Introduction to Risk Management and Risk

Return Trade off

Learning Objectives :
1. Classification of Risks
2. Basics of Risk Management
3. Diversifiable and Non Diversifiable Risk FRM
4. Efficient Frontier Theory Course at
NMIMS
5. Capital Asset Pricing Model Mumbai
Classification of Risk

BUSINESS NON BUSINESS

RISK RISK
Reputational
Strategy Non Financial
Regulatory
Product Financial Credit

Market
Technology
Liquidity

Competition Operational

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Financial Risks…

MARKET RISK CREDIT RISK LIQUIDITY RISK OPERATIONS RISK

Equity Price Risk Downgrade Risk Market Liquidity Process

Risk

Interest Rate Risk Default Risk People

Funding
Liquidity Risk
Settlement Risk Systems
Commodity Price
Risk
External events
Currency Risk

These risks can flow from one type to another, i.e they are closely interrelated 3
Basics of Risk and Risk Management

❑Potential variability / fluctuations in return

❑Uncertainty is to say “ I don’t know” , Risk attempts to quantify the uncertainty using probability
functions

❑Financial managers attempt to price risk so that the risk –return trade off is favorable

Basic idea is to assess risk appropriately , and quantify it to the extent possible

However there is no trade off in Operational Risk , that simply needs to be minimised
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Basics of Risk and Risk Management…(cont’d)

❑Financial assets generate cash flows; hence riskiness of a financial asset is measured in terms of
riskiness of cash flows

❑Riskiness can be on a standalone basis or portfolio basis

❑For portfolio, risks are Diversifiable Risk (Idiosyncratic) and Market Risk ( Non- diversifiable)

❑Investors will accept higher risk for higher return

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Risk Management is a Dynamic Process…

Identify
Known Risks

Root Cause Determine

Analysis Probability
and Impact

Random / Accept, Pursue

Unknown or Avoid and
Events Impact

Risk
Monitoring

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The Risk Return Trade Off
INDIA : 1978-2013 Nominal (%) Real (%) Average Risk Premium
(Extra returns versus
1 year G Sec)
1 Year G Sec 9.12 2.46 0

AAA Rated Corporate Bond 12.19 5.54 3.08

BSE Sensex 18.92 12.27 9.81

US: 1978-2017 Nominal(%) Real (% Average Risk Premium

(Extra returns versus
Treasury Bills )
Treasury Bills 3.8 1 0

Government Bonds 5.4 2.4 1.5

Common stocks 11.5 8.4 7.7

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We measure returns through Arithmetic Mean

❑Returns per year is ( Change in price + Dividends) / Initial investment

❑Average returns for a period can be computed either through Arithmetic Mean or Geometric
Mean
Asset Price at end
of year Returns
Year 0 100
Year 1 80 -20%
Year 2 100 25%
Year 3 110 10%

AM 5.0%
GM / CAGR 3.23%

❑ If the cost of capital is estimated from historical returns, always use arithmetic averages

❑The difference between Geometric mean and Arithmetic mean is a measure of Standard Deviation 8
Why is Arithmetic Mean used
❑Suppose an equity share has an expected return of 15% and SD of 30%
❑Assume there are two equally possible outcomes , 45% and – 15%
❑So Arithmetic Mean is 15%

Price Year 1 Year 2 Probability

210 0.25
145
100 123 0.5
85
72 0.25
❑The Expected value of all outcomes is 0.25 X 210 + 0.5X 123 + 0.25 X 72 = 132, which is same as
100 X 1.15 X 1.15 .

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We measure risks through Standard Deviation

❑Measures variability of returns

Deviation
Period Returns (Ri) ( Ri-Rm) ( Ri-Rm)2
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
10 546

∑Ri= 60, Rm=10. ∑ (Ri-Rm)2= 546, σ2 = 546 / (n-1)= 109.2, σ = √109.2= 10.45

❑Excel can calculate it easily.

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Does diversification reduce risk ?

❑ Download last 5 years data from Yahoo Finance for any two Nifty 50 company

❑Compute the SD for each separately

❑Now make an equal weighted portfolio in the two scrips

❑Compute SD for the portfolio

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The concept of covariance

❑ While expected returns on a portfolio of stocks is simply weighted average , SD of the portfolio is
not weighted average
❑Covariance is a measure of the manners in which the stocks covary , correlation shows the extent
to which they are related
❑It can be written as Expected value of [ (RA- RA mean) X ( RB-RB Mean)]
❑To calculate Correlation, we divide Covariance by product of the Standard Deviations of A and B
❑Standard Deviation of a Portfolio is given as
 P = w11 + w2 2  P = w12 12 + w22  22 + 2w1w2 1 2
ρ = Cov(1,2)/σ1 σ2

❑ For a portfolio of n stocks, the calculation gets very complicated ! ∑∑ xixjσiσj [ (N2-N)/2 terms!]

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 Why does Diversification reduce Risk?

❑As you add more scrips , portfolio risk reduces.

❑ Essentially Non Systematic risk ( company specific) can be diversified away to a great extent
❑However, market risk is something that remains

Risk

Non Systematic Risk

Market Risk( Not diversifiable)

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Nos of stocks----→
 Key takeaways

❑Diversified portfolios reduce risk

❑Thus all large investors should ,theoretically, hold a diversified portfolio
❑The risk of a well diversified portfolio depends on the market risk of securities included in the
portfolio
❑How do we assess market risk of a security ?

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 How individual stocks affect portfolio risks

❑Different securities exhibit different sensitivity to market movements

❑This is measured by β
❑β > 1 reflects higher sensitivity/ volatility , less than 1 reflects lower sensitivity / volatility . Usually
varies between 0.3 and 2
❑For we well diversified portfolio, market risk depends on the average beta of the securities

❑Its calculated using the equation E (Ri) = Rf + βi [ E (Rm) – Rf]

where βi= Cov ( Ri, Rm)/ Var(Rm)

❑Mathematically its calculated using the formulae Cov ( Rj, Rm) / Var (Rm)’
Where Rj and Rm are returns on the security and the market respectively

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How is Beta [β] Calculated

Return on Stock Return on Market Product of Previous

Year (Rs) (Rm) (Rs-Mean) (Rm-Mean) two columns (Rm-Mean)2
1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
MeanStock
Return----> 12 ∑ 778 1,022
Mean Market
Return---> 13 COVAR----> 86
Variance Market
Return---> 114
Alpha 2.10 Beta 0.76

Excel Formulae : SLOPE for BETA And INTERCEPT For Alpha

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To recap

❑Securities are risky because their returns are variable

❑Most important measure of risk is Standard Deviation

❑Risk of a security can be spilt into Non-Systematic Risk and Market Risk

❑Non-Systematic risk can be diversified away ( largely )

❑Normally upto 20 stocks is recommended for gains of diversification

❑Beta (β ) is a measure of a securities sensitivity to overall market conditions

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The efficient frontier theory

❑ Suppose you have two stocks, which you combine in a portfolio with different weightages
Expected Return and Standard
Security A Security B
E[r(A)] 12.00% E[r(B)] 20.00%
Deviation
σ(A) 20.00% σ(B) 40.00% 21%
σ^2(A) 0.0400 σ^2(B) 0.1600
17%
ρ(A,B) (0.2000)
13%

Weight of A Weight of B Portfolio SD Portfolio Mean 9%

100% 0% 20% 12%
90% 10% 18% 13% 5%
76% 24% 16% 14% 0% 10% 20% 30% 40% 50%
50% 50% 20% 16%
25% 75% 29% 18%
0% 100% 40% 20%

As you invest more in stock B, your expected returns goes up , albeit with higher volatility.
There is one combination which gives the highest return with lowest SD 18
Question (Hull 1.15)

✓Investment A has a mean return of 8% , Standard Deviation of 14%

✓Investment B has a mean return of 12% and Standard Deviation of 20%
✓Correlation is 0.3
✓Draw the efficient frontier for various combinations of A and B

Weight of A Weight of B SD Mean Expected Return and Standard Deviation

100% 0% 14% 8.00% 21%
90% 10% 13% 8.40% 17%
76% 24% 13% 8.96% 13%
50% 50% 14% 10.00% 9%
25% 75% 16% 11.00% 5%
0% 100% 20% 12.00% 0% 10% 20% 30% 40% 50%
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 So what is an efficient frontier in n security case

❑A portfolio is efficient if and only if there is no combination with

✓Higher Expected Returns and lower SD
✓Same Expected Return and lower SD
✓Lower SD and same Expected Return
Efficient Frontier
Expected
Return

Investments

S.D. of
Return
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 What if you introduce borrowing (and lending)

❑Suppose an efficient portfolio P has an Expected Return of 15%. And SD of 16%

❑Suppose risk free rate is 5%. What will be its SD ?
❑You invest some money in P (efficient portfolio) and half in Treasury Bills
❑Alternatively, you borrow some amount and invest fully in P
Rf rate 6.00%

Market Portfolio Market Portfolio Portfolio

E[r(P)] 15.00% Weight Weight of Rf Portfolio SD Mean
σ(A) 16.00% 100% 0% 16% 15%
σ^2(A) 0.0256
50% 50% 8% 10%
Risk Free
25% 75% 4% 8%
E[r(B)] 5.00%
σ(B) 0.00% 200% 0% 32% 25%
σ^2(B) -

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 Combination of efficient portfolio with lending -
Capital Market Line
Expected Return
J

M
E(RM)
I
Previous Efficient
F Frontier
RF
New Efficient
Frontier

M
S.D. of Return

❑So you get highest return (for a given SD) with a combination of Portfolio M and borrowing or
lending
❑This line also offers the highest ratio of risk premium to SD known as Sharpe ratio. = (Er-Erf)/ σ 22
More on Capital Market Line

❑ Capital Market Line ( CML) shows the tradeoff between risk and return for a portfolio that
consists of Risk Free Asset and Market Portfolio. ( Remember the line tangent to Efficient Frontier)

❑ Capital Market Line ( CML) : E ( R p) = Rf + σp([E(Rm) – Rf]/ σm)

❑[E(Rm) – Rf]/ σm is also known as the Sharpe Ratio

❑Sharpe ratio is a very popular measure to compute risk adjusted return

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Basic Assumptions

❑Investors want high return and low SD

❑The portfolio which offers the best combination of returns and SD is called “Efficient portfolio”

❑If investor can borrow and invest , the best combination is the one that gives the highest Sharp
ratio

❑A risk averse investor will combine a risk free investment with Efficient portfolio

❑An aggressive investor can borrow and invest in the efficient portfolio

❑The composition of this depends on the investors assessment of returns and risk

❑In a portfolio, individual stocks contribution to the overall portfolio risk is what matters. β

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Relation between Risk and Return - Capital Asset
Pricing Model ( CAPM)
❑ In a competitive market, expected risk premium SML
varies in direct proportion to Beta Riskier

❑ E (Rj) = Rf + β[ E(RM) – Rf] Safer

SML
where E (Rj) = Expected return on stock E(Rm)
Market Portfolio
Rf = Risk free rate ;
E(RM) = Expected return on market
Rf
❑ For Gsec, β = 0, Expected Return = Rf
❑For Market portfolio, β = 1 , Expected Return is
E (Rm)
1
❑This is also known as the Security Market Line βm β
(SML)
What is the expected return when β is neither
0 nor 1?
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Question (Hull 1.16)

✓The expected return on the market is 12% and the risk-free rate is 7%.
✓ The standard deviation of the return on the market is 15%.
✓ One investor creates a portfolio on the efficient frontier with an expected return of 10%. Another
creates a portfolio on the efficient frontier with an expected return of 20%.
✓ What is the standard deviation of the return on each of the two portfolios?

Use E ( R p) = Rf + σp([E(Rm) – Rf]/ σm)

Thus 10% = 7% + σA(12% -7%)/15%

And 20% = 7% + σB(12% -7%)/15%

Solving, σA = 9% and σB= 39%

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Recap :CML vs SML : Differences

❑Both these graphs shows the difference between Risk and Return

❑Capital Market Line ( CML) shows the tradeoff between risk and return for a portfolio that

consists of Risk Free Asset and Market Portfolio. ( Remember the line tangent to Efficient Frontier)

❑ Security Market Line (SML) is the graphical depiction of the CAPM, in other words trade off

between risk and return for an individual asset

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CML vs SML : Differences

CML SML
Non existent portfolio Borrowing Riskier

Lending Safer
CML SML
E(Rm)
E(Rm)

Rf
Rf
Inefficient Portfolios

σM σ βm β

Expected Return is Y axis in both cases. For CML, X axis is Standard Deviation σM, in SML, X axis is Beta (βm)

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Equations: CML vs SML

❑Capital Market Line ( CML) : E ( R p) = Rf + σp([E(Rm) – Rf]/ σm)

❑Security Market Line (SML) E (Ri) = Rf + βi [ E (Rm) – Rf]

Sharpe Ratio
where βi= Cov ( Ri, Rm)/ Var(Rm)

❑Intercept for both is Rf Market Risk Premium

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 How valid is CAPM in India ?

❑ Look at Nifty constituents in 4 brackets

FMCG : Britannia, ITC, Nestle , HUL

Banking & Financial Services : HDFC Bank, Bajaj Finance , ICICI Bank, Kotak Bank
IT : TCS , Wipro, Infosys, Tech Mahindra
Manufacturing : Tata Steel, Ultrattech , Tata Motors, Maruti Suzuki

❑Compute their Beta with Nifty returns over a 5 year period(2013-2018-Monthly returns)

❑Compare their actual returns over the next 5 years

Discuss the correlation .

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Alternate Theories

❑Defenders of CAPM say it is concerned with expected returns, what we are observing is actual
returns
❑Actual returns get influenced by a lot of noise.
❑Arbitrage Pricing Theory says Returns are a function partly of “macro economic factors” and partly
of “noise”
✓Return = a + b1 (factor 1) + b2 (factor 2) + b3 (factor 3)+…noise
✓These factors could vary depending on the stock

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Summing up

❑Investors like high returns and low volatility

❑For a given volatility / SD, the portfolio that offers the maximum return is Efficient Portfolio
❑Depending on the risk profile , an investor can combine Efficient Portfolio with Risk Free securities
❑For portfolio , one should not look at risk of individual stocks
❑Rather one should look at the contribution of individual stocks to the riskiness of the portfolio , that
is given by Beta
❑CAPM , while being a pioneering theory, has its limitations

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