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Security Analysis & Portfolio Management

Rohit Sood

Risk & Return

 Course Outcomes
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 Appraise with the relation between risk and return.

 Enumerate and identify different types of risks in security

analysis

 Explain what the standard deviation of returns is, explain

why it is especially useful in finance, and be able to
calculate it

 Explain what an expected return is, and calculate the

expected return for an asset
 Risk and Return
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Fundamental Relationship
The greater the risk, the greater the expected return (positively
related)

Investors assumed to be risk averse

They will want the same return Assume greater risk only for
with less risk. greater returns.

Risk and Return relationship varies over time.

 Expected Risk and Preference

Risk-Averse Investor

A risk-averse investor will choose among investments with the

equal rates of return, the investment with lowest standard
deviation and among investments with equal risk she would
prefer the one with higher return.

Risk-Neutral Investor

A risk-neutral investor does not consider risk, and would always

prefer investments with higher returns.

Risk-Seeking Investor

A risk-seeking investor likes investments with higher risk

irrespective of the rates of return.
 Concept of Return
4

Return can be defined as

Rewards from investing received as
Level of profit from an investment
current income and increased value

Current income
• Periodic cash flow
• “Yield” measures relate income return to a price

Total
for the security
• Must be in form of cash or readily convertible into
cash.
• Dividend from stock, mutual funds or sukuk

Return Capital gain

• Appreciation of
• The
value
change in price of the asset or change of market
value in investment
 What Are Investment Returns?
5

 Investment returns measure the financial results of an

investment.

 Returns can be expressed in:

🞑 Monetary terms
🞑 Percentage terms

 Typically, investment returns are not known with certainty.

 Investment risk pertains to the probability of earning a return

less than that expected.

 The greater the chance of a return far below the expected

return, the greater the risk.
 Measuring Return
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Historical Expected
(Prospective) Level of Return
Performance
Return
• Past data often • Vital • Depend on
provide a measurement of internal
meaningful basis performance characteristics
for future and external
expectation forces
 Types of Returns on Investment
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Types of Returns

Ex Ante Returns Ex Post Returns

• Returns derived from a probability • Returns based on a time series of historical
distribution data
• Based on expectations about future cash
flows

Investment decisions largely based on ex post

analysis – modified by ex ante expectations
 Risk and Return
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• Uncertainty - the possibility that the actual return

may differ from the expected return
• Probability - The probability of an unwanted
What is risk?
event which may or may not occur.
• An unwanted event The cause of an unwanted
event) which may or may not occur

Risk, from a
finance • These uncertainties would translate into volatility or
viewpoint, fluctuation of returns from an investment.
refers to the
uncertainties • Measured by standard deviation.
associated
with returns • Gains & losses, “upside” potential &
from an “downside” possibility
investment
Types of Risks in Finance
 Components of Risk
8

It refers to that portion of variation in return caused by

factors that affect the price of all securities.
SYSTEMATIC
RISK (Can’t be For Example-Economic, Political, Social. It cannot be
diversified) diversified because securities is influenced by general
market trend.

It refers to that portion of variation in return caused by

UN factors are unique to that particular securities.
SYSTEMATIC
RISK (Can be It can be eliminated by diversification
Diversified
 SYSTEMATIC
RISK (Cannot
be Diversified)

Interest Rate
Market Risk Inflation Risk
Risk

It refers to that portion of It refers to that portion of variation in

variation in return due to return due to change in purchasing
change in market price of power of amount to be received in
investment. future.
All securities move with market That is purchasing power of cash
trend. flows.

It refers to that portion of variation in return due to change in

level of interest rate.
Such change first appears in Fixed Income Bearing securities
which has inverse relationship with level of interest rate. Than
it also effect indirectly securities
 Sources of Risk in Investment
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Regulatory Risk • Affects income return

Business Cycle Risk • Overall market effects (Seasonal)

Inflation Risk • Purchasing power variability Demand Pull Inflation and Cost
Push Inflation

Liquidity Risk • Ability to liquidate investment conveniently

Business Risk (non-systematic) • Investment earning and ability to pay the return (interest,
principle, dividend)

Financial Risk • Payment attributable to the mix of debt and equity to

finance business (Default, Liquidity, Marketability, Leverage)

Exchange Rate/Currency/Tax Risk • Changes in code, treatment, fluctuation

Alpha Risk • Failure to achieve the expected return on investment

Political Risk • Overall market effects (Political implications on business)

 Exchange Rate Risk

Return Calculation:

Invested Amount: US$ 1,000 * 45 = Rs. 45,000

Interest earned = 10% * 45,000 = Rs. 4,500
Value at the end = Rs. 49,500

If he repatriates the money back to US, he would receive = Rs.

49,500/50
= US$ 990
Profit/Loss = US$990 - US$1,000
Loss = US$10

So even after earning 10% return, US citizen made a loss in investment,

because of currency depreciation.

If the rupee had appreciated, the US citizen would have made a gain
of more than 10% on his investment.
 Inflation Rate Risk

If Grocery bill is Rs. 100 today, the next year grocery bill could be Rs. 105 because
of rise in prices.
So to have same standard of living, investor would require Rs. 105 instead of Rs. 100
after 1 year.

In such a case, the inflation is said to have been 5% for the year.
Inflation is cumulative and hence has a compounding effect over long periods.
Someone planning for a lifetime should consider inflation as the biggest risk.

Assume that the inflation is 7% p.a. for the next 20 years.

If the household expenses are Rs. 10,000 per month today, 20 years later, one would
need almost Rs. 39,000 to maintain the same standard of living.
 https://www.livemint.com/mutual-fund/mint-30/confused-about-where-to-invest-in-a-
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Investment Evaluation on risk and return

 Inflation Rate Risk

• A Bank is offering 6% interest on deposits

above 3 years. Rate of inflation is 9%. Find
Effective annual return?

• EAR=(1+r)/(1+i)-1
 Risk-Return Trade-off
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•The risk-return trade-off is the

principle that potential return
rises with an increase in risk.
•Low levels of uncertainty or risk
are associated with low
potential returns, whereas high
levels of uncertainty or risk are
associated with high potential
returns.
•According to the risk-return
trade-off, invested money can
render higher profits only if the
investor is willing to accept the
possibility of losses.
•For investors, the risk-return
trade-off is one of the essential
components of each investment
decision as well as in the
assessment of portfolios as a
Risk-Return Trade-off whole.
 Type of Risk in Investment
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Types of Risk
Systematic (general) risk Non-systematic (specific) risk
•Pervasive, affecting all securities, cannot •Unique characteristics specific to issuer
be avoided
•Interest rate or market or inflation risks

Total Risk = General Risk + Specific Risk

 Speculators and Hedgers Behavior on Risk
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The riskiness of
Speculators
an asset or a
Hedgers • Taking positions transaction
that increase their
• Taking positions to
exposure to certain cannot be
reduce their
exposures.
risks in the hope of assessed in
increasing their isolation or in
wealth.
abstract.
 SUM UP
14

The riskiness of
an asset or a
transaction
cannot be
assessed in
isolation or in
abstract.
 SUM UP
14

The riskiness of
an asset or a
transaction
cannot be
assessed in
isolation or in
abstract.
FRAGILE 5 of 2013 (Taper Tantrum)
NEWS Analysis https://www.bloombergquint.com/economy-
finance/nomura-lists-out-troubled-10-ems-is-india-in-there
 Troubled 10 EMs

India escapes the list of 10 this time. The countries included in the grouping are: Brazil,
Colombia, Chile, Peru, Hungary, Romania, Turkey, South Africa, Indonesia, and the
Philippines.

We disagree with those who believe The New Vulnerabilities:

that EM is in a more resilient position
now than it was on the eve of the
 A growing EM bank-sovereign
2013 taper tantrum. debt nexus

EM has developed new sources of

 Not less susceptible to large
capital flight.
vulnerability, with a combination of
chronically weak growth, rising  extraordinarily large fiscal
inflation and a marked deterioration in
deficits will likely leak into
sizable current account deficits.
fiscal finances, and yet real policy
rates remain deeply negative
QUIZ
• A portfolio having two risky securities can be
turned risk less if

a)The securities are completely positively

correlated
b)If the correlation ranges between zero and one
c)The securities are completely negatively
correlated
d) None of the above.
QUIZ

• Return on any financial asset consists of

capital yield and current yield.
a) True
b) False
QUIZ

• Investments are distinguished from savings on the basis of

a) length of time held.

b) depreciation.

c) voting rights.

d) level of risk and expected return.

QUIZ

• Of the following fund types, the highest risk is

associated with

a) Balanced Funds

b) Gilt Funds

c) Equity Growth Funds

d) Debt Funds
QUIZ
• Of the following, which would be suitable for a
retiree with a modest risk appetite

a) Value Fund

b) Diversified Equity Fund

c) Growth Fund

d) Balanced Fund
QUIZ
• Which of the following is/are examples of
systematic risk of a stock?

• (a) Interest Rate Risk

• (b) Operating Risk

• (c) Political Risk

• (d) Both (a) and (c) above

QUIZ
• Which of the following is not a source of
systematic risk?

• (a) Interest Rate Risk

• (b) Financial Risk

• (c) Political Risk

• (d) Market Risk

QUIZ
• Standard deviation determine

• Systematic risk of a security

• Unsystematic risk of security

• Total risk of security

• Premium of security
QUIZ
• Non-systematic risk is furthermore identified
as

a) no diversifiable risk

b) market risk

c) random risk

d) company specific risk

QUIZ
• Unsystematic risk can be eliminated by

a) Diversification

b) Market trend

c) Can not be eliminated

d) None of the above

QUIZ
• Compounding of interest is best explained by

a) Balanced fund

b) Growth fund

c) Value fund

d) Income fund
Thank you