SYSTEMATIC & UNSYSTEMATIC RISK

PRESENTERS
MAHARUKH HOZDAR VAIBHAV THAKKAR POOJA MEHTA SANKET DOSHI ANKIT SHAH

PROF: Mr. KUNNADKARNI 14 SECURITY ANALYSIS PORTFOLIO MANAGEMENT

CONCEPT OF RISK
 All investments are risky, whether in stock and capital market or banking and financial sector, real estate, bullion, gold, etc.  The degree of risk however varies on the basis of the features other assets investment instruments, the mode of Investment  Even the so called riskless assets like- bank deposits carry some cost and time in realization of proceeds or in conversion into cash

SYSTEMATIC RISK
Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc. It arises out of external and uncontrollable factors, arising out of the market, nature of the industry and state of economy and host of other factors.
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Examples of systematic risk

Market risks Interest rate risk Purchasing power risk The inflation rate increases. The RBI promulgates a restrictive credit policy. The government relaxes the foreign exchange controls and announces full convertibility of Indian rupee. The government withdraw tax on dividend payments by companies.

UNSYSTEMATIC RISK
Risk factors that affect a limited number of assets Also known as unique risk and asset-specific risk Includes such things as labor strikes, part shortages, etc.

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EXAMPLES OF UNSYSTEMATIC RISK

Business Risk Financial Risk Insolvency Risk The company workers declare strike . The company loses a big contract in a bid. The company makes a break through in process innovation. The company is unable to obtain adequate quantity of raw material.

RETURNS
Total Return = expected return + unexpected return Unexpected return = systematic portion + unsystematic portion Therefore, total return can be expressed as follows: Total Return = expected return + systematic portion + unsystematic portion

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TOTAL RISK
Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk
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SYSTEMATIC RISK PRINCIPLE

There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that assets systematic risk since unsystematic risk can be diversified away

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MEASURING SYSTEMATIC RISK

How do we measure systematic risk? We use the beta coefficient to measure systematic risk What does beta tell us? A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than
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the overall market

TOTAL VERSUS SYSTEMATIC RISK

Consider the following information:
Standard Deviation Security C 20% Security K 30% Beta 1.25 0.95

Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?
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RISK: SYSTEMATIC AND UNSYSTEMATIC

We can break down the risk, U, of holding a stock into two components: systematic risk and unsystematic risk: W Total risk; U I Nonsystematic Risk; I Systematic Risk; m

R ! R U becomes R ! Rm where m is the systematic risk is the unsystemat ic risk

n

SYSTEMATIC RISK AND BETAS

For example, suppose we have identified three systematic risks on which we want to focus: 1. Inflation 2. GDP growth 3. The dollar-euro spot exchange rate, S($, ) Our model is:

R ! Rm R ! R
I I

FI 

GDP

FGDP 

FS 

is the inflation beta is the GDP beta is the spot exchange rate beta

GDP S

is the unsystemat ic risk

SYSTEMATIC RISK AND BETAS: EXAMPLE

R ! R

FI 

GDP GDP

FS 

Suppose we have made the following estimates:  FI = -2.30  FGDP = 1.50  FS = 0.50. Finally, the firm was able to attract a superstar CEO and this unanticipated development contributes 1% to the return. ! 1%

R  2.30 v FI  1.50 v FGDP  0.50 v FS  1%

Systematic Risk and Betas: Example

R ! R  2.30 v FI  1.50 v FGDP  0.50 v FS  1%
We must decide what surprises took place in the systematic factors. If it was the case that the inflation rate was expected to be by 3%, but in fact was 8% during the time period, then FI = Surprise in the inflation rate = actual expected = 8% - 3% = 5%

R ! R  2.30 v 5%  1.50 v FGDP  0.50 v FS  1%

Systematic Risk and Betas: Example

R ! R  2.30 v 5%  1.50 v FGDP  0.50 v FS  1%

If it was the case that the rate of GDP growth was expected to be 4%, but in fact was 1%, then FGDP = Surprise in the rate of GDP growth = actual expected = 1% - 4% = -3%
R ! R  2.30 v 5%  1.50 v ( 3%)  0.50 v FS  1%

Systematic Risk and Betas: Example

R ! R  2.30 v 5%  1.50 v (3%)  0.50 v FS  1%
If it was the case that dollar-euro spot exchange rate, S($, ), was expected to increase by 10%, but in fact remained stable during the time period, then FS = Surprise in the exchange rate = actual expected = 0% - 10% = -10%

R ! R  .30 v 5%  1.50 v (3%)  0.50 v (10%)  1%

SYSTEMATIC RISK AND BETAS: EXAMPLE

R ! R  2.30 v 5%  1.50 v (3%)  0.50 v FS  1%

Finally, if it was the case that the expected return on the stock was 8%, then
R ! 8%

R ! 8%  2.30 v 5%  1.50 v ( 3%)  0.50 v ( 10%)  1% R ! 12%

SYSTEMATIC RISK AND BETAS

The beta coefficient, F, tells us the response of the stock s return to a systematic risk. In the CAPM, F measures the responsiveness of a security s return to a specific risk factor, the return on the market portfolio.

DIVERSIFICATION
Portfolio diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 IT stocks, you are not diversified However, if you own 50 stocks that span 20 different industries, then you are diversified
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THE PRINCIPLE OF DIVERSIFICATION

Diversification can substantially reduce the variability of

returns without an equivalent reduction in expected returns

This reduction in risk arises because worse than expected

returns from one asset are offset by better than expected returns from another
However, there is a minimum level of risk that cannot be

diversified away and that is the systematic portion

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Figure 13.1

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DIVERSIFIABLE RISK
The risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unique or asset-specific risk If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away
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Case Study
Maharukh (working in SEBI) - Infosys Vaibhav (working in Kale Consultancy)- ICICI BANK Pooja (student) - COAL INDIA Sanket (student) NITIN FIRE Ankit (working in Nomura holdings) - ADVISE

INFOSYS LTD

Thus there is fall in share price is 25.41% aprox

ICICI BANK LTD

Thus there is fall in share price is 16.16% aprox

COAL INDIA LTD

Thus there is rise in share price of17.54% aprox

NITIN FIRE LTD

Thus there is rise in share price of 45.53% aprox

EXPERTS ADVICE
By taking expert advise by an expert he made us invested in various sectors and diversify the risk component. This will help mitigate the risk which is exposed by investing in a single sector. Hedging your risk is also important part of diversifying your risk. However, this can not guarantee that the value of a portfolio won't fall in a market crash. But it certainly ensures that the long-term goals of the investors will be met.

A DIVERSIFIED PORTFOLIO
Clients A portfolio as of AUGUST, 2011
2-Aug-11 Amount ,500 00 83 8,300 00 1805.5 180,550.00 397.1 39,710.00 1130.7 113,070.00 32.05 3,205.00 1733.7 173,370.00 323. 32,3 0.00 227.85 22,785.00 180.65 18,065.00 Portfolio Value 754,895.00 Stocks RIL DFC A ERO O DA COAL I DIA TCS ARTI AIRTEL TOU RO LARSE UL DLF TPC

 We have a BSE -SENSEX closing of 18110.00 point on 2nd August 2011 We will compare the SENSEX gain/loss to the gain/loss in the portfolio. The client A has a portfolio of about 7.55 lacs Lets see in the next slide s how diversification helps in mitigating risk & lowering the loss and also to earn better profits.

 Clients A portfolio as of 26th AUGUST, 2011 The BSE-SENSEX CLOSED AT 15849

-11 A o nt Sto s 22 2,200 00 L 4 4 , 00 00 D CBAN 1955 195,500 00 E O ONDA 60 25 6,025 00 COAL ND A 949 25 94,925 00 TCS 400 40,000 00 B A T A TEL 1529 152,9 0 00 LA SEN TOUB O 19 05 1,905 00 UL 1 5 1 ,5 0 00 DL 16 2 16, 20 00 NT C Portfolio Value 701,515.00 26-A

COMPARISION & OBSERVATION

The BSE- SENSEX Closed at points 15849 which is 12.5 % down from August closing The portfolio value has been down to Rs 701,515.00 and the fall in % terms is 7% this We see that diversification helps in mitigating the Risk. We invested in different sectors of the companies which were included in the Sensex, yet the Sensex got battered more than the portfolio Over diversification can also prove to be harmful.

THANK YOU