Risk can be defined as deviations of the actual

results from the expected.

We all would like to eliminate this risk
altogether and live in the world of certainty.
However, complete elimination of risk is
impossible, but certain steps can be taken to
mitigate risk to a considerable extent.
For example, when we buy an insurance policy
against theft in the house or for a vehicle, we
are attempting to minimize the potential loss
that we may incur upon theft.
The impact or magnitude of risk is normally
estimated from the following two factors:
1. The probability of an adverse event
happening.
2. In case the event occurs, the magnitude of
the loss it can cause.

The measures to mitigate risk are
determined by the combined impact of the
probability and magnitude of loss.
Risk can be classified in two ways:
1. Risk of small losses with high probability
e.g. changes in the stock prices, commodity
prices. The changes are small but occur
frequently.
2. Risk of high losses with low probability
e.g. earthquakes, tsunami, theft, etc. cause
huge losses but probability of their
occurrence is far lower.
The ways to manage risk include attempt to
control potential damage, diffuse, diversify and
transfer risk to those willing to accept it.
Management of risk through derivatives is
commonly referred to as hedging which enable
offsetting of risk emanating from one situation.
1. Control potential damage:
e.g. once we decided to own a vehicle for
personal use, we observe speed control and
traffic rules to avoid damage to life and property.
Another measure of managing risk is that we can
buy an accident insurance policy. Similarly, firms
can protect against potential losses by buying
suitable loss of profit insurance.
Contd

2. Diffuse the risk across sources of risk:
e.g. many call centres prefer to have multi-
location operations to protect against
natural disasters. It is referred as disaster
management. Similarly, most network
connections maintain redundancy by having
alternate routes available in case one of the
communication channels breaks down.


Contd

3. Diversification:
e.g. in case of portfolio management, investors
prefer to have investment in many alternative
securities to protect themselves against fall in
expected return from single investment.
Likewise, firms prefer to have many
suppliers/customers to manage business as all
of the suppliers do not fail to deliver at the
same point of time, or all customers cannot be
weaned away by competitors.

Contd

4. Transfer risk to another party who is willing
to assume risk:
e.g. insurance companies do not do anything
to contain the risk per se but assume risk on
your behalf. They have no means of
controlling thefts, floods, earthquakes, riots,
etc. but offer insurance against these risks.
Risk as such does not vanish but gets
transferred from one wants to avoid it to the
one who is willing to accept the risk upon
exchange of consideration.
Basics of Risk Management
What is Corporate Risk?
Broadly, corporate risk is the risk that stems from events
and processes that deteriorate the corporates
performance.
A simple corporate risk categorization is
Business risk e.g.

Non-Business risk e.g.
Strategic decisions, Expansions in new markets and sectors,
Technological risk, etc.
(Geo)political events, Macro-economic events, Legal
changes, etc.
Basics of Risk Management
Another risk categorization stems from the CAPM
CAPM has been developed by William Sharpe, John
Lintner, and Jack Treynor in the early 1960s.
The Capital Asset Pricing Model (CAPM) is a model that
provides a framework to determine the required rate of
return on the asset and indicates the relationship
between return and risk of the asset.
Formula E(R
j
) = R
f
+ |
j
[E(R
m
) - R
f
]
Where, E(R
j
) = expected return on security j; R
f
= risk-
free return; |
j
= beta of security j; E(R
m
) = expected
return on the market portfolio
The required return on security consists of two
components:
1. Risk-free return : R
f
2. Risk premium : |
j
[E(R
m
) - R
f
)]

Basics of Risk Management
CAPM know 2 types of risk:
CAPM RISK
Systematic Risk
also called
Market Risk or
Common Risk
Unsystematic Risk
also called
Company specific or
Idiosyncratic risk
Unsystematic Risk can reduced by Diversification but Systematic Risk
not.

Systematic risk refers to that portion of total
variability in returns caused by factors affecting the
prices of all securities. Economic, political, and
sociological changes are sources of systematic risk.

Unsystematic risk refers to that portion of total risk
that is unique or peculiar to a firm or an industry,
above and beyond that affecting securities markets in
general. Factors such as management capability,
consumer preferences, labour strikes, etc. can cause
unsystematic variability of returns for a companys
stock.

Total risk = systematic risk + unsystematic risk
Components of Systematic Risk
Market risk: It is caused by investor reaction to tangible
events (political, social or economical) as well as
intangible events (market psychology).
Interest rate risk: It refers to the uncertainty of future
market values caused by fluctuations in the general level
of interest rates.
Price risk: All markets, be it of commodity, stocks, or
materials, are dynamic. The forces of demand and supply
vary continuously. The prices of commodities, shares,
industrial products, etc. are subject to continuous
change. This change in price causes the profit of a
business enterprise to change, which is a cause of
anxiety for managers of the firm.
Exchange rate risk: It emanates from the
transactions denominated in foreign currency,
where a firm or an individual faces uncertainty
regarding the exchange rate at which the foreign
currency will be converted in the domestic
currency or vise versa.
Components of Unsystematic Risk
Business risk: This risk relates to the variability of the
business sales, income, profits, etc. which in turn
depend on the market conditions for the product
mix, input supplies, strength of competitors, etc.

Financial risk: This risk relates to the method of
financing adopted by the company.
Basics of Risk Management
Investment decisions are crucial for firms as well as
individuals.

The two key determinants of any investment
decision are
Return, and
Risk associated with it.

Return and risk cannot be studied in isolation as
both are very closely interlinked and affect each
other.

Investment Decision: Risk and Return
Return represents the total gain or loss on an
investment.

The (rate of) return on an asset/investment
for a given period, say a year, is the annual
income received plus any change in market
price.
Symbolically, the rate of return is defined as,
Rate of Return =
Annual income + (Ending price Beginning
Price)

Beginning price


Annual income is in the form of dividends.
Rate of Return= D
t
+ (P
t1
P
t0
)

P
t0
Where, D
t
= annual income/cash dividend at the end
of time period t
P
t1
= security price at time period t
1
(closing/ending
security price)
P
t0
= security price at time period t
0

(opening/beginning security price)
Rate of return would consist of the current
(dividend) yield and the capital gain yield.
Dividend yield is the reward of ownership that
accrues due to holding of the asset.
Dividend yield = Annual income / beginning
price
Capital gains arise due to difference in the
prices at the beginning and end of the
holding period.
Capital gain yield = (Ending price-beginning
price) / beginning price





Example: One year back share of Reliance
was at Rs. 500. You bought 100 shares.
Assume that Reliance declared a dividend of
Rs 10 per share. At the end of one year the
share price of Reliance was Rs 600 per share.
Calculate the rate of return from the above
information.




Expected Return

Expected returns may be calculated by historical
price data of the financial asset.
Arithmetic mean and geometric mean are the two
very common measures of return.
Arithmetic mean is the simple average.

e.g. An investor has bought shares of six companies
and invested equally in each of them. The returns
offered by the six companies in the last one year
have been 21%, 24%, 25%, 18%, 120%, and 16%.
Find the average return of the investor in the last
year.
Geometric Mean

Geometric mean, computed by the n
th
root of the
returns over holding period.
Geometric mean tells the holding periods return.
It is calculated with the help of following formula:

G

= |(1+R
1
) (1+R
2
) ------------ (1+R
n
)|
1/n
- 1

Where,
(1+R
1
), (1+R
2
) ------------ (1+R
n
) are return
relatives.

Expected return is the weighted
average return on a risky asset, from today
to some future date. The formula is:


| |

=
=
n
1 s
s i, s i
return p return expected
Risk is measured by the variability of
returns.

Risk has several measures:
1. Standard deviation
2. Variance
3. Coefficient of variation
4. Beta
The variance of expected returns is calculated
as the sum of the squared deviations of each
return from the expected return, multiplied
by the probability of the state.
The formula is:


( ) | |

=
=
n
1
2
i
i ) ( R p Variance
i
i R E
Where, p=probability; R
i
=possible return;
E(R
i
)=expected return; n=total no. of
different outcomes.


The standard deviation is simply the square root of
the variance.
It is an absolute measure, which can be applied
when the mean is same.

Variance Deviation Standard = =o
( ) | |

=

n
1
2
i
i ) ( R p
i
i R E
The coefficient of variation is a relative
measure of the degree of uncertainty.
The standard deviation is misleading when
comparison is to be made of two series or
two projects or portfolios, if they differ in
size and mean. In such cases, the coefficient
of variation is the correct technique.
The higher the coefficient of variation, the
more risky is the project or portfolio.
CV =
i
/E(R) or
Or, CV = Standard deviation of returns
Expected rate of return
It measures the responsiveness of the return
on security to the changes in the return on
market portfolio.
It shows how the price of a security responds
to market forces.
The more responsive the price of a security is
to changes in the market, the higher will be
its beta.

Beta is calculated by using the following formula:
= Cov (R
j
, R
m
)

m
2


= r
jm

j

m

m
2
Where,
Cov is the covariance between the return on security j
and the return on market portfolio m.
r
jm
= coefficient of correlation between the returns on
security and returns on market portfolio.

j
= standard deviation of the return on security.

m
= standard deviation of the return on market
portfolio.

m
2
= variance of the return on market portfolio.




For calculating the beta of a security, the
following market model is also employed:

R
jt
=
j
+
j
R
mt
+ e
j

Where,
R
jt
= return on security j in period t

j
= intercept term alpha

j
= regression coefficient beta
R
mt
= return on market portfolio in period t
e
j
= random error term
If a security has a beta value greater than
1.0, it will be classified as an aggressive
security. In a bull market it would rise faster
than the market average, and in a bear
market it would fall more than the market
average.
If a security has a beta value less than 1.0,
it will be classified as a defensive share. In a
bull market it would rise more slowly than
the market average, and in a bear market it
would fall less than the market average.
A beta value of 1.0 would simply follow the
market.