MODULE 1: RISK ANALYSIS IN CAPITAL BUDGETING

Meaning of Risk. Types of Risks of a Business Enterprise. Risk Analysis in Capital Budgeting –
Measuring and Managing Capital Budgeting Risks – Sensitivity Analysis, Scenario Analysis,
Simulation, Standard Deviation and Co-efficient of Variation, Risk- Adjusted Discount Rate
Method, Certainty Equivalent Co-efficient Method, Decision Tree Analysis and Probability
Distribution Method

Concept of Risk
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from an expected outcome or return. Risk includes the possibility of losing some or all of
an original investment.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In

finance, standard deviation is a common metric associated with risk. Standard deviation provides
a measure of the volatility of asset prices in comparison to their historical averages in a given
time frame.

Types of Risk
1. Interest rate Risk
Interest rate risk is referred to variability in returns of a security which result from changes in the
level of interest rates. Generally, securities are inversely affected by such changes. This means
that the price of security moves inversely to the interest rate provided other things being equal.
Bonds are more affected by interest rate risk than common stocks but normally both are affected
by interest rate risk and it is very significant factor of sources of risk for many investors.

2. Market Risk
Market risk is considered as the variability in the returns as a consequence of fluctuations in the
entire market or aggregate stock market. Mostly common stock is more affected by market risk
but all other securities are also exposed to that risk. There is wide range of exogenous factors
associated with the securities that are included in the market risk like wars, recessions, changes
in the consumer preferences, structural changes in the economy etc.
3. Inflation Risk
The purchasing power risk is the factor that affects all the securities. It also refers as the
likelihood that the purchasing power of the invested dollars will fall. Even if the nominal return
is safe, the real return involves risk with uncertain inflation. The risk is associated with the
interest rate risk because the increase in inflation results in the increase in the interest rates. The
reason behind this fact is that additional inflation premiums are demanded by the lenders in order
to compensate for the loss of purchasing power.

4. Business Risk
Business risk is the risk of conducting business in certain industry or environment. For example
the traditional telephone powerhouse AT&T confronts many challenges in quickly changing
telecommunication industry.

5. Financial Risk
The utilization of debt financing by companies includes the financial risk. When more assets of
the company are financed through debt then the variability in the return is enhanced provided
other things keep equal. Financial leverage is associated with the financial risk.

6. Liquidity Risk
The risk connected with certain secondary market in which there is trading of security is
considered as liquidity risk. An investment that can be sold or brought immediately and without
any important concession in price is regarded as liquid. When there is high uncertainty about the
time aspect arid the concession in price, the liquidity risk is high. There is little or no liquidity
risk for the Treasury bill while the over-the-counter (OTC) stock contains sufficient liquidity
risk.

7. Exchange Rate Risk

Exchange rate risk is associated with international investments in which the returns gained in
other countries are converted back into the local currency which creates uncertainty. In old days,
the US investors did not take into account the international investment alternatives but in current
days the exchange risk must be identified and understood by the investors. The variability in
returns on security as a result of fluctuations in currency is referred to as exchange rate risk.
Exchanger rate risk in also regarded as currency risk.
For example, when US investor purchases German stocks designated in marks. He must finally
convert back the returns of the stock into the US dollars. If the exchange rate is not in favor of
the investor than the losses from the movements of exchange rate can partially or completely
counterbalance the originally gained returns.

Risk Analysis in Capital Budgeting

Risk analysis is the process of evaluating the nature and scope of expected and unexpected
setbacks that may derail the achievement of investment goals. A capital budgeting risk is the
likelihood of a long-term investment failing to generate the expected cash flows. Capital
budgeting is the evaluation and selection of long-term investments on the basis of their costs and
potential returns. The process provides a framework for formulating and implementing the
appropriate investment strategies. Cash flow estimates are used to determine the economic
viability of long-term investments. The cash flows of a project are estimated using discounted
and non-discounted cash flow methods.

A. Conventional Techniques:
Payback period, Risk-adjusted discount rate, certainty- equivalent are the conventional
techniques.

1. Sensitivity Analysis
In corporate finance, sensitivity analysis refers to an analysis of how sensitive the result of a
capital budgeting technique is to a variable, say discount rate, while keeping other variables
constant.

Sensitivity analysis is useful because it tells the model user how dependent the output value is on
each input. It gives him an idea of how much room he has for each variable to go adverse. It
helps in assessing risk. Sensitivity analysis differs from scenario analysis in that scenario
analysis is more complex because it allows us to change more than one variable at once.

2. Analysis
Scenario analysis is a strategic process of analyzing decisions by considering alternative possible
outcomes (sometimes called “alternative worlds”). It is not a predictive mechanism, but rather an
analytic tool to manage uncertainty today.
Many scenario analyses use three different scenarios: base case, worst case and best case. The
base case is the expected scenario: if all things proceed normally, this is what the expected
outcome will be. The worst and best cases are obviously scenarios with less and more favorable
conditions, but they are still confined by a sense of feasibility. For example, an investor creating
the worst case scenario would not be well served to have it include a meteor strike that destroys
the company. While clearly a bad scenario, it is not realistic enough to be helpful.

The purpose of scenario analysis is not to identify the exact conditions of each scenario; it just
needs to approximate them to provide a plausible idea of what might happen.

3. Decision Trees Analysis

A decision tree is a decision support tool that uses a tree-like graph or model of decisions and
their possible consequences.

A decision tree is a decision support tool that uses a tree-like graph or model of decisions and
their possible consequences, including chance event outcomes, resource costs, and utility. They
help to identify the strategy that is most likely to reach the declared goal. For an investor, this
may be used to help determine which bond to buy in order to get the highest expected return with
only a certain amount of risk. Decision trees are set up much like an organizational flow chart.

This decision tree highlights the outcomes of different investing strategies. Next to the terminal
nodes is blue text with the yield and gain.

Unlike a flow chart, a decision tree consists of three types of nodes:

 1. Decision nodes – commonly represented by squares – the user gets to decide which
branch to take.

2. Chance nodes – represented by circles – the branch taken is determined by probabilities.

3. End nodes – represented by triangles – there are no more branches extending from the
node, and the final value of the strategy is listed.

4. Simulation Analysis and Testing

Simulation analysis should always be followed up with real-world tests. As Admiral Rickover
knew, simulation analysis is not a substitute for testing, but validates that we are performing the
correct tests (the ones at or below the borderline). The combination of simulation analysis and
testing forms the verification process that ensures our product meets requirements and intent.

Simulation analysis is critical to the product development process, using computer power to help
us define the best product for our needs, as quickly, affordably, and safely as possible.

5. Payback period:
It is one of the oldest and commonly used methods for explicitly recognizing risk associated with
an investment project. This method, as applied in practice, is more an attempt to allow for risk in
capital budgeting decision rather than a method to measure profitability.

Business firms using this method usually prefer short pay back to longer ones, and often
establish guidelines such that the firm accepts only investments with some maximum payback
period, say three of five years,

Advantages:

The merit of payback as discussed in the previous question is its simplicity. Also, payback makes
an allowance for risk by i) focusing attention on the near term future and thereby emphasising
the liquidity of the firm through recovery of capital, and ii) by favouring short term project over
what may be riskier, longer term projects.

Limitations:

It suffers from three major limitations.

1. It ignores the time value of cash flows

2. It does not make any allowance for the time pattern of the initial capital recovered.

3. Setting the maximum payback period as two three or five years usually has little logical
relationship or risk preferences of individuals or firms.

6. Risk-adjusted discount rate:

The more uncertain the returns it is the future, the greater the risk and the greater the premium
required. Based on this reasoning, it is proposed that the risk premium be incorporated into the
capital budgeting analysis through the discount rate.

If the time preference for money is to be recognised by discounting estimated future cash flows,
at some risk-free rate, to their present value, then, to allow for the riskiness, of those future cash
flows a risk remunerate may be added to risk- free discount rate.

Such a composite discount rate will allow for both time preference and, risk preference and will
be a sum of the risk-free rate and the risk-premium rate reflecting the investor’s attitude towards
risk.

The risk adjusted discount rate method can be formally expressed as follows:

Advantages:

1. It is simple and can be easily understood.

2. It has a great deal of intuitive appeal for risk-averse businessman.

3. It incorporates an attitude (risk-aversion) towards uncertainty.

Limitations:

1. There is no easy way of deriving a risk-adjusted discount rate.

2. It does not make any risk adjustment in the numerator for the cash flows that are forecast over
the future years.

3. It is based on the assumption that investors are risk averse. Though it is generally true, there
do exist risk- seekers in the world. Such people do not demand premium for assuming risks; they
are willing to pay a premium to take risk.

7. Certainty-equivalent:
A common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash
Flows to some conservative level. For example if an investor, according to his “best estimate”,
expects a cash flow of Rs. 60,000 next year, he will apply on intuitive correction factor and may
work with Rs. 40,000 to be on safe side.

Informal way the certainty equivalent approach may define as:

Where t = period

At = the forest of cash flow without risk adjustment

αt = the risk adjustment factor or the certainty aquivalent coefficient

I = risk-free rate, assumed to be constant for all periods

The certainty equivalent coefficient, α assumes a value between 0 and 1, and varies inversely
with risk. A lower oc, will be used if greater risk is perceived and a higher oc, will be used if
lower risk is anticipated.

The coefficients are subjectively or objectively established by the decision-maker. These

coefficients reflect decision maker’s confidence in obtaining a particular cash flow in period t.

The certainty-equivalent coefficient can be determined as a relationship between the certain cash
flows and the risky cash flows. That is:
Advantages:

The certainty-equivalent approach explicitly recognises risk, but the procedure for reducing the
forecasts of cash flows is implicit and likely to be inconsistent from investment to investment.

Limitation:

The forecaster, expecting the reduction that will be made in his forecasts, may inflate them in
anticipation. This will no longer give forecasts according to “best estimate”.

If forecasts have to pass through several layers of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra conservative.

3. By focusing explicit attention only on the gloomy outcomes, chances are increased for passing
by some good investments.

B. Statistical Techniques:
Probability assignment, standard deviation and coefficient of variation are the statistical
techniques.

1. Probability assignment:
Probability may be described as a measure of someone’s opinion about the likelihood that an
event will occur, if an event is certain to occur, we say that it has a probability of 1 of occurring.
If an event is certain not to occur, we say that its probability of occurring is 0. Thus, probability
of all events to occur lies between 0 and 1. The probability estimate, which is based on a very
large number of observations, is known as an objective probability.

The probability assignments that reflect the state of belief of a person rather than the objective
evidence of a large number of trials are called personal or subjective probabilities.

Expected monetary value:

Once the probability assignments have been made to the future events, the next step is to find out
the expected monetary value. The expected monetary value can be found out by multiplying the
monetary values of the possible events by the probabilities. The following equation describes the
expected monetary value.
Where

A = expected cash flow or return (monetary value) for a period

A jt = the cash flow for the event in time period t

Pjt = the probability of the cash flow for the event in time period t.

2. Standard deviation:
This is an absolute measure of risk. It measures the deviation or variance about the expected cash
flow of each of the possible cash flows, the formula to calculate the standard deviation is as
follows:

3. Coefficient of variation:
A relative measure of risk is the coefficient of variation. It is defined as the standard deviation of
the probability distribution divided by its expected value. The coefficient of variation is a useful
measure of risk when we are comparing the projects which nave i) same standard deviations but
different expected values, or ii) different standard deviations but same expected values, or iii)
different standard deviations and different expected values.
 MODULE 2: INVESTMENT RISKS AND DERIVATIVES
Meaning of Derivatives. Types of Derivatives. – Forward Agreements, Future Contracts Terms
associated with Futures – Stock Futures and Index Futures, Differences between Forwards and
Futures, Margin and Settlement Mechanism of Futures

Derivatives
Derivatives are financial contracts whose value is linked to the value of an underlying asset.
They are complex financial instruments that are used for various purposes, including hedging
and getting access to additional assets or markets.

Types of Derivatives
Derivative contracts can be differentiated into several types. All the derivative contracts are
created and traded in two distinct financial markets, and hence are categorized as following
based on the markets:

 Exchange Traded Contract

Exchange-traded contracts trade on a derivatives facility that is organized and referred to as an
exchange. These contracts have standard features and terms, with no customization allowed and
are backed by a clearinghouse.

 Over The Counter Contract

Over the counter (OTC) contracts are those transactions that are created by both buyers and
sellers anywhere else. Such contracts are unregulated and may carry the default risk for the
contract owner.

1. Forward Contracts
A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of
currency at a specified time in the future at an agreed exchange rate (the forward rate).

Forward contracts are the simplest form of derivatives that are available today. Also, they are the
oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a
future date. The price at which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the
exchange is not an intermediary to these transactions. Hence, there is an increase chance of
counterparty credit risk. Also, before the internet age, finding an interested counterparty was a
difficult proposition. Another point that needs to be noticed is that if these contracts have to be
reversed before their expiration, the terms may not be favorable since each party has one and
only option i.e. to deal with the other party. The details of the forward contracts are privileged
information for both the parties involved and they do not have any compulsion to release this
information in the public domain.

2. Futures Contracts
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at
a predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is
taking on the obligation to buy and receive the underlying asset when the futures contract
expires. The seller of the futures contract is taking on the obligation to provide and deliver the
underlying asset at the expiration date.  An important point that needs to be mentioned is that in
case of a futures contract, they buyer and seller do not enter into an agreement with one another.
Rather both of them enter into an agreement with the exchange.

 Single stock futures are futures contracts that use the price of a single stock as the
underlying asset. So, the value of the contract is only derived from the price of that single
stock.
 Stock index futures are futures contracts that use the value of an index as an underlying.
An index constitutes multiple stocks with weightages according to their market cap. The
movement of the index is generally determined by averaging the movements in individual
stocks. So, in case of index futures, the value of the contract is determined by movement
of the index. The index usually tracks particular sectors or the market as a whole.

Index futures, however, are not delivered at the expiration date. They are settled in cash on a
daily basis, which means that investors and traders pay or collect the difference in value daily.
Index futures can be used for a few reasons, often by traders speculating on how the index or
market will move, or by investors looking to hedge their position against potential future losses.

When you trade the Nifty or Bank Nifty index, it is called index futures. While the same if it is
done on individual stocks, it is called single stock futures. Index is a combination of many stocks
that form the index, where volatility can be low. While in stock futures, the moves can be stock
specific. It is not necessary that the stock moves in tandem with the index.
For example, Nifty index is bearish does not mean that Sun Pharma has to be traded on the short
side. If the strength and the line of least resistance on the bullish side, even if the Index is bearish
one should trade the stock on the long side or considering long position.
Please have adequate knowledge before exposing real money into your trades, futures can be
very risky for a novice.

3. Option Contracts
Option is a contract which gives the buyer (the owner or holder of the option) the right, but not
the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to
or on a specified date, depending on the form of the option.

The third type of derivative i.e. option is markedly different from the first two types. In the first
two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at
a certain date. The options contract, on the other hand is asymmetrical. An options contract,
binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the
option. So, one party has the obligation to buy or sell at a later date whereas the other party can
make a choice. Obviously, the party that makes a choice has to pay a premium for the privilege.

There are two types of options i.e. call option and put option.

 Call option
It allows you the right but not the obligation to buy something at a later date at a given
price.
 Put option
It gives you the right but not the obligation to sell something at a later date at a given pre
decided price.

Any individual therefore has 4 options when they buy an options contract. They can be on the
long side or the short side of either the put or call option. Like futures, options are also traded on
the exchange.

4. Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the
participants to exchange their streams of cash flows. For instance, at a later date, one party may
switch an uncertain cash flow for a certain one. The most common example is swapping a fixed
interest rate for a floating one. Participants may decide to swap the interest rates or the
underlying currency as well.

Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are
usually not traded on the exchange. These are private contracts which are negotiated between
two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too
carry a large amount of exchange rate risks.

So, these are the 4 basic types of derivatives. Modern derivative contracts include countless
combinations of these 4 basic types and result in the creation of extremely complex contracts.

Margin and Settlement Mechanism of Futures

Comparison forward contract vs futures contract
BASIS FORWARD CONTRACT FUTURES CONTRACT

Meaning Forward Contract is an agreement A contract in which the parties agree to

between parties to buy and sell the exchange the asset for cash at a fixed price
underlying asset at a specified date and and at a future specified date, is known as
agreed rate in future. future contract.

What is it? It is a tailor made contract. It is a standardized contract.

Traded on Over the counter, i.e. there is no Organized stock exchange.

secondary market.

Settlement On maturity date. On a daily basis.

Risk High Low

Default As they are private agreement, the No such probability.

chances of default are relatively high.

Size of contract Depends on the contract terms. Fixed

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High

 MODULE 3 : FUTURE CONTRACTS – HEDGING AND TRADING
Hedging with Futures – Stock Hedging: When there is a future contract available on the stock
and when there is no future contract available on the stock. Portfolio Hedging: Adjusting
Portfolio Risk, Pricing of Futures

Hedging arrangement refers to an investment whose aim is to reduce the level of future risks in
the event of an adverse price movement of an asset. Hedging provides a sort of insurance cover
to protect against losses from an investment. It typically consists of shielding a portfolio by using
one financial instrument investment to offset the risk of another investment.

What is Short Hedge?

A short hedge is a strategy used to reduce the risk of price movement of any share, commodity,
or any other financial instrument. This strategy generally utilized against the risk of a declining
asset price at some point in the future.

The short hedge occurs when hedger already owns the asset and planning to mitigate the risk by
shorting an asset with a derivative contract and selling at a specific price in the future.

Example of Short Hedge

As earlier, we’ve discussed that short hedge is an investment strategy used to protect against
losses and potentially earn a profit in the near future. It is generally used by agricultural
businesses.

Let’s assume that today is March 01 and a refined soy oil producer is planning to produce soy oil
in June. So, he negotiated a contract to sell 10,000 kg of soy oil at June 01 market price.
Currently, the cash price of soy oil is Rs. 425 per 10 kg June NCDEX futures price of soy oil is
Rs. 450 per kg.

Now the farmer is worried that the cash price of soy oil June will decrease significantly. In such
a situation, the farmer can use short hedging to hedge against the risk of declining soy oil price.

What is Long Hedge?

Long hedge is an investment strategy where one involves in taking a long position in a future
contract. Generally, this strategy is utilized when one knows he has to purchase a certain asset in
the future and fear the rise in price of the asset. Thus, one who enters the long hedge is not for
the profitability but the stability of the price.

The long hedge investment strategy often used by the manufacturers to remove price volatility
and stabilize the purchase price.