unique and peculiar to a firm or an industry. If one’s equity investment is in Tata Motors, , and Infosys, adverse news about Infosys will only impact investment in Infosys; all other stocks will feel any impact. Unsystematic risk stems from financial leverage, managerial inefficiency, technological in the production process, availability of raw material, changes in consumer preferences and labour blems. The nature and magnitude of the above-mentioned factors differ from industry to industry and company 1. These factors have to be analysed separately for each industry and firm. Changes in consumer affect consumer products like television sets, washing machines, refrigerators, etc., more than affect the iron and steel industry. Technological changes affect the information technology industry} Securit iy Analysis and Porttolio Management ‘More than the consumer product industry, Thus, the impact ) of raising fina , i€., the debi-equity portion of the companies, ; tisk and ae paying back the loans involve a risk element. All these Se oa SeeBUsinese i: to the total variability of the return. Broadly, uunsystematic risk can be ¢ : Tisk, which refers to the difference between revenue. and earnings before intere , EBM), ana Financial risk, which refers tothe difference between EBIT and earnings before tax (EBT). Business Risk Business risk is that portion of unsystematic risk caused by the o Variations in the expected operating income reflect business risks. environment are reflected in the operating incomes and expected dividen the difference between revenue and EBIT. For example, consider two companies, Anu and Vinu. In Anu Company, operating income as much as 15 per cent and go as low as 7 per cent. In Vinu company, the operating income can be, 12 per cent or 9 per cent. When both the companies are compared, Anu ‘Company’s business risk is’ because of its high variability in operating income compared to Vinu Company. Business risk ars the inability of a firm to maintain its competitive edge and the growth or stability of the earnings, risk can be divided into internal business risk and external business risk. The concept of business, illustrated in Figure 7.2. Business Risk yperating environment of the bus Variations that occur in the oper \ds. Business risk is concer Internal bussiness risk * Fluctuations in sales + Research and development + Personnel management + Fined cost + Single productRisk 129 help to tide over this problem. Bi: cates boil i etapa Puionen lack this diversified custoneee ee ies have a long chain of distribution channels. Smal search and development (R&D) Sometimes the Product may go out of style or become obsolete. It the management that has to overco) me. the problem of obsolescence by concentrating on the in-house &D programme. For example, if Maruti has to survive the competition, it has to keep its R&D active introduce consumer-oriented technological changes in the automobile sector. This is often carried out by introducing sleekness, seating comfort, and brake efficiency in its automobiles. New products have to be produced to replace the old ones, Shortsighted cutting of the R&D budget would reduce the operational efficiency of any firm, onnel management Personnel management in a company also contributes to the operational efficiency e firm. Frequent strikes and lockouts result in loss of Production and high fixed capital costs. Labour productivity can also suffer. The challenge of labour management exists in all firms. It is up to the company to solve the problems at the negotiating table and Provide adequate incentives to encourage the increase in Tabour productivity. Encouragement given to labourers at the floor level will boost the morale of the labour force and lead to higher productivity, and less wastage of raw materials and time, Fixed cost The cost component also generates internal risks, if fixed costs are high in the total cast. During @ recession or low demand for a product, the company cannot reduce the fixed costs. At the same time, in & boom period, it cannot change the fixed factors at a short notice. Thus, a high fixed cost component ean be a burden to the firm. The fixed cost component must always be kept at a reasonable level, so it does not affect the profitability of a company. | Single product Internal business risks are higher for a firm producing a single product. The fall in the demand for a single product can be fatal for the firm. Further, some products are more vulnerable to business cycles while some products resist and can go against the tide. Hence, a company must diversify its Product base if it has to face the competition and business cycles successfully. Take for instance, Hindustan Lever Ltd, which is producing a wide range of consumer cosmetics and is thriving in this business. Even When a company diversifies its product base, it must guard against unknown and unrelated product to minimize the risk factor. Poorly thought out diversification is as dangerous as producing a single good. External business risk External risks arise from operating conditions imposed on the firm by circumstances beyond its control. The external environments in which it operates exerts some pressure on the firm. These could be social and regulatory factors, monetary and fiscal policies of government, business cycles or the general economic _ nvironment in which a firm or an industry operates. A government policy that favours an industry will lead 0 a rise in the stock prices of the particular industry. For instance, the Indian sugar and fertilizer industries very vulnerable to external factors. Social and regulatory factors A harsh regulatory climate and legislation against environmental degradation impair the profitability of an industry: Price controls, volume controls, importexport controls and. ‘ronment controls reduce the profitability of a firm. This risk is high in industries related to public utility ectors such as telecom, banking and transportation. The government's t Policy for the telecom sector 7 a direct bearing on its earnings, Likewise, interest rates and norms for lending can affect the profitability of banks. The Calcutta Blecetric Supply Corporation has not been able to increase its Power tariff owing lo stiff resistance from the West Bengal government. The Pollution Control Board has asked most ofthe 7 tanneries in Tamil Nadu to close, and this has affected the leather industry. r190 Security Analysis and Porttolo Management With a change i Politleal risk Potitial risk arises out of changes in government Dei he tbertized ig my Party, policies also change, When Dr Manmohan Singh was the net jee det sige le N jronomy. During the Bharathiya Janata Party government, even thou pe Deana te ca x ip investment stress was placed on indigenous production. Politcal risks aPB* TiN Ne TTS AOE of fn investment. The host « rules and regulations regal ign investnen 1s must dilute their equity and share their ther holdings in Indian compan" cxample, in 197, the government decided that multinational with Indian investors. This forced many multinationals to liquidate Business eyele Fluctuations in business cycle may lead to fuctuations in oS ae Company, irateninletecession could lead to a drop in the ouput of many industries. Stel an! Wills conser industries tend to move in tandem with the business cycle. During a boom, there is much demand fo Products and white consumer goods. However, in a recession, demand for such goods takes a hit, In Tecent times, the information technology industry has resisted business cycle, and moved counter clay during a recession. The effects of business cycles vary from one company to another. Sometimes, with inadequate capital and consumer base may be forced to close down. In some other cases, there a fall in profits, and the growth rate may decline. This risk factor is external to the corporate bodies, f they may not be able to control it. Financial Risk ; This refers to the variability in income vis-a-vis the equity capital because of the debt capital. Financial rig 4s associated with the capital structure of the company. This structure consists of equity funds and funds. The presence of debt and preference capital results in a commitment of paying interest ora pe-in tate of dividend. The residual income alone is available to the equity holders. The interest payment afer the payments that are due to the equity investors. Debt financing increases the variability of the refuns to the common stockholders and affects their expectations regarding the retum. The use of debt with om funds to increase the return to shareholders is known as financial leveraging, ¢ Debt financing evables companies to have funds at a low cost and offer financial leverage to te shareholders. As long as the earnings of a company are higher than the cost of borrowed funds, shareholden’ earnings go up. At the same time, when the earnings are low, it may lead to bankruptcy for equity holders, This is illustrated in Table 7.1. _Company A Equity capital:10 per share : 20,00,000 Debt fund (10% interest) 00,000 ‘Operatine income Equity capital: 210 per share 10,00,000 Debt fund (10% interest) 20,00,000 20,00,000 20,0000 _ Operating income 3,00,000 4,00,000 2,00,000 ne} Risk 131 The example detailed in Table 7.1 deals with three different situations. In the year 20X6, both the companies earned the same amount and earnings per share were the same, In the year 20X7, there was 33.33 per cent hike in the earnings of the two companies. In company A, a 33.33 per cent rise in operating income resulted in a 50 per cent increase in earnings per share, In company B, the effect of an increase in operating income was so considerable that the earnings per share increased by cent per cent, i.¢., from 71 to 2. The reason behind this is that the bondholder receives only the pre-fixed interest amount, whether the company fares well or not. The increase in earnings per share would cause a change in the capital appreciation of the shares of company B during a good year In 20X8, the economic climate changed, and there was a fall in the operating profit by 33.33 per cent for both the companies. This caused a 5 per cent fall in earnings per share for company A compared to 20X6. However, company B's earning per share fell to zero, affecting shareholders adversely. If we assume another situation of negative earnings, the situation would be worse in company B, and the shareholders will be further adversely affected. A few years of persistent negative earnings will erode the shareholders’ equity. Fixed return on borrowed capital either enhances or reduces the return to shareholders. ; The financial risk considers the difference between EBIT and EBT. Business risks cause variations between revenue and EBIT. The payment of interest affects the eventual earnings of the company stock. Volatility in the rates of return on the stock is magnified by borrowed money. The variations in income caused by borrowed funds in highly leveraged firms are greater compared to companies with low leverage. The financial leverage or financial risk is an avoidable risk because, the management decides the share of equity and borrowed funds in the total capital. MINIMIZING RISK EXPOSURE Every investor wants to guard against risk. This can be done by understanding the nature of the risk and by careful planning. The following paragraphs explain how investors can protect themselves from the different types of risks, Protection against Market Risk An investor must study the price behaviour of the stock. Usually, history repeats itself even though it is not in perfect form. The stock that shows a growth pattern may continue to do so for some more periods. The Indian stock market expects the growth pattern to continue for some more time in information technology stock and depressing conditions to continue in textile-related stocks. Some stocks may be cyclical stocks. It is better to avoid such stocks. The standard deviation and beta indicate the volatility of the stock. The standard deviation and beta are available for the stocks included in the indices. The NSE news bulletin provides this information. By looking at the beta values, the investor can gauge the risk factor and make decisions according to his risk tolerance, Further, the investor should be prepared to hold the stock for a minimum period to reap the benefits of Tsing trends in the market. He should be careful about the timing of the purchase and sale of the stock, He Should purchase it when it is low and should exit at a higher level. Protection against Interest Rate Risk An investor can protect himself against interest rate risk by: * Holding the investment to maturity: If he sells it in the middle due to fall in the interest rate, the capital __ invested will experience a heavy loss. Buying treasury bills and bonds of short maturity: After maturity, to suit the market interest rates. {nvesting in bonds with different maturity dates: When the bonds mature on different dates, reinvestment the invested money can be reinvested182 Security Analysi Ind Portfolio Management rrity diversification past According to the changes in the investment climate, Maturity Protection against Inflation The following points should be noted: ® The general opinion is that the bonds or debentures with fixed f bond yield is 13 to 15 per cent with low risk factor, it can provi Another way to avoid risk is to have investment in nae investments. A rising consumer price index may wipe out the rea is ¢ SUNGGvesisentcivesisention can also solve this problesi to 8 cert een Tee Z } his investment to include real estate, precious metals, arts and antiques, Desi bat tt aaa ensure that such diversification will provide a perfect hedge against inflation, cr loss due to fall in purchasing power. returns cannot solve the p ide a hedge against inflation, rm securities and to al rate of interest in the lon Protection against Business and Financial Risk Investors can protect themselves © Analysing the strength and pean of the industry to which the company belongs. If the of the industry is too much of government interference by way of rules and regulations, it is} avoid it. * Analysing the profitability trend of the company. The calculation of standard deviation would yil variability of return. If there is inconsistency in the earnings, it is better to avoid it, The invest choose a stock with a consistent track record. * Analysing the capital structure of the company. If the debt equity ratio is high, the investor exercise caution. Along with an analysis of the capital structure, he should also take into ul interest payments. In a boom, the investor can select a highly leveraged company but should n during a recession. RISK MEASUREMENT in some quantitative terms. Expressing the risk of a stock in quantitative terms makes possible with other stocks. Measurements cannot be cent per cent accurate because risk is caused by factors-social, political, economic, and managerial. Measurement provides an approximate of risk. Ex-post Risk Variance from the mean value measures the ex-post risk using historical data. The variance uses the returns of an asset to measure risk. For example, if one wants to with a stock, one has to take the returns of the stock over a period. Then he has to cal stock return, The value of variance indicates the risk of that stock,n the past return of the stock. Then, using the standard normal probability distribution, one can find probability of return on that stock falling below that mean or expected return. stock price is not normally distributed, subjective estimates of probabilities of returns are needed. aan investor can find out the expected return of that stock. Then the calculation of variance gives of the expected stock return, . e other statistical tool often used to measure and used as a proxy for risk is the standard deviation. deviation It is a measure of the values of the variable around its mean. In other words, it is the Toot of the sum of the squared deviations of variable values from the mean divided by the number of ances. The monthly returns of SBI stock for the financial year 2011-12 are given in Table 7.2 along he relevant calculations for the standard deviation. Table 7.2 Monthly returns for SBI Stock in 2011-12Stat = P-value Lower 95% Intercept (a) 0.108 en X Variable (8) _ 1.006 7.128 _9.896-07 _0.710 1.301 Correlation 21x 33.34 —(-0.86)(1.37) r= Var x 33.235 —(-0.86)? oa 2.1 x 46.225 ~ (1.37) 698.96 “26.404x3113 8° P=(@O.85P = 0.72 A beta value of 1.006 indicates that one unit change in Sensex will cause a 1.006 ee HDFC return. This shows that the market and the HDFC Bank stock move in unison. An uptun in the market will reward Mr Mohan with a marginally higher return than market return. downwards trend has a negative effect on the return. If a boom period is anticipated, it is a goo investment. Otherwise, he has to reconsider his investment proposal. The r’ indicates that 72 per Cent of the variation that occur in stock return is explained by variations in the Sensex return. This shows the high relationship of the stock with the market. Anyhow, Mr Mohan is advised to have data at least for a year to confirm the results. SUMMARY * Risk is measured by the variability of return. Risk has two components, systematic and unsyst * Systematic risk affects the market as a whole. Tangible events such as war and global financial crisis intangible events like investor's psychology affect the entire stock market, which are known as mi risk. Interest rate risk is the variation in return caused by the changes in the market interest rate. Purchasing power risk is caused by inflation. Inflation reduces the real rate of return © Unsystematic risk is unique to the particular industry or company. This is and financial risk. "i Business risk is caused by the operating environment of the business, This rs like fluctuations in sales or personnel management or external fac