Security Analysis

and
Portfolio Management
Rahul Kumar
(Department of Business Administration-
M.J.P. Rohilkhand University, Bareilly)

1
• “Often the difference between a successful
person and a failure is not one has better
abilities or ideas, but the courage that one
has to bet on one's ideas, to take a
calculated risk - and to act.”

– Andre Malraux (French novelist)

RISK & RETURN FRAMEWORK
 Risk
• The literal meaning of risk varies based on
one’s perception.
• The Websters Dictionary says that risk is the
possibility of something unpleasant happening
or the chance of encountering loss or harm.
Thus risk is perceived almost entirely in
negative terms.
 Risk
• Risk, in the present context means the
uncertainty of future cash flows.

• Risk refers to the likelihood that we will

receive a return that is different from the
return we expected to make.
 Two characteristics of risk

– Uncertainty – the risk may or may not

happen, that is, there are no 100% risks
(those, instead, are called constraints)

– Loss – the risk becomes a reality and

unwanted consequences or losses occur
 TYPES & SOURCES OF RISK

RISK

SYSTEMAT UNSYSTEMAT
IC IC

INTERES FINANCI
INFLATIO MARKET BUSINES
T RATE AL RISK
N RATE RISK S RISK
RISK

Internal External
Business Business
Risk Risk
 Systematic Risk
• Also known as "un-diversifiable risk" or "market
risk."
• Changes occur in the economic, political and social
systems constantly effects our performance of
companies and there by on their stock prices
• Recession, corporate profits etc
• Thus, the impact of economic, political and social
changes is system-wide and that portion of total
variability in security returns caused by such system
wide factors is referred to as systematic risk.
• Systematic risk can be mitigated only by being
hedged.
Even a portfolio of well-diversified assets cannot
 Examples of Systematic Risk
•The government changes the •The government relaxes the
interest rate policy. The foreign exchange controls
corporate tax rate is and announces full
increased. convertibility of the Indian
rupee.
•The government resorts to
massive deficit financing. •The government withdraws
tax on dividend payments by
•The inflation rate increases companies.

•The RBI promulgates a •The government eliminates

restrictive credit policy. reduces the capital gain tax
rate.
 Types of Systematic Risk

Systemati
c Risk

Interest Inflation Market

Rate Risk Rate Risk
 Interest Rate Risk
• This is a type of systematic risk.
• Affects debt securities like bonds and
debentures.
• A bond having a face value of Rs.100 issued with
a coupon rate of 10% when the market interest
rate is also 10% will have a market price of
Rs.100.
• If subsequent to the issue, the market interest
rate moves up to 12.5%, no investor will buy the
bond with 10% coupon interest rate unless the
holder of the bond reduces the price to Rs.80.
 Market Risk
• Another type of systematic risk
– Shares prices rise=Bullish trend
– Shares prices fall=Bearish trend
• The stock market is seen to be volatile. This
volatility leads to variations in the returns of
investors in shares. The variation in returns
caused by the volatility of the stock market is
referred to as the market risk.
Inflation rate/Purchasing Power Risk
• Another type of systematic risk.
• It refers to the variation in investor returns
caused by inflation.
• Inflation results in lowering of the purchasing
power of money.
• Time value of money
 Unsystematic Risk
What Does Unsystematic Risk Mean?
The Returns from a security may sometimes vary
because of certain factor affecting only the company
issuing such security. Eg-Raw material scarcity, labour
strike, management inefficiency.

Also known as "specific risk", "diversifiable risk" or

"residual risk".

For example, news that is specific to a small number

of stocks, such as a sudden strike by the employees of
a company you have shares in, is considered to
be unsystematic risk.
 Examples of Unsystematic Risk
✔The company workers declare✔The company makes a
strike. breakthrough in process
innovation.
✔The R&D expert leaves the
company. ✔The government increases
custom duty on the material
✔A formidable competitor used by the company.
enters the market.
✔The company is unable to
✔The company loses a big obtain adequate quantity of
contract in bid. raw material.
 Types of Unsystematic Risk

UNSYSTEMATIC

FINANCI
BUSINES AL RISK
S RISK

Internal External
Business Business
Risk Risk
 Business Risk
• Operating conditions faced by company

• The variability in operating income caused by

the operating conditions of the company.
 Financial Risk
• Financial leverage in capital structure.

• Levered firm and Unlevered firm

• This variability in EPS due to the presence of

debt in the Capital Structure of a company is
referred to as financial risk.
 Measurement of Total Risk
• Total risk = Systematic Risk + Unsystematic Risk
• Risk is associated with variability in the likely
outcomes.
• If a security’s return has no variability, it has no
risk.
• Risk is caused by a number of factors, cent per
cent accuracy can not be assured by any method
of measurement.
• Statistical tools are often used to measure the
variability of returns.
 Total Risk = Systematic Risk +
STD DEV OF PORTFOLIO RETURN
Unsystematic Risk

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

There are Different methods to measure the
variability of returns(Unsystematic Risk):

1. Range : It is equal to difference between

highest possible rate of return and lowest
possible rate of return, i.e. R=HR-LR
2. Variance: The variance of a security’s rate of
return can be found as the sum of the
products of the squared deviations of each
possible rate of return from the expected
value of return multiplied by the probability
that the rate of return may occur.
V = {(Xi-EV)2 Pxi)}
3. Standard Deviation (σ) : Simply the square root of
the variance of the rates of returns.
Σ= V
2
Or Σ {(Xi-EV) Pxi)}
Situation 1– Returns on shares of company A
and company B for various possible outcome
are given below along with their probabilities:
Company A’s Shares Company B’s Shares
Outcom Returns( Probabili Outcom Returns,( Probabili
es %) ty e %) ty
1 8 .15 1 9 .30
2 9 .20 2 10 .40
3 10 .30 3 11 .30
4 11 .20
5 12 .15

Which company’s shares are more risky?

 Company A’s Shares
Xi Pxi Xi . Pxi (xi-EV) (xi-EV)2 (xi-EV)2 . Pxi

8 .15 1.20 -2 4 0.60

9 .20 1.80 -1 1 0.20
10 .30 3.00 0 0 0
11 .20 2.20 +1 1 0.20
12 .15 1.80 +2 4 0.60
10.00 EV 1.60 Variance

•Range = 12-8 = 4, Coefficient of Range =

12 -- 8 = 4 = .02
12 + 8 20
•Variance = 1.60
• σ = 1.60 = 1.26
 Company B’s Shares
Xi Pxi Xi . Pxi (xi-EV) (xi-EV)2 (xi-EV)2 . Pxi

9 .30 2.70 -1 1 0.30

10 .40 4.00 0 0 0
11 .30 3.30 +1 1 0.30
10.00 EV .60 Variance

Range = 11-9 = 2,
11 -- 9 = 2 = .1
Coefficient of Range =
11 + 9 20
Variance = 0.60
σ = 0.60 = 0.77
• We see that expected average returns (EV) of
both company’s share are identical i.e. 10%.
• Range is different.
– The range in company A is from 8 to 12 i.e., 0.2
and for company B it is 9 to 10 i.e., 0.1 only.
• However, position is more clear by standard
deviation, which is 1.26 in the case of
company A and only 0.77 in the case of
company B.
• Thus company A’s Shares are more risky
 Measurement of Systematic Risk
• The systematic risk of a security is measured
by a statistical measure call Beta.

• Two statistical methods may be used for the

calculation of Beta, namely the Correlation
method or the regression method.
 Correlation Method to find out
Beta
ᵝ = rimσiσm
2
σ m
• Rim = Correlation coefficient between the returns of
stock I and the returns of the market index
• σi = Standard deviation of returns of stock i.
• σm = Standard deviation of returns of the
market index.
• σ 2m = Variance of the market returns.
 Correlation of Coefficient

nΣXY –(ΣX) (ΣY)

r=
nΣX2 –(ΣX)2 . nΣY2 –(ΣY)2

X= One data series (Rm)

Y= Other data series (Ri)
n=Number of items.
Standard deviation and variance can be
calculated by using the following formula:

• Variance, σ2 = NΣX2 –(ΣX)2

N2

• Standard deviation, , σ = NΣX2 –(ΣX)2

N2
X = Original data
N= Number of Items
 Regression Method
Y= ά + βX
• Y = Dependent variable.
• X = Independent Variable
• ά and β are constants.
The formula used for the calculation of ά and β are :
•n=Number of items
ά = Y – βX •Y=Mean value of the dependent
variable scores.
•X= Mean value of independent
β = nΣXY– (ΣX)(ΣY) variable scores.
•Y=Dependent variable scores.
nΣX2 –(ΣX)2 •X=Independent variable scores.
 For the Calculation of beta, the return of the individual
security is taken as the dependent variable, and the
return of the market index is taken as the independent
variable. The regression equation is represented as
follows:
Ri = ά + βRm
Ri = Return of the individual security.
Rm = Return of the market index.
ά = Estimated return of the security when the market is stationary.
βi = Change in the return of the individual security in response to
unit change in the return of the market index. It is, thus, the
measure of systematic risk of a security.

A Security can have betas that are Positive, negative or zero.

Situation-2—Monthly return data (%) are presented below for
ITC stock and BSE National Index for a 12 month period.
Calculate beta of ITC Stock.
Months ITC BSE National Index
1 9.43 7.41
2 00.00 -5.33
3 -4.31 -7.35
4 18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.00 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15
 Calculation of Correlation coefficient
Months ITC BSE National Index Y2 X2 XY
Y(Ri) X (Rm)
1 9.43 7.41 88.92 54.91 69.88
2 00.00 -5.33 00.00 28.41 00.00
3 -4.31 -7.35 18.58 54.02 31.68
4 18.92 -14.64 357.97 214.33 276.99
5 -6.67 1.58 44.49 2.50 -10.54
6 26.57 15.19 705.96 230.74 403.60
7 20.00 5.11 400.00 26.11 102.20
8 2.93 0.76 8.58 0.58 2.23
9 5.25 -0.97 27.56 0.94 -5.09
10 21.45 10.44 460.10 108.99 223.94
11 23.13 17.47 535.00 305.20 404.08
12 32.83 20.15 1077.81 406.02 661.52
Total 111.69 49.82 3724.97 1432.75 2160.49
 Correlation of Coefficient
nΣXY –(ΣX) (ΣY)
r=
nΣX2 –(ΣX)2 . nΣY2 –(ΣY)2

(12 x 2160.49) – (49.82 x 111.69)

r= (12 x 1432.75) – (49.82) 2 (12 x 3724.97) – (111.69) 2

= 20,361.48 = r = 0.935

21,772.94

X= One data series (Rm)

Y= Other data series (Ri)
n=Number of items.
Variance and Standard deviation of ITC Returns

ΣRi = 111.69, ΣRi2 = 3724.97, N = 12

Variance, σ2 = NΣY2 –(ΣY)2

N2
= (12 x 3724.97) – (111.69)2 = 223.78
122

Standard deviation, , σ i = NΣX2 –(ΣX)2 = 223.78

N2
Standard deviation, , σ i = 14.96
Variance and Standard deviation of IBSE Index Returns
ΣRm = 49.82, ΣRm2 = 1432.75, N = 12

Variance, σ2 = NΣX2 –(ΣX)2

N2
= (12 x 1432.75) – (49.82)2 = 102.16
122

Standard deviation, , σ m = NΣX2 –(ΣX)2 = 102.16

N2
Standard deviation, , σ m = 10.11
 Beta (β)
β = rimσiσm
2
σ m
= (0.935) (14.96 x 10.11) = 141.41
102.16 102.16
βi = 1.384
Eg-Monthly return data (%) are presented below for ITC stock
and BSE National Index for a 12 month period. Calculate beta
of ITC Stock. Using the regression model.
Months ITC BSE National Index
1 9.43 7.41
2 00.00 -5.33
3 -4.31 -7.35
4 18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.00 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15
 Calculation of Regression
Months ITC BSE National Index Y2 X2 XY
Y(Ri) X (Rm)
1 9.43 7.41 88.92 54.91 69.88
2 00.00 -5.33 00.00 28.41 00.00
3 -4.31 -7.35 18.58 54.02 31.68
4 18.92 -14.64 357.97 214.33 276.99
5 -6.67 1.58 44.49 2.50 -10.54
6 26.57 15.19 705.96 230.74 403.60
7 20.00 5.11 400.00 26.11 102.20
8 2.93 0.76 8.58 0.58 2.23
9 5.25 -0.97 27.56 0.94 -5.09
10 21.45 10.44 460.10 108.99 223.94
11 23.13 17.47 535.00 305.20 404.08
12 32.83 20.15 1077.81 406.02 661.52
Total 111.69 49.82 3724.97 1432.75 2160.49
 Dependent variable Y = Ri
Independent variable X = Rm
ΣXY= 2160.49, ΣX=49.82, ΣY=111.69, ΣX2 =1432.75, n = 12
Y= ΣY = 111.69 = 9.31
n 12
X = ΣX = 49.82 = 4.15
n 12
β = nΣXY– (ΣX)(ΣY) = (12 x 2160.49)– (49.82 x 111.69)
nΣX2 –(ΣX)2 (12 x 1432.75) –(49.82)2
β = 1.384
Y = ά + Βx
α = Y – βX = 9.31 – (1.384 x 4.15) 9.31= ά + 1.384 x 4.15
= 9.31 – 5.74 = 3.57 9.31= ά + 5.74
ά = 9.31 – 5.74
Y = ά + Βx (9.31=3.57+1.384x4.15) ά = 3.57
If beta = 1.0, stock is average risk.

If beta > 1.0, stock is riskier than

average.

If beta < 1.0, stock is less risky than

average.

Most stocks have betas in the range of

0.5 to 1.5.
 Return
• Return is a kind of income what investor
receives for making an investment.

• It is a kind of motivating force in the form of

rewards inspiring the investors to undertake a
particular investment preferably investment in
financial assets.
 Component of Return
• Return is basically made up of two components:
– The periodic cash receipts or income on the investment
in the form of interest and dividends. Also Yield-refers to
the income derived from a security in relation to its
market price/purchase price. This can be zero or
positive.
– The appreciation(and for that matter depreciation also)
in the price of the investment; this is referred to as
capital gains/loss. This is the difference between ending
price( price at which investment can be sold) and
beginning price(purchase price). This can be zero
positive or even negative.
 Historical Return
cash payment received during the period +
Price change over the period
• Total return =.....................................................
Price of the investment at the beginning
R Total return over the period
C +(PE - P B ) C Cash Payment received during the period

PE Ending price of the investment

R = -------------------------
PB Beginning price
PB
 Example: Historical Returns
Consider the following information for an equity stock:
Price at the beginning of the year : Rs 60.00
Dividend paid at the end of the year : Rs 2.40
Price the end of the year : Rs 69.00

C +(PE - P B )
R= -------------------------
PB

2.40 +(69.00 – 60.00 )

R= ----------------------------------------------- =
0.19 or 19%
60.00

11-45
 It is helpful to split the rate of return into two components:
Current yield and capital gains/losses yield as follows:

Rate of return = Current yield + capital gain yield

Cash payment Ending price – Beginning price

--------------------- + --------------------------------------------
Beginning price Beginning price

2.40 69.00-60.00
= -------- + --------------------
60.00 60.00

4% current yield + 15 % Capital gains yield

RATE OF RETURN = 19%
 We have seen in the example above that returns form
each share have two components:

The dividend income and The capital gain

Hence, the rate of return on a share would consist of

the dividend yield and the capital gain yield.
Rate of return = Dividend yield + capital gain yield

Cash payment Ending price – Beginning price 2.40 69.00-60.00

--------------------- + -------------------------------------------- = -------- + ----------------
Beginning price Beginning price 60.00 60.00

4% current yield + 15 % Capital gains

yield
THANK YOU