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Barun Jit Maitra
Roll No-04 PGDM 09-11
What is RISK?
Risk is generally defined as return volatility, or the degree of ups and downs of returns. Risk is the chance that your actual return will be less than you expected.
• Depending on the nature of the investment, the type of investment risk will vary. • A concern with any investment is that you may lose the money you invest - your capital. This risk is therefore often referred to as "capital risk." • If the assets you invest in are held in another currency there is a risk that currency movements alone may affect the value. This is referred to as "currency risk." • Many forms of investment may not be readily saleable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. Assets that are easily sold are termed liquid; therefore this type of risk is termed "liquidity risk." • The risk that there may be a disruption in the internal financial affairs of the investment,
Market Risk V/s Unique Risk
• Market Risk is also • Unique Risk is also called systematic called or nonunsystematic or diversifiable risk. diversifiable risk • General factors • Specific factors affecting all affecting only this firm • Growth rate of GNP, inflation • Development of Rate, Interest new product, rate structure, strike, liquidity government o ta lri = M a rke t R i crunch, n i u e R i sk sk + U new q sk spending. competitor
Outlined below are several systematic risks an investor faces. • Market-volatility risk • Inflation risk • Business-cycle risk • Liquidity risk • Interest rate risk • Marketability risk
Market-volatility risk • The market as a whole is up at times and down at others. If several companies in a related field are doing poorly, that could bring down the value of other companies in the same field just by that association alone. Inflation risk • This is the risk that your money will lose buying power to price increases; also known as inflation. In essence this means that a dollar next year will buy you slightly less than what it will buy you today.
Business cycle risk • You may have heard terms like recession or expansion on the news. In general the economy has periods where it is growing and periods when it does not. The exact duration of these periods is not preset and will be affected by many things. Most businesses are affected by these general movements in the economy. Some businesses are less affected by these movements; for example regardless of the business cycle people are going to need to pay for certain expenses that cannot be cut, diapers is one example, utilities are another. Their value may be less sensitive to changes in the business cycle. Liquidity risk • Liquidity is the speed and ease at which an asset can be converted into cash. Money in a savings account or checking account is extremely liquid as you can go to your bank or an ATM and withdraw the money instantaneously. Stocks and bonds are less liquid than money in a savings or checking account. You can sell your stocks and bonds in one day but it may take several days before you have access to the cash from the sale. Further, since prices
Interest rate risk • As with the overall business cycle, interest rates fluctuate. Typically if interest rates increase, the value of stocks and bonds decreases. If interest rates decrease, the value of stocks and bonds increase. In both situations however, interest rate risk is more closely associated with bonds than stocks. Marketability risk • This risk occurs if you have to sell a particular asset quickly, you may not get the market price for that asset. An easily understood example would be if you needed to sell your home in a hurry. In order to do so you would probably have to lower the asking price considerably. If you were not in such a hurry to sell, you could afford to wait longer and ask for a fair market price.
Expected return of a portfolio
• E(Rp)= w1 E(R1) + w2 E(R2) E(R ) is the expected return of the p portfolio w s o i 1 i th e p ro p o rti n o f p o rtfo l o i ve ste d i se cu ri 1 . n n ty E(R ) is the expected return of security 1 1 w 2 is the proportion of portfolio invested in security 2
Behavior of Returns Over Time
Risky Security Conservative
Effect Of Diversification
State of Probability Economy 1 0.25 2 3 4 0.25 0.25 0.25 Return Return On on A (%) B (%) 15 -5 -5 35 25 15 5 35 Return on Portfolio 5 (%) 5 20 30
• • • Expected return on stock A, E (A) = 0.25(15%) + 0.25(-5%)+0. 25(35%) +0. 25 (25%) = 17.5% • • Expected return on stock B, E (B) =0.25(-5%) +0 .25(15%)+.0 25(5%) +0.25 (35%) = 12.5%
• Expected return on portfolio, = 0.25(5%) +0.25(5%)+0. 25(20%)+0. 25 (30%)= 15%
• Standard Deviation on stock A, = 25(1517.5) 2+ .25(-5-17.5) 2 +. 25(35-17.5) 2+ . 25 (25-17.5) 2 = √218.75 = 14.79% • Standard Deviation on stock B,= 25(-512.5)2 + .25(15-12.5)2+. 25(5-12.5) 2 +. 25 (35-12.5) 2 = √218.75 =14.79% • Standard Deviation on portfolio, A and B =25(5-15)2 + .25(5-15)+. 25(20-15)2+. 25 (30-15)2 = √87.5 = 9.35 % • So, from the above as we can interpret
Relationship between diversification and risk
Market Risk Measurement
• The sensitivity of a security to market movements is called beta (β) • Measure of the extent to which the return on a security fluctuates with the return on market portfolio • By definition, the beta for the market portfolio is 1 • A security which has a beta of 1.5 is experiences greater fluctuation than the market portfolio
Calculation of Beta
• Rjt = αj + βj RMt +ej • Rjt is the return of security j in period t,
• αj is the intercept term • Βj is the regression coefficient • RMt is the return on market portfolio in period t is the random error • ej
• βj =Cov(Rj , RM) / σ2M • • Cov is the covariance between the return on security j and return on market portfolio M • σ2M is the variance of return on the market portfolio •
The Security Market Line
• The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. • The relationship between β and required return is plotted on the security market line (SML) which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is E(Rm)− Rf. The security market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:
30 20, 27.5 25 15, 25
Return on asset
Slope = Beta = 1.5
0 -15 -10 -5 -5, -5 -5 0 5 10 15 20 25
-5, -15 -10, -17.5
-20 Return on market
• Determinants of Beta •
• 1. Cyclicality of revenues – How responsive are revenues to changes in the business cycle? • Does the firm produce normal goods or inferior goods? • Highly cyclical high covariance with the market high beta. • • 2. Operating Leverage (Degree of Operating Leverage) – Degree to which costs are fixed. • High FC relative to VC high operating leverage • • Contribution margin = Price – VC = incremental profit from an additional sale • • Low Contribution margin = low FC & high VC = low DOL – example is grocery store • High Contribution margin = high FC & low VC = high DOL – example is airline • High Operating Leverage profits are more responsive to
• 3. Financial Leverage – similar to operating leverage if we think of debt as a FC • • Equity = Equity beta = beta of a firm’s stock. This is what we have been measuring and looking at thus far. It is a measure of both the firm’s business risk and its financial risk. • • Asset = Asset beta = weighted average of the betas of all a firm’s securities (common stock, debt and preferred stock). This is a measure of the firm’s business risk only. • • Asset = Debt (D) + Equity (E) • D+E D+E • • If a firm has no debt, Asset = Equity • So, we can think of Asset as what Equity would be if the firm had no debt – if it is an unlevered firm. •
• Securities are risky because their returns are variable • The most commonly used measure of risk is σ • Risk of a security-------Unique and Market • Unique------Firm specific factors • Market------ Economy wide factors • Portfolio Diversification washes away Unique risk • The risk of a fully diversified portfolio is its Market Risk • Contribution of a security to the risk of a fully diversified portfolio is beta