CHAPTER 7

RISK

HAPTER QUERY
EMohan, a bepinner in the stockmarket, stving toracethe movements oftheSensox
which crossed the 20,000 mark in October 207ttook only 10trading days to gain 1,000
points after the index crossed the 19,000-mark on 15 October. The major drivers were
wweight companies such as Larsen and Toubro, Reliance Industries, ICICIBank, HDPC Bank
dSBI.
n the third week of January 2008, the Sensex experieneed a big fall along with other market
at
ices around the world. On 21 January 2008, the Sensexsaw its biggest-ever loss of 1,408 pointslow
end of the trading session. It recovered and closed at 17,605.40 after it tumbled to the day's
6,963.96.
On 21 January 2008, the BSE Sensex went into free fall It hit the lower circuit breaker in barely
minute after the markets opened at 10 a.m. Trading was suspended for an hour On reopening at
5 a.m.the market sawits biggest intra day fall, and bit a low of 15,332 Itwas down by
23 points. However, after a reassurance from the finance minister, the market recovered and
8sed at 16,730: Yet, it had lost 875 points. The Indianstock market found mention among the worst
ormers across the world in 2011-and suffereda löss of 25 per cent
These facts are creating panic in Mohan and giving rise to many questions inthehis mind Why
factors causing
annot the Sensex move smoothly? Why are there these ups and downs? What are the
with index?
se fuctuations? How can I assess volatility? Have allstocks moved along reasonably well?
the Why
some stocks not reward their investorseven when themarket seemsto be doing

CHAPTER OBJECTIVES
To understand the concept of risk
and unsystematic risk
To distinguish between systematic
To know how to measure risk

investment in all financial

Mr Mohan should accept the fact that equity investment is the most risky
the rSks
markets. Any rational investor, before investing his or her investible wealth in a stock, analyses
return, and the
soCiated with it. The actual return he receives from a stock may vary be caused expected
from his
by several factors, ether
SK1S expressed in terms of variability of return. The downside risk maythe risk factors because a thorough
Eimon to all stocks or specific to a stock. Investors like to analyse
wledge of the risk helps them plan their portfolios to minimize risk.
 Marager
Potolio
124 Securty Anaysis and Porttobo end Dew

Managenment Analyss prices

ise,
o

DEFINITION OF RISK the 20,000 mark. It

Secunty interestHence,
rales
the

supported by
oecCn
Sensex closed above was
foreign institutional rates

Onmvest ors (F
i
The
Risk
dictonary meaning of risk
is defined
is the
possibility of loss or injury and the degree or probabihty ot 007: the inflow was 69,731. 10 crore for
the calendar year till 10 December. On2
21 lamuary secur
When ites.
inierest
making tbose older,
as
variability
in return or
ess than the expected retum. Thus, risk means volatility in returm. Risk is the chance of the
actual
sSucn 1oss.
retum Deing
lest 1,408.35 points. The riSing mumber of detaults in the US sub-prime market
This led to the failure of many leading financial institutions, including the Lehma market affee
affecPd the US85 Wben fregovernment,
probability that the returns from any asset will any deviation from expected retuns. More specifiçally, ne ehman Brothers T
I n e r e s ta
, n
inves

asset. In nsk differ from the expected yields is the risk inherent in that adversely affected the Indian markets. Sub-prime credit refers to high-interest,
listed
assessment, the probable outcomes of
all the possible events are listed. with poor credit records or ratings. FlIs' investment and failure of high-t
financial instititio
L i k e w i s S ei
, 1

subjectively, the derived probabilities be assigned to the entire Once the events are g
bnS are tangbe
investor can analyse and find can
out the
possible range of returns from his possible events. kör
exampie, ue to
hav

subjective probability to his retuns, such investments. He can assign Intangible events Intangible events are related to market psychology. Such
some tangible events become over-Teactions and pushpsychology
as 50
offe

share as dividend and per cent of the time there events. However, reactions to is aff
50 per cent of the is a likelihood of
time the getting <2 the market eith
Darket eithet upwart
nterchangeably with
uncertainty. In uncertainty, thepossible dividend may be 3 per share. Often isk is per dowaward.
are not known.
Hence, risk and possible events and the used Thus, any untoward political or economic event can lead to a fall in the
two components: probabilities
uncertainty are different from each other. Risk of their
Occurrence price of the secu ty
further accentuated by the over-reactions and herd-like behavi0ur of
Systematic risk Eternal factors cause
-
consists of the
following start disposing of their stocks, it can cause fear that
investors. If some which
financial inski can t
spreads
Systematic risk affects theunsystematic
control this risk. to investors. This
risk to a sell the stocks. The actions of the financial institutions would will then result in a nieh.
Unsystematic risk Here, the factors market as a whole. company. The company 1s not aDIe
10 have a snowballing effect.
are specific, unique and related to the reaction affects the market adversely, and the scrips" This tvpe oi
prices can fall below their intrinsic
industry or company. beyond the control of the corporations. values. This s
SYSTEMATIC RUSK Figure 7.1 illustrates some of the events that have created the bull
Systematic risk affect and bear run in the Indian
bear hug or is in a bull the entire market. Often we read in the stock marker
grip. This newspaper that the stock market is
or
upwards. Economic conditions, indicales that the entire market
the political is moving in a caught in
direction either downwardsa
25000
Inflow of Fil Investment
A recession can situation or
affeca the
profit prospects of the industry and sociological changes affect the securities and high GDP
growth
The recession
exparienced by
the stock market. market. Initation, slowdoen
of GDP and
over the world.
The exonomic crisis developed and
developing countries in 2008 affected stock markets 20000 global recesSion
in the US affected all
beyond the control of tise the stock markets
worldwide. These factors Global finanal crisis
means, systematic risk-is corporation
or the
investor. They are
cannot be entirely avoided by the investor. This
Market risk
Interest rate risk
Purchasing power risk
unavoidable. Systematic risk is further
sub-divided into the following:
15000

10000 Corecive measures and

ww
Market Risk recovery of the economy
Jack Clark Francis has
defined market risk as that
alternating forces of the bull and bear portion of total
phases. Both tangibie and variability
of returm that is
caused by the 2 Apr
0 . 7

During the bull and bear phases more than

2 AugO. 7

intangible
2 Dec0. 7
2Ap0r 8

events can affect the market. 2 Dec0. 8

80 per cent of the

2Apr
0 .9
2Aug
0 . 9

stock market indices. securities' prices rise or fall 2 Aug.

2 Aug1. 0
2 D e c1
. 0

When the security index moves

along with the 2 Apr
1 .1
2 D e c1
. 1

upward haltingly for a significant period, the

2 Aug

market. In a bull market,

with rising investor
the index moves from a low level
to its
peak.
market is known as abull
A bull market tends to
Figure 7.1 Movement of the BSE Sensex
confidence and be 2007-11
A bear market is
just
expectations of further capital gains.
the reverse of a bull associatedInteres Rate Risk
low point called the market; the index declines halingly from the hnterest rate risk is the
trough for a peak to a market- variation in
economic news and low investorsignificant period. A bear market is typified by falling stock commonly, interest rate risk affects thethe return caused
by fluctuations
confidence in the prices, adverse in the market
The forces that affect
the stock market can be economy. Bond return following interest rate. Most
either tangible or Cost of borrowing
intangible.
Tangible events Tangible events are real
events such as
2007, the stock market touched an earthquake, war, Sond return Fluctuations in interest
value of currency. In
poliucal
uncertanty 1ad
all-time high on 21 December and u
when the benchmark anges that occur in the interest ratesrates are caused
by changes in the
Ond price and
its return, which in
of treasury bills and government bonds. monetary policy and government's
turn lead to These cause
changes in investment changes in the patterns. These are
summarized here.
 Secuny And)SIs aPtvNMao ALaraerrmyN
Peic 127

Wen interest racs risSe, cw iSstes will apprach the market with higher interest rates than older
wholesale price index also is used to measure inflatiom. The real return of any investzent can be calculated
svurntes Hene. the pnoes of the latter o own in the following way
When interst rates devine, new bond issues come to market with lower yiclds than older securities,
For cxample, if an investor gets a return of l12 per cent on his investmet aned the infiation
maing those okder, higher-yiekting ones worth more. Hence, their prices go up
rate
is 0.063
If the goverument. to tide oer the deficit in the budget, floats a new loan/bond with a higher rale ofs
then the real valuc would be
inticrest, an investor woukd like to switch his investments from private-sector bonds to public-sector ones Real rate of returm 1.0+
Likewise. if the stck market is depresed, investors woud like to shift their money to the bond marke, 1.0 + IR
199%6 when most of the initial public
to have an assurrd rate of retun. The best example is that of April
offerings of many companies remained undersubscribed but IDBI and IFC bonds were oversubscribed
Where, IR = Inflation rate, r = return

The assured rate of rerurn attracted investors from the stock market to the bond market. 1.0+0.12 -
I = 1.0486 I =
0.0436 =
46
1.0+0.068
Cost of borrowing The rise or fall in interest rate affects the cost of borrowing. This affects stock traders
and corporate bodies in the following ways: This shows that his actual rate of return is only 4.86 per cent. The purchasing porwer has no increased by
Most stock traders rade in the stock market with borrowed funds. The increase in the cost of margins 12 per cent according to his earnings. If he really wants to protect himself from inflation. and earn a 12 pE
affects the proitability of the traders. This dampens the spirit of the speculative traders who use cent real rate of return, then his rate of return should be 19.6 per cent.
borrowed
funds. The iall in the demand for securities leads to a fall in the value of the stock index.
10 +r
interest rates not only affect the security traders but also corporate bodies that carry on their business RR
with borrowed funds. The cost of borrowing increases; a heavy outflow of profit takes place in the form 1.0 + IR
of interest on the capital borrowed. This leads to a reduction in the earnings per share and a consequent
+r
fall in the price of the share. = 0.12 + l= 1.1961 1
1.0 +0.068
= -

=0.196 =19.6
Purchasing Power Risk
If the investor earns a 5 per cent return from his invesment in stocks, even though it gives a lasn o
the loss of purchasing power of the
Varnanions in reurns are caused also by Purchasing power risk
currency. earning, his earning is actually negative. The following calculation explains it.
is the probabie koss in the
purchasing received Inflation is the reason behiad
power of the returns to be
the loss of purchasing power. Infiation, defined as a persistent increase in
prices, is serious risk for any
a
RR =
1.0 +
long-term investor. The level ofinflation proceeds faster than the increase in capital value. The risein
1.0+ IR
price penal+zes the returns to the investor, and every potential rise in price is a risk to the investor. Broadly
nflation is classified as: 1.0 +0.05
I = -0.0169 = -1.69%
Demand-pull 1.068
Cost-push
The investor's income has increased by 5
Demand-pul inflation In the demand-pull inflation, the demand for goods and services exceeds their per cent. However. his real rate of renurn has decined by
.69 per cent. His investment has a
supply At full employment level of factors of production, the economy would not be able to supply goods negative real rate of return. Thus, the changes thai occur n the purchas1ng
Power also cause variations in the expected retum and the acrual retum. lo ide over the purchas1ng power
in the short run, and the demand for products pushes the price cannot be
upwards.The
Theequilibrium
supply betweenincreased
demand
nSK, the investor should try to ensure that the nominal rate of rerurm is
greater than the nflanon raie
unless there is an expansion of labour force or machinery for production. prevailing in the economy. Thus, purchasing power risk affects reurns from bonds, debenures, and sOCKS.
and supply is attained at a higher price level.

Cost-push inflation Cost-push inflation, as the name indicates, refers to the rise in prices caused by
UNSYSTEMATIC RISK
Unsystematic risk is unique and peculiar to a firm or an industry. If one's equty invesmient is in lata Motors.
the increase in costs. The increase in the cost of raw material, labour and equipmeni makes the cost HL, and Infosys, adverse news about Infosys will only impact invesanent in lnfosys: all other stocks will
production high and results in high price level. The producer tries to pass tne ngucr cUt oP Dot feel any impact Unsystematic risk stems trom financial leverage, managerial inetficiency, iechnological
the consumer. The labourers or the workforce iry to make the corporation share ne ncrase r uc
Change in the production process, availability of raw material, changes in consumer preferences and labour
iving by demanding higher wages. Thus, cost-push inflation has a spiraling effect on the price level. problemis
The and
Real rate of return The changes in the price levels are measured by the cosumer price inaex lor nature magnitrude of the above-mentioned factors difler rom indhustry 1o industry and company
uus to company. These factors have be to analysed separately for eachindustry and fim. Changes in consumer
workers. This index uses a basket of goods used by industrial labourers in different parts of India. The
PeTences aftfect consumer products like television sets, washing machines, retrigerators, etc.. more than
y affect the iron and steel industry. Technological changes affect the information technology industry
 Portolid
and

PolAnaliticyalriskPol
sis iticalis
128 Security Analyss axd Poxttolo AManagement Security cnan

also

oosancrproducrindustry Thus, the impact varies trom industry to idustry, Finamci may bep to tde ve ths probem.5ug coporate bodies have a long chain of disrib
130 poliCies
ecOnomy
D . u r nt
g he

ribution ckote
investestment.
men,
res

erage otthe companies, i.e., the debt-equity portion of the companies, also varies. The nature and modfims often lack this diversified customerDase
party,
ot raising hnance and
paying
back the
loans involve a risk element. All these factors constitute
nsk and contnbute to unsystematç Research and development (R&D) Sometimes the product may go out of
the total variability of the retun. Broadly, unsystematic risk can be classified as: style or becOmee ssiee CAample
invesu
Business risk, which refers to the diflerence
berween revenue and earmings before interest and is the management that has to overcome the problem of obsolesce+ice by concentrating
taxe R&D programme. For exATmple, if Maruti has to survive the competition, it has to
keen ite theDt
hl
(EBIT). and with

Financial risk, waich refers to the amd introduce consumer-oriented technological changes in the automobile sector. This is often c
difference between EBIT and earnings betore
tax (EBI). s introducing sleekness, seating comfort, and brake efficiency in ts automobiles. New carmied o
Business Risk he Droduced to replace the old ones. Shortsighted cuting ot the R&D budget would reduceproducti
Business risk is that the operatie
portion of unsystemaric risk caused by the operating environment of the eficiency of any firm.
Vanations in the expected
operating income reflect business risks. Variations that occur in the business
environment are retlecied in the
operating incomes and expected dividends. Business risk is concerned operating Prsonnel management Personnel management in a comparny also contributes to the
the difference between
revenue and EBIT. withofthe firm. Frequent strikes and lockouts result in loss of production and high fixed operational efficiency
for example, consider two rodictivity can also suffer. The challenge of labour management exists in all capital costs. Labour
companies, Anu and Vinu. In Anu Company, operating income firms. It is up to the compary
as much as 15
per cent and go as low as 7 per cent. In Vinu could grow to Solve the problems at the negotiating table and provide
12 per cent or 9 company, the operating income can be either adequate incentives to the increase in
because of ts high
per cent. When both the companies are
compared, Anu Company's business risk is higher labour productivity. Encouragement given to labourers at the floor level will boostencourage
the morale of the labour
variability operating income compared to Vinu
in orce and lead to higher productivity, and less wastage of raw materials and time.
the inability of a firm to maintain its Company. Business risk arises from
isk can be divided into internal competitive edge and the growth or stability of the earnings. Business
business risk and extermal business risk. The ed cost Ihe cost component also generates internal risks, if fixed costs are
llustrated in Figure 7.2 concept of business risk isa recession or low demand tor a product, the bigh in the total cost. During
a boom period, it cannot
company cannot reduce the fixed costs. At the saine
change fixed factors at a short notice.
the time, in
be a burden to the firm. The fixed a Thus, high fixed cost componeni can
cost
affect the profitability of a component must always be kept at a reasonable level. so it does
Business Risk
company. no
Single product Internal business risks are
demand for a single product can be fatal higher for a firm producing a single product. The fall in the
for the firm. Further,
business cycles while some some
products are more vulnerabie to
Internal bussiness risk products resist and can go against the tide.
External business risk product base if it has to face the competition and business Hence, a company must
Lover- Ltd, which is producing a wide range of cycles successfully. Take for instance,diversify iis
consumer cosmetics and is Hindustan
wen company diversifies its product base, it
a
thriving in this business. Even
mimimize the risk factor. must guard against unknown and unrelated
Fluctuations in sales Poorly thought
dangerous as producing a singleproduct
Social and regulatory out
diversification
factors is as
o

Research and development Political factors

External business risk good.
Personnel manageme Business cycles
Entermal risks arise from operating conditions
Fixed cost imposed on the firm by circumstances
Single product he external environments in which it beyond its controi.
d
regulatory factors, monetary and fiscaloperates exerts some
pressure on the fim. These could be social
avironment in which a firm or an policies of government, business
Figure 7.2 Business risks
banse in the stock industry operates. A government policy thatcycles or the

favours
general economic
aTe very
prices of the particular industry. instance, the Indian sugar and industry will lead
For
an
vulnerable to external factors. fertilizer industries
Internal business risk
Internal business risk is associated with the Social and regulatory factors A harsh regulatory climate and
operational efficiency of the firm. This ditfers trom
compau ne legislation against enviroamental degradarion
to company. The efficiency of operations is reflected in the company's achievement of its g0als and u
prontabilhty
reduce
of
industry. Price controls, volume controls,
an
import/export controks
fulfilment of its promises to investors. COntrois
such as
the
profitability firm. This risk is high in industries
of a
related to public utiity
and
ors telecom, banking and transportation. The
Fluctuations in sales The sales level has
Sa direct bearimg on its earnings. Likewise, interest rates govemment' s tariff policy for the telecom sector
and norms for
to be maintained. It is common in bus1ness to lose lending can affect the profitability
abruptlybecause of competition. Loss of customers will lead to a loss in custon C aicuta Elecetric Supply
Corporation has not been able tw
increase its
operational income. Hence, SUitf resistance from the West tariff owing
company has to build a wide customer base Bengal government. The Pollution Control Board has power
through various distribution channels. A diversitied sales fo ES n lamil Nadu to
close, and this has affected the leather industry. asked most of the
 Prsk 131
and Portotio Managoment
130 Security Analysis
The cxample detailed in Table 71 deals wth three different sitations in the
With a change in the ruling year 20X6, both the
Political risk Political risk arises out changes in governent policy.
of companies carned ihe same arnount and earningp per share were the sarne. In the year 20K7, there was
minister he liberalized the Indian
When Dr Mannmohan Singh was the finance 33.33 per cent hike in the carnings of the two comiparnes in coAnpary A, a 33.33 per cem rise in
party, policies also change. efforts were made to augment foreign operating
economy. During the Bharathiya
Janata Party government, even though income resulted in a S0 per cent increase in earnings per share In mpary B, te effect of an increase in
Political risks arise mainly in the case of toreign ooerating income was so considerable that the earnings er share increased b C per cETt, 1.¬.. from ?i
investnent, sress was placed on indigenous prxluctiou.
its rules and regulations regarding foreign
investment.
For
investment. The host governnent may change
and share their growth
to 2. The reason behind this is that the bondholder receives idy the pe-ftzed interest amaunt, whether
multinationals must dilute their equity the company fares well or not. The incTeast in earnings per share auid cause a change n the
in 1977, the government decided that
example, in Indian companies. capital
with Indian investors. This forced multinationals to liquidate their holdings
many appreciation of the shares of company B during a good year
In 20X8, the economic climate changed, and there was a fail in he operating profit by 33 33 per cenn
fluctuations in the earnings of a company. An
Business cycle Fluctuations in business cycle may lead to for both the companies. This caused a 50 per cent fall in earnings per share or conpay A compared io
economic recession could lead to a drop in the output
of many industries. Steel and white consumer goods 20X6. However, company B's earning per share fell to zero, affecting sharehoiders adverely. 1f we zsune
a boom, there is much demand
for steel
industries tend to move in tandem with the business cycle. During another situation of negative earnings, the situation WOuld be worse in cpary B, and the sharebolders
a recession, demand for such goods
akes a hit. In more
goods. However, in will be further adversely affected. A few years of persistent negative earnings will ernde the sharetolders
products and white consumer
has resisted business cycle, and moved couter cyclically
recent times, the information technology industry from one company to another. Sometimes, companies
equity. Fixed return on boTowed capital either enhances or reduces the return to starehoider
during a recession. The effects of business cycles vary to close down. In søme other cases, there may be
The financial risk considers the difference between EBIT and EBT. Business risks cane varatios
with inadequate capital and consumer base may be forced between revenue and EBIT. The payment of interest affects the evenbual.earni gs of te company suock.
decline. This risk factor is extemal to the corporate bodies, and
a fall in profits, and the growth rate may

they may not be able to control it. caused

Volbyatility in the
borrowed
rates of return on theleveraged siockis
funds in highly firms
magnified
are
by
greater
borrowed
compared
money
to
The
compams
varations
with low
n mcome
leverage
The financial leverage or financial risk Is an avoidable risk because. the managemena decides the stare of
Financial Risk equity and borrowed funds in the total capital
income vis-a-vis the equity capital because of the debt capital. Financial risk
This refers to the variabili
is associated with the capital structure of the
company. This structure consists of equity funds and borrowed
a commitment of paying interest or a pre-fixed
MINIMIZING RISK EXPOSURE
funds. The presence of debt and preference capital results in Every investor wants to guard against risk. This can be done by understanding the nature of the rsk and by
The residual income alone is available to the equity holders. The interest payment affects
rate of dividend.
increases the variability of the returns
careful planning. The following paragraphs explain how investors can protect themscives from the daiieree
the payments that are due to the equity investors. Debt financing types of risks.
with own
to the common stockholders and affects
their expectations regarding the return. The use of debt
funds to increase the return to shareholders is known as financial leveraging.
and offer financial leverage to the Protection against Market Risk
Debt financing enables companies to have funds at a low cost
shareholders. As long as the earnings of a company are higher than the cost of borrowed funds, shareholders An investor must study the price behaviour of the stock. Usually, history repeats itselí oven though it is n o

earmings go up. At the same time, when the earnings are low, it may lead to bankruptcy for equity holders. inIndian
perfect fom. The stock that shows growth patterm may continue do or a more penods. The
stock market expects the growth pattern to coninue for some more ume in míormabon technology
to so some

This is illustrated in Table 7.1.

stock and depressing conditions to continue in textile-related stocks. Some stocks may be ayclical stocks It
Table 7.1 Capital Structure and EPS is better to avoid such stocks.
Thestandarddeviationand beta indicate the voiatility of the stock. The standard devanon and beta are
available for thestocks included in the indices. The NSE news bulletin provides this inaormatüon. By kooking
20X6 2028 atthe beta values, the investor can gauge the tactor and make decisions according to his risk toierance

Company A Further, the investor should be prepared to hold the stock for a minimum period uo reap the benefits of
Equity capital: R10 per share 20,00,000 20,00,000 20,00,000
Tsing trends in the market. He should be careful about the timing of the purchase and sale of the siock. He
should purchase it when it is low and shoyld exit at a higher levei.
Debt fund (10% interest) 10,00,000 10,00,000 10,00.000
3,00,000 40,00,00 20,00,00
Operating income Protection against Interest Rate Risk
1 1.5 0.5 Aninvestor can protect himself against interest rate risk by
Earnings per share
Company B Holding the investment to maturity: If he sells it in the middle due to fall in the interest raie. the capital

10,00,000 n,invested will experience a heavy loss.

10,00,000 10,00,000
Equity capital:R10 per share ibuying treasury bills and bonds of short maurity: Atter maturity, the invested money can be reinvested
Debt fund (10% interest) 20,00,000 20,00,000 20,00,000 to suit the market interest rates.

Operating income 3,00,000 4,00,000 2,00,000 Anvesting in bonds with different maturity dates: When the bonds maure on different dates, renvestment
Earnings per share .0 2.0 Ni
 CIOLOH
DUP

Te S Uh Anay ts an yttho Maagerer SsABuy Auediwo y

based on the past return of the stock. Then,using the standard normal probabilitv di .
Aunoas
an kn acwding to the changes in the investment climate. Maturity diversification can yield the t

s t esults
out the probability of return on that stock falling below thai mean or expected return
If the stock price is not normally distributed, subjective estimates of
Protection against Inflation probabilities c

culationTeDT
Using that an investor can find out the expected retúrn ot that stock. Then the calculation
Te ollowing points should be noted: the risk of the expected stock return. od var
e gcneral opmon is that the bonds or debentures with fixcd returns cannot solve the The other statistical tool often used to measure and used co |
oad yied is 13 to 15 problem. If he as 2 proxy for risk is the stand
per cent with low risk factor, it can
Another way to avoid nsk is provide
a hedge
against inflation. andard dei
to have investment in
short-term securities and to avo1d Standard deviation It is a measure of the values of the variable around its
mean. In other r d
investnents A rising consumer long-le
price index may wipe out he real rate of interest in the long erm. square root of the sum of the squared deviations of variable values from the mean divided s,
lvestmment diversiñcadon can
the r
his tnvestment to nclude
also solve this problem to a certain extent.
real estate,
The investor has to
divers observances. The monthly returns of SBI stock for the financial year 201l-12 are given inbyTable 712 murmber
cnsure that such
precious metals, arts and antiques, besides securities. One with the relevant calculations for the standard deviation. aka
diversification will provide a perfect
hedge against cani
loss due to fall in
purchasing power. inflation,
but it can minimize
te
Table 7.2 Monthly returns for SBI Stock in 2011-12
Protection against Business and Financial Risk Returm
investors can
protect.themselves by: 3.17 4.71
Analysing the strength and weakness of the 22.1841
of the industry is too much of
industry to which the company belongs.
f the -14.63
govemnent interference by way of rules and weaknes 13.09
171.33481
avoidi t. regulations, it is better t 3.27 4.81
Analysing the prafitability trend of the
company. The calculation of standard deviation would -3.27
.1361
variability of retum. If there is inconsistency in the yield 1.73
choose a stock with a earnings, it is better to avoid it. The investor the -15.77 29929
consistent track record. mus 14.23
Analysing the capital structure of the company. If the debt 4.15 202 4929
exercise caution. equity ratio is high, the investor .shoud 2.61
6.8121
Along with an analysis of the capital structure, he should also take into
2.36
nterest paymenis. In a boom, the
investor can select a account the -3.9
15.21
during a recession. highly leveraged comnpany but shouid not do 7.33
5.82
-10.98 9.44
33.8724
RISK MEASUREMENT 1136
26.47 -28.01
Understanding the nature of the risk is not adequate unless the investor or 84 601
analyst is
quantitative terms. Expressing the risk ofa stock in quantitative terms makescapable expressing
of 8.01
in some
-9.55
with other stocks. Measurements canot be cent possible comparisom
per cent accurate because risk is caused by
.62 912025
4.08
factors-social, political, economic, and managerial. Measurement numerou 16.6464
of risk. provides an approximate quantificatiom Average: X=4A=154
N
Ex-post Risk
Variance from the mean valuethe ex-post risk using historical data. The statistical
measures
variance uses the returns of an assetrisk. For example, if one wants to measure risk
to measure
measure d
wIth a stock, one has to take the returns of the associatel
stock over a period. Then he has to calculate the variance
stock return. The value of variance indicates the d 1459.71 1152
risk of that stock.
12-1
Ex-ante Risk
The word ex-ante refers to future events.
When risk is measured ex-ante, variance is calculated with Standard deviation Excel
Open the Excel spread sheet; type the monthly return
-

of probable returns. If the variable a

the
has normal distribution, the theory of normal distribution
menu and choose Standard Deviation.
Select Colunn A and
in Column A. Click the
can
eas standard deviation. press Enter: automatically you will get the
be applied to find out the probability of this deviation. Otherwise,
subjective estimates of the
have to be made. probabil h e arithmetic mean of the returns may be sarne for
kor can be illustrated with an example. two
companies, the retuns may vary widely. This
example, say the changes in a stock price follow a normal distribution. One can take the mean ret Now let us take two
companies A and B to calculate the expected returns.
134 enty Anahysis and Portoko Management 135

For CompanyB
Company A Company

0.1 4
0.10 0.6 0.1 0.4
1.2 6 2 -2
025 1.75 02
0.4 3.2 0:4
24 8
0 02 20 10 02 2 4 0.8
a25 225
1.00 12 0.1 12 12 0.1 A 6 16
0 010
4.8
EE)=8.00 2E=8.00

In the example given above the expected means are the same in both the companies.
the B retum varies from 4% to 12%. To
The A company's retu
find out the variation, te
a- -Eln
varies from 6% o 10% while company's
Standard deviation technique is applied.
d-480-219

d-A-E() The expected returns are the same for A and B companies
but the variations a enpected renuns are
different-Company A's expected return is stable compared to Company B's expected return. Tie szndard
deviation helps to measure the variability of return. The variabilitry in rerurn includes both sysicmatic and
Variance ()=Pl -E unsystematic risks.

Characteristic Regression Line (CRL)

The characteristic regression line or CRL is a simple linear regression model
esunated for particular
a

Hence G=Variance (o*) index to measure its diversifiable and undiversifiable risks The moiel is
stock against the market return

ForCompanyA R= Returm of the it stock

E EOF P-EOF a, Lntercept
6 0.10 4 0.4
B =
Slope of the it stock
0.25 R =
Returm of the market index
0.25 1
The error term
30 0
0.25 The security return is
0.25
4 0.40
10 0.10
1.30 Today's price Yesterday's price x 100
Today's security return=
Yesterday's price

N Yesterday's index
Today's index -

L00
2-E Today's market rerurn =F

Yesterday's index

instead of
a=130 114 this week's and last week's pnces
LIKe daily returns, weekly reurns can be calculated by using r e u n s also can be
calculated.
above-menioned formula. Monthly
ONay 's and yesterday's prices in the
 Portoio
M

resist
the

and
135 Security Ana) siS and Pbrtolio Management Analyss negative beta

Securty with
Let us consider the daily prices of the Shaji Auto stock and the index for the period 5 October 2012
etober to2012. The objcctive of this example is only to illustrate the computation of beta. USualy to nEXY-(ErEy) 3 Stocks
values have be calculated from
data of fairly long period to minimize the
a
bes pnE-(2x* y rare.
sampling error. very
9x9132-(-7.09(0.778)
October 5 ShejiAuto 9x82.75-(-7.09)
October 6 904.95 597.80 119
October 7 845.75 570.80
874.25 a =7-
October 8 582.95
October 9 847.95
849.10
559.85 =0.086
October 12 554.60
October 13 835.80
October 14 816.75
545.10 - 9
0.79
519.15
October 15 843.55
835.55
560.70 = 0.086-(119x-0.79)
October 16 560.95 a=1.02
639.50 597.40
To calculate the beta, the returns The manual calculation seems to be laborious.
have to be At present betä can
be calculated with the
co-efficient can be calculated. Then using the formula calculators and computers very easily. When an investor help of hand
calcuiated. below, the beta and
alpha has to calculate for a
wOuld be of great use. Along with
beta, other information also can be
long period, a
computer
spreadsheet for the previous example, i.e., for Shaji Auto stock returnobtained. Given below is the
computer
PnXY-(ExEy)
on NSE imdex
returm
X -(2X) R =
+
1.02
a, B, R +e
a=Y-X a, =

p, =
1.19 standard error is 0.0266
The calculations Standard deviation of
are
given below. stock returm
Variance of stock return
:4.39
Standard deviation of index returm 19.27
3
Shai Auto Variance of the index return
9
ock retUny Correlation coefficient
-6.54 0.795
42.77 4.52
3.37 20.43 Beta: Beta is the
11.36 29.56 slope of the characteristic
-3.01
2.13 4.54 7.18
stock's return and the index regression line. Beta describes the
9.06 -3.96 15.68
ndex return would returms. In the above
example, beta indicates that relationship between the
0.14 11.92 cause 1.19 per cent
U.02
-0.94 00.88
change in the Shaji Auto stock return. one per cent change in NSE
-1.57 2.46 -0.13 1) Beta
-1.71 + 1.0
=

-2.28 2.92 2.68 One per cent

5.20 4.76 change in market
3.28 10.76
22.66 10.85 indicates that the stock moves index return causes exactly I per cent
-0.95
8.00 64.00 26.24 2) Beta in tandem with the
market. change in the stock return.
It
0.90 0.04
=
+0.5
0.47 0.00 -00.04 Une per cent
022 6.50 change in market index return causes
-7.09 82.75
42.25 3.06
is less volatile
coipared
to the market.
0.5 per cent
change in the stock return. The
0.78 173.36 3) Beta =
+ 2.0 stock
91.32
One per cent change in market index
return
return is more volatile. causes, 2 per cent change in the stock returm. The
When there is a decline
beta of 2 would of 10 stock
give a negative return of 20 per cent. per cent in the market return, the stock with a
considered to be risky. The stocks with more than one
beta value are
Negative beta value indicates that the stock
A stock with a returm moves in the
negative beta of -l would provide a return of opposite direction to the market return.
by 10 per cent and vice versa. 10 per cent, if the
market return declines

6),

(c)

sbo*
 Stock Return

Stock Return

Stock Return

EEERREE
 ,

76

.
Secucurriinty
At Analysi and P