Module 4

RISK & RETURN VALUATION OF SECURITIES

Concept of Risk, Types of Risk- Systematic risk, Unsystematic risk,
Calculation of Risk and returns of individual security, Portfolio Risk and
Return, Alpha and Beta of a Portfolio, Calculation of Beta.
Concept of Risk

Risk is the probability that an accidental phenomenon produces in a

given point of the effects of a given potential gravity, during one
given period.
Business risk is the exposure a company or organization has to
factor(s) that will lower its profits or lead it to fail. Anything that
threatens a company's ability to achieve its financial goals is
considered a business risk.

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Types of Risk-

• Systematic risk
• Unsystematic risk

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Systematic risk

Systematic risk is risk that impacts the entire market or a large sector
of the market, not just a single stock or industry. Examples include
natural disasters, weather events, inflation, changes in interest rates,
war, even terrorism.
Systematic risk refers to the risk inherent to the entire market or
market segment. Systematic risk, also known as “undiversifiable risk,”
“volatility” or “market risk,” affects the overall market, not just a
particular stock or industry.

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Types of Systematic Risk
Systematic risk includes market risk, interest rate risk, purchasing power risk, and
exchange rate risk.
1. Market Risk
Market risk is caused by the herd mentality of investors, i.e. the tendency of investors to follow the direction
of the market. Hence, market risk is the tendency of security prices to move together. If the market is
declining, then even the share prices of good-performing companies fall. Market risk constitutes almost two-
thirds of total systematic risk. Therefore, sometimes the systematic risk is also referred to as market risk.
Market price changes are the most prominent source of risk in securities.
2. Interest Rate Risk
Interest rate risk arises due to changes in market interest rates. In the stock market, this primarily affects
fixed income securities because bond prices are inversely related to the market interest rate. In fact, interest
rate risks include two opposite components: Price Risk and Reinvestment Risk. Both of these risks work in
opposite directions. Price risk is associated with changes in the price of a security due to changes in interest
rate. Reinvestment risk is associated with reinvesting interest/ dividend income. If price risk is negative (i.e.,
fall in price), reinvestment risk would be positive (i.e., increase in earnings on reinvested money). Interest
rate changes are the main source of risk for fixed income securities such as bonds and debentures.

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3. Purchasing Power Risk (or Inflation Risk)
Purchasing power risk arises due to inflation. Inflation is the persistent and sustained increase
in the general price level. Inflation erodes the purchasing power of money, i.e., the same
amount of money can buy fewer goods and services due to an increase in prices. Therefore, if
an investor’s income does not increase in times of rising inflation, then the investor is actually
getting lower income in real terms. Fixed income securities are subject to a high level of
purchasing power risk because income from such securities is fixed in nominal terms. It is often
said that equity shares are good hedges against inflation and hence subject to lower
purchasing power risk.
4. Exchange Rate Risk
In a globalized economy, most companies have exposure to foreign currency. Exchange rate
risk is the uncertainty associated with changes in the value of foreign currencies. Therefore,
this type of risk affects only the securities of companies with foreign exchange transactions or
exposures such as export companies, MNCs, or companies that use imported raw materials or
products.

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Unsystematic risk
Unsystematic risk is the risk that is unique to a specific company or
industry. It's also known as nonsystematic risk, specific risk,
diversifiable risk, or residual risk.
Examples of unsystematic risk include a new competitor in the
marketplace with the potential to take significant market share from
the company invested in, a regulatory change (which could drive down
company sales), a shift in management, or a product recall.

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Types of unsystematic risk
1. Business risk/Liquidity risk
Business risk, basically, implies the type of unsystematic risk which questions whether the firm will be
able to earn a considerable amount of profits or not.
Every business has some usual expenses, and to cover them, there should be at least as much earning
which covers the usual expenses. For instance, salaries, marketing cost, and so on.
2. Financial risk/Credit risk
A firm’s financial risk implies the use of financial leverage or loan that the firm may use for funding its
operations or a part of the operations. Financial risk is the liability on the firm to pay interest
payments on the loan(s).
•There are some factors which can make a firm vulnerable to financial risks, such as:
•An interest rate hike in the market can increase the expense all of a sudden as compared to the
earning
•Less equity financing as compared to the leverage financing
•Management issue with regard to speculation of both expenses and income

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3. Operational risk
An operational risk implies the loss that every organisation is prepared to bear
since it includes all those errors which are natural.
The error can be:
•Employees related such as a human error
•Relating to the hardware system (computer, machine), such as a technical
problem
•Relating to an old process being followed for a task that requires an advanced
process

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Calculation of Risk and returns of individual
security
What Is Expected Return?
The expected return is the profit or loss that an investor anticipates on
an investment that has known historical rates of return (RoR). It is
calculated by multiplying potential outcomes by the chances of them
occurring and then totaling these results.

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Expected return = risk free premium + Beta (expected market return - risk free
premium)
•where:
•ra = expected return;
•rf = the risk-free rate of return;
•β = the investment's beta; and
•rm =the expected market return

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For example, let's assume we have an investor interested in the tech sector. Their
portfolio contains the following stocks:
Alphabet Inc., (GOOG): $500,000 invested and an expected return of 15%
Apple Inc. (AAPL): $200,000 invested and an expected return of 6%
Amazon.com Inc. (AMZN): $300,000 invested and an expected return of 9%
With a total portfolio value of $1 million the weights of Alphabet, Apple, and
Amazon in the portfolio are 50%, 20%, and 30%, respectively.
Thus, the expected return of the total portfolio is:
(50% x 15%) + (20% x 6%) + (30% x 9%) = 11.4%

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Measurement of the Risk

How Do You Measure the Risk of an Investment?

There's a multitude of ways to measure risk. Beta is a measurement
that compares the risk or volatility of an investment against the
general market. Standard deviation measures the dispersion of
performance from an investment's average. The Sharpe Ratio
measures whether an investment's returns are fairly compensating an
investor for the associate level of risk assumed.

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Portfolio Risk and Return
A portfolio is composed of two or more securities. Each portfolio has
risk-return characteristics of its own. A portfolio comprising securities
that yield a maximum return for given level of risk or minimum risk for
given level of return is termed as ‘efficient portfolio’.
This is dependent upon the interplay between the returns on assets
comprising the portfolio. Another assumption of the portfolio theory is
that the returns of assets are normally distributed which means that
the mean (expected value) and variance analysis is the foundation of
the portfolio.
i. Portfolio Return:
The expected return of a portfolio represents weighted average of the
expected returns on the securities comprising that portfolio with
weights being the proportion of total funds invested in each security
(the total of weights must be 100).

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The following formula can be used to determine expected return of a portfolio:

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ii. Portfolio Risk:
Unlike the expected return on a portfolio which is simply the weighted average of the
expected returns on the individual assets in the portfolio, the portfolio risk, σp is not the
simple, weighted average of the standard deviations of the individual assets in the portfolios.
It is for this fact that consideration of a weighted average of individual security deviations
amounts to ignoring the relationship, or covariance that exists between the returns on
securities. In fact, the overall risk of the portfolio includes the interactive risk of asset in
relation to the others, measured by the covariance of returns. Covariance is a statistical
measure of the degree to which two variables (securities’ returns) move together. Thus,
covariance depends on the correlation between returns on the securities in the portfolio.
Covariance between two securities is calculated as below:
1. Find the expected returns on securities.
2. Find the deviation of possible returns from the expected return for each security
3. Find the sum of the product of each deviation of returns of two securities and respective
probability

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The formula for determining the covariance of returns of two
securities is:

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iii. Diversification:
Diversification is venerable rule of investment which suggests “Don’t put all your
eggs in one basket”, spreading risk across a number of securities.
Diversification may take the form of unit, industry, maturity, geography, type of
security and management. Through diversification of investments, an investor can
reduce investment risks.

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Problems and Solutions

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1. An investor has two investment options before him. Portfolio A offers risk-free
expected return of 10%. Portfolio B offers an expected return of 20% and has
standard deviation of 10%. His risk aversion index is 5. Which investment portfolio
the investor should choose?
Solution:
The following equation can be used to measure utility score of a portfolio:

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2. Companies X and Y have common stocks having the expected returns and
standard deviations given below:

The expected correlation coefficient between the two stocks is – 35.

You are required to calculate the risk and return for a portfolio comprising 60%
invested in the stock of Company X and 40% invested in the stock of Company Y.
Solution:
(i)Return of p = (.60)(.10) + (.40)(.06) = 0.06+0.024=0.084 approx. 8.4%
(ii)Risk of company X & Y= .60*(0.10-0.084)2(this is square)+ 0.40(0.05-0.084)2
= 0.60*0.000256+ 0.40*0.001156
= 0.0001536+ 0.0004624
= 0.000616 approx. 0.06 %

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Alpha and Beta

• Alpha and beta are two different parts of an equation used to

explain the performance of stocks and investment funds.
• Beta is a measure of volatility relative to a benchmark, such as the
S&P 500.
• Alpha is the excess return on an investment after adjusting for
market-related volatility and random fluctuations.

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Calculation of Beta
• Beta could be calculated by first dividing the security's standard
deviation of returns by the benchmark's standard deviation of
returns. The resulting value is multiplied by the correlation of the
security's returns and the benchmark's returns.

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• Covariance measures how two stocks move together. A positive covariance
means the stocks tend to move together when their prices go up or down. A
negative covariance means the stocks move opposite of each other.
• Variance, on the other hand, refers to how far a stock moves relative to its
mean. For example, variance is used in measuring the volatility of an
individual stock's price over time. Covariance is used to measure the correlation
in price moves of two different stocks.

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