Risk and Return

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RISK
Risk in holding securities is generally associated with possibility that realized returns will be less than the expected returns. OR Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Risk could be categorized depending on whether it affects the market as whole, or just a particular industry. Types of Investment Risk Systematic Risk Unsystematic Risk Risk is the potential for variability in returns. Total variability in returns of a security represents the total risk of that security. Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk
Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and social changes are sources of systematic risk. Nearly all stocks listed on the National Stock Exchange (NSE) move in the same direction as the NSE Index. On an average, 50 percent of the variation in a stocks price can be explained by variation in the market index. In other words, about half of the total risk on an average common stock is systematic risk. Systematic Risk is further subdivided into: Market Risk, (variation in returns caused by the volatility of stock market) Interest Rate Risk (Variation in bond prices due to change in interest rate) Purchasing Power Risk (Inflation results in lowering of the purchasing power of money) (Demand pull inflation and cost push inflation)

Unsystematic Risk
Unsystematic risk is the portion of total risks that is unique to a firm or industry. Factors such as management capability, consumer preferences, raw material scarcity and labour strikes cause unsystematic variability of returns in a firm. Unsystematic factors are largely independent of factors affecting securities markets in general. Unsystematic Risk is further subdivided into:
(Operating Environment, and Financing Pattern)

Business Risk (Variability in Operation Income caused by Operating Conditions) Financial Risk (Variability in EPS due to the presence of debt in Capital Structure)

Remember the difference: Systematic (market) risk is attributable to broad macro factors affecting all securities. Non-systematic (nonmarket) risk is attributable to factors unique to a security.

Risk and Expected Return

The risk involved in investment depends on various factors such as: i) ii) The length of the maturity period - longer maturity periods impart greater risk to investments. The credit-worthiness of the issuer of securities - the ability of the borrower to make periodical interest payments and pay back the principal amount will impart safety to the investment and this reduces risk.

iii) The nature of the instrument or security also determines the risk. Generally, government securities and fixed deposits with banks tend to be riskless or least risky; corporate debt instruments like debentures tend to be riskier than government bonds and ownership instruments like equity shares tend to be the riskiest. The relative ranking of instruments by risk is once again connected to the safety of the investment.

iv) Equity shares are considered to be the most risky investment on account of the variability of the rates of returns and also because the residual risk of bankruptcy has to be borne by the equity holders. v) The liquidity of an investment also determines the risk involved in that investment. Liquidity of an asset refers to its quick salability without a loss or with a minimum of loss. vi) In addition to the aforesaid factors, there are also various others such as the economic, industry and firm specific factors that affect the risk an investment. Another major factor determining the investment decision is the rate of return expected by the investor. The rate of return expected by investor consists of the yield and capital appreciation. the

Risk-Return Relationship

Return

Low risk

Average risk

High risk

Slope indicates required Return per unit of risk Risk-free return R(f) Risk and Return Relationship
Cont.

Measurement of Risk
Unsystematic Risk
Volatility may be described as the range of movement (or price fluctuation) from the expected level of return. The variance and standard deviation measure the extent of variability of possible returns from expected return.

Measurement of Risk
Systematic Risk
Beta is a measure of the systematic risk of a security that cannot be avoided through diversification.

PORTFOLIO AND SECURITY RETURNS

A portfolio is a collection of securities. Since it is rarely desirable to invest the entire funds of an individual or an institution in a single security, it is essential that every security be viewed in a portfolio context.

Cont.