Q1: Define risk and distinguish between systematic and unsystematic 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.
The risk is the degree of uncertainty in any stage of life. For instance, while crossing the road, there is
always a risk of getting hit by a vehicle if precautionary measures are not undertaken. Similarly, in the
area of investment and finance, various risks exist since the hard-earned money of individuals and
firms are involved in the cycle.

In this article, we shall be focusing on the differences between Systematic and Unsystematic Risk.
These risks are inevitable in any financial decision, and accordingly, one should be equipped to
handle them in case they occur.

 Systematic Risk does not have a specific definition but is an inherent risk existing in the stock
market. These risks are applicable to all the sectors but can be controlled. If there is an
announcement or event which impacts the entire stock market, a consistent reaction will flow
in which is a systematic risk. E.g., if Government Bonds is offering a yield of 5% in
comparison to the stock market, which offers a minimum return of 10%. Suddenly, the
government announces an additional tax burden of 1% on stock market transactions; this will
be a systematic risk impacting all the stocks and may make the Government bonds more
attractive.
 Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also
known as “Specific Risk,” “Diversifiable risk,” or “Residual Risk.” These are risks which are
existing but are unplanned and can occur at any point in causing widespread disruption. E.g.,
if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the
shares of the airline industry and fall in the prices of the stock impacting this industry.

One should keep in mind the below formula, which in a nutshell highlights the importance of these 2
types of risks faced by all kinds of investor The above risks cannot be avoided, but the impact can be
limited with the help of diversification of shares into different sectors for balancing the negative
effects.

Q 2: What are the statistical tools used to measure the risk of the securities
return? Explain.

 Is a crucial process used to make investment decisions? The process involves identifying
and analyzing the amount of risk involved in an investment, and either accepting that risk or
mitigating it. Some common measures of risk include standard deviation, beta, value at risk (VaR),
and conditional value at risk (CVaR). measures the dispersion of data from its expected value. The
standard deviation is used in making an investment decision to measure the amount of historical
volatility associated with an investment relative to its annual rate of return. It indicates how much the
current return is deviating from its expected historical normal returns. For example, a stock that has
high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated
with the stock.

For those interested only in potential losses while ignoring possible gains, the semi-
deviation essentially only looks at the standard deviations to the downside.

Sharpe Ratio
The Sharpe ratio measures performance as adjusted by the associated risks. This is done by removing
the rate of return on a risk-free investment, such as a U.S. Treasury Bond, from the experienced rate
of return. A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward
price movements on standard deviation to focus on the distribution of returns that are below the target
or required return. The Sortino ratio also replaces the risk-free rate with the required return in the
numerator of the formula, making the formula the return of the portfolio less the required return,
divided by the distribution of returns below the target or required return.

Another variation of the Sharpe ratio is the Treynor Ratio that uses a portfolio’s beta or correlation the
portfolio has with the rest of the market. Beta is a measure of an investment's volatility and risk as
compared to the overall market. The goal of the Treynor ratio is to determine whether an investor is
being compensated for taking additional risk above the inherent risk of the market. The Treynor ratio
formula is the return of the portfolio less the risk-free rate, divided by the portfolio’s beta.

Beta

Beta is another common measure of risk. Beta measures the amount of systematic risk an individual
security or an industrial sector has relative to the whole stock market. The market has a beta of 1, and
it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price
moves in time step with the market. A security with a beta greater than 1 indicates that it is more
volatile than the market.

Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the
market. For example, suppose a security's beta is 1.5. In theory, the security is 50 percent more
volatile than the market.

Value at Risk (VaR)

Value at Risk (VaR) is a statistical measure used to assess the level of risk associated with a portfolio
or company. The VaR measures the maximum potential loss with a degree of confidence for a
specified period. For example, suppose a portfolio of investments has a one-year 10 percent VaR of
$5 million. Therefore, the portfolio has a 10 percent chance of losing more than $5 million over a one-
year period.

Conditional Value at Risk (CVaR)

Conditional value at risk (CVaR) is another risk measure used to assess the tail risk of an investment.
Used as an extension to the VaR, the CVaR assesses the likelihood, with a certain degree of
confidence, that there will be a break in the VaR; it seeks to assess what happens to investment
beyond its maximum loss threshold. This measure is more sensitive to events that happen in the tail
end of a distribution—the tail risk. For example, suppose a risk manager believes the average loss on
an investment is $10 million for the worst one percent of possible outcomes for a portfolio. Therefore,
the CVaR, or expected shortfall, is $10 million for the one percent tail.

R-squared

R-squared is a statistical measure that represents the percentage of a fund portfolio or a security's
movements that can be explained by movements in a benchmark index. For fixed-income
securities and bond funds, the benchmark is the U.S. Treasury Bill. The S&P 500 Index is the
benchmark for equities and equity funds.

Regression is a statistical tool used to understand and estimate the relationship between two or more
variables. The primary application of regression in business and finance is forecasting. For example,
the investors rely on regression analysis to estimate the relationship between the asset activities and
interest rate. The companies’ advertising department applies regression analysis to estimate the
relation between corporation’s sales and advertising expenditures. Also, the regression can be used to
forecast the future demand for a product in a company. Performance measurement is the process of
collecting, analysing and reporting of the information to help us understand, manage, and improve our
goal. It usually tells us how well we are doing, if there is space to improve, if we are meeting our
goals, if our customers are satisfied, etc. There are multiple approaches of performance measurements
such as return on investment, number of accidents per day, units of mile per gallon, etc. These units or
numbers tell people about the efficiency, productivity, safety, quality, etc. Performance measure is
widely used in many industries in real life and it is one of the 10 most significant topics we will talk
in our project since we need these measurements to reflect the profitability of our portfolio.

Q 3: Cite recent examples of political or economic events that have affected

the Indian stock market and the stocks of the industry of your choice.
1.     State elections

India is going to hold state elections in 2018 and general elections in 2019. Even though the focus
is primarily on the 2019 general elections, the state elections also play a vital role.

Karnataka held its state elections earlier in May, while other important states like Madhya Pradesh,
Rajasthan, and Chhattisgarh will hold them later this year. If the election results are in favor of the
ruling party, it would have a positive impact on the stock markets.

On the contrary, if the Opposition wins, the stock market may endure a negative impact
considering the uncertainty in governance that will follow.

2.     Inflation

With the Indian inflation rising, the RBI might impose corrective measures to curb it by
controlling liquidity or by increasing the interest rates. This action can be detrimental for the
economy and the ruling government. Higher inflation will cause a rise in stock market prices
resulting in a financial crunch.

3.     Monsoon

India is a country that is still significantly dependent on its agricultural revenue. Hence, monsoon
would be a deciding factor. Nevertheless, agricultural prices still face a decline even in cases of
bountiful harvests. The government, in its recent Union Budget, implemented steps to price all
kharif crops at cost plus 50% return to raise the income of the agricultural sector.

4.     Growth

The implementation of demonetization and the Goods and Service Tax (GST) has brought
significant growth to the economy. As the per the quarterly report, there has been a rise in
investments. An increase in employment could also lead to an impact on the stock market.

5.     Government’s financial status

Collection of taxes is an essential source of revenue for the government. If tax collection is very
less, then the government will need to borrow the deficit amount. This borrowing will lead to a
rise in the interest rates. According to financial experts, the government’s financial position will
get clear by mid-2018.
6.     Crude oil

The price of crude oil plays a significant role in the government budgeting. However, the
drawback of crude oil is that its price cannot be predicted. If there the price is too high, the
government has to cut back on taxes levied on the consumption of petrol and diesel to minimize
the losses of the common man. This action will result in heavy losses for the economy.

7.     Commodity market

India is a prominent exporter of agricultural commodities and a key importer of metal

commodities. Metal commodities gain value when they become finished products, thus resulting in
inflation

8.     World economy

Changes brought about by developed countries have indirectly helped many countries to profit.
For example, countries that produce unique commodities have benefitted from the price gains.
Equity markets are also witnessing robust growth in the Indian economy due to increased investor
awareness. A fall-out in these factors will have a negative impact on the stock markets.

9.     Global markets

The liquidity of the global bond markets is gradually decreasing as developed countries impose
stricter policies in the bond market and halt circulation. The withdrawal of monetary support will
have a negative impact on interest rates and will result in a liquidity influx in the financial
markets.

10.Britain’s exit from EU (Brexit)

Brexit is a major event that can cause a potential impact on the stock markets. Even though the
public voting for removing Britain from the Euro countries has taken place, Britain is yet to find
ways to steady their economic growth and minimize the impact on the economy. The British
economy is tied to economies around the world. A negative or positive outcome is sure to affect all
other economies, and it will take many years to align with the result.

However, though it is possible to predict some of these events, their impact on the world cannot be
predicted. It is to better to be prepared for the future and make the wise decision of applying
techniques to safeguard one’s investment against uncertainties .

Q-4 What do you mean by derivatives?

What are the features of derivatives?
Classify the different types of derivatives?
What are the reasons for the growth of derivatives in business?

A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Common underlying
instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.

FEATURES OF FINANCIAL DERIVATIVES

1. Financial Derivative is a contract.
2. It derives value from underlying assets.
 3. It has specified obligation as per the contract which means there are parties involved with
specified conditions.
4. Financial Derivatives are carried off-balance sheets.
5. Trading of underlying assets is not involved.
6. Financial Derivatives are mostly secondary market instruments.
7. Financial Derivatives are exposed to risks such as operational, counter party and legal

. Derivatives have a maturity or expiry date post which they terminate automatically.
. Derivatives are of three types i.e., futures forwards and swaps and these assets can equity,
commodities, foreign exchange or financial bearing assets.

The four major types of derivative contracts are options, forwards, futures and swaps.
 Options: Options are derivative contracts that give the buyer a right to buy/sell the
underlying asset at the specified price during a certain period of time. The buyer is not under
any obligation to exercise the option. The option seller is known as the option writer. The
specified price is known as the strike price. You can exercise American options at any time
before the expiry of the option period. European options, however, can be exercised only on
the date of the expiration date.
 Futures: Futures are standardized contracts that allow the holder to buy/sell the asset at an
agreed price at the specified date. The parties to the futures contract are under an obligation to
perform the contract. These contracts are traded on the stock exchange. The value of future
contracts is marked to market every day. It means that the contract value is adjusted according
to market movements till the expiration date.
 Forwards: Forwards are like futures contracts wherein the holder is under an obligation to
perform the contract. But forwards are unstandardized and not traded on stock exchanges.
These are available over-the-counter and are not marked-to-market. These can be customized
to suit the requirements of the parties to the contract.
 Swaps: Swaps are derivative contracts wherein two parties exchange their financial
obligations. The cash flows are based on a notional principal amount agreed between both
parties without exchange of principal. The amount of cash flows is based on a rate of interest.
One cash flow is generally fixed and the other changes on the basis of a benchmark interest
rate. Interest rate swaps are the most commonly used category. Swaps are not traded on stock
exchanges and are over-the-counter contracts between businesses or financial institutions.

Factors contributing to the growth of derivatives

Price Volatility. A price is what one pays to acquire or use something of value. ...

Globalization of the Markets. ...

Technological Advances. ...

Advances in Financial Theories
5-(a) Explain the different uses of derivatives? Who are the different
participants in the market?
The participants in the derivatives market can be broadly categorized into the following four
groups:
 
1. Hedgers
Hedging is when a person invests in financial markets to reduce the risk of price volatility in
exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most
 popular instruments in the sphere of hedging. It is because derivatives are effective in
offsetting risk with their respective underlying assets.
 
2. Speculators
Speculation is the most common market activity that participants of a financial market take
part in. It is a risky activity that investors engage in. It involves the purchase of any financial
instrument or an asset that an investor speculates to become significantly valuable in the
future. Speculation is driven by the motive of potentially earning lucrative profits in the
future.
 
3. Arbitrageurs
Arbitrage is a very common profit-making activity in financial markets that comes into effect
by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make
a profit from the price difference arising in an investment of a financial instrument such as
bonds, stocks, derivatives, etc.
 
4. Margin traders
In the finance industry, margin is the collateral deposited by an investor investing in a
financial instrument to the counterparty to cover the credit risk associated with the
investment.
8-what is alpha? Distinguish between negative and positive Alpha?
a-Alpha is the measurement of an investment portfolio’s performance against a certain
benchmark –usually a stock market index. In other words, it’s the degree to which a trader
has managed to ‘beat’ the market over a period of time. The alpha can be positive or
negative, depending on its proximity to the market.

Alpha is not only used as a measure of the portfolio compared to the underlying market, but
also of the performance of the fund manager – who implements the strategies and manages
trading activity.
b- Essentially, alpha reflects the degree to which a stock's returns meet or exceed the returns
generated by the market. ... A positive alpha indicates the security is outperforming the market.
Conversely, a negative alpha indicates the security fails to generate returns at the same rate as the
broader sector

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or
those due within one year. It tells investors and analysts how a company can maximize the current
assets on its balance sheet to satisfy its current debt and other payables.
9- Write Short Notes on –
Bond Risk
Yield to Maturity
Real Rate of Return.
A current ratio that is in line with the industry average or slightly higher is generally considered
acceptable. A current ratio that is lower than the industry average may indicate a higher risk of
distress or default. Similarly, if a company has a very high current ratio compared to its peer group, it
indicates that management may not be using its assets efficiently.

The current ratio is called “current” because, unlike some other liquidity ratios, it incorporates all
current assets and current liabilities. The current ratio is sometimes called the working capital ratio .
Yield to Maturity
Yield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact
till the maturity date. In other words, a bond’s expected returns after making all the payments on time
throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the
yield to maturity measures the value of the bond at the end of the term of a bond. YTM considers
the effective yield of the bond, which is based on compounding. The below formula focuses on
calculating the approximate yield to maturity, whereas calculating the actual YTM will require trial
and error by considering different rates in the current value of the bond until the price matches the
actual market price of the bond. Nowadays, there are computer applications that facilitate the easy to
calculate YTM of the bond. –

Real Rate of Return

Real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation.
Therefore, the real rate of return accurately indicates the actual purchasing power of a given amount
of money over time.
Adjusting the nominal return to compensate for inflation allows the investor to determine how much
of a nominal return is real return.
In addition to adjusting for inflation, investors also must consider the impact of other factors, such as
taxes and investing fees, to calculate real returns on their money or to choose among various investing
options.