Risk

Management
DR. RAKESH KUMAR SHARMA
FACULTY OF ACCOUNTING AND FINANCE
THAPAR INSTITUTE OF ENGINEERING AND
TECHNOLOGY (DEEMED UNIVERSITY ), PATIALA
Risk
• Risk in a Traditional Sense Risk in holding
securities is generally associated with possibility
that realized returns will be less than the returns
that were expected.
Risk
• Risk is a state of Uncertainty where some of the
possibilities involve a loss.
• Normally, when the outcome of an event is not
known and a probability or if element is attached to
it, then there is a risk.
Systematic risk

• Systematic risk is due to risk factors that affect the

entire market such as investment policy changes,
foreign investment policy, change in taxation
clauses, shift in socio-economic parameters, global
security threats and measures etc.
Market Risk

• Finding stock prices falling from time to time while

a company’s earnings are rising, and vice versa, is
not uncommon.
• The price of a stock may fluctuate widely within a
short span of time even though earnings remain
unchanged.
Contd.....
• The causes of this phenomenon are varied, but it is
mainly due to a change in investors’ attitudes
toward equities in general, or toward certain types
or groups of securities in particular.
Interest-Rate Risk

• Interest-rate risk refers to the uncertainty of future

market values and of the size of future income,
caused by fluctuations in the general level of
interest rates.
Contd......
• The root cause of interest-rate risk lies in the fact
that, as the rate of interest paid on U.S. government
securities (USGs) rises or falls, the rates of return
demanded on alternative investment vehicles such
as stocks and bonds issued in the private sector,
rise or fall.
Purchasing-Power Risk

• Purchasing-power risk is the uncertainty the

purchasing power of the amounts to be received. In
more everyday terms, purchasing-power risk refers
to the impact of inflation or deflation on an
investment.
Contd....
• If we think of investment as the postponement of
consumption, we can see that when a person
purchases a stock, he has foregone the opportunity
to buy some good or service for as long as he owns
the stock.
• If, during the holding period, good or services rise,
the investor actually loses purchasing power.
Contd....
• Rising prices on goods and services are normally
associated with what is referred to as inflation.
Falling prices on goods and services are termed
deflation.
Unsystematic Risk

• Unsystematic risk is the portion of total risk that is

unique or peculiar to a firm or an industry, above
and beyond that affecting securities market in
general.
Contd....
• Factors such as management capability, consumer
preferences, and labor strikes can cause unsystematic
variability of returns for a company’s stock.
Types of Unsystematic Risk
• Business Risk
(a) Internal Business Risk
(b) External Business Risk
• Financial Risk
Minimizing Risk Exposure
• Every investor wants to guard himself from the
risk. Understanding the nature of the risk and
careful planning can do this. Lets see how can we
protect ourselves as an investor from the different
types of risks.
 Protection from Market Risk
• Some stocks may be cyclical stocks. It is better to avoid such type of
stocks. The standard deviation and beta indicate the volatility of the
stock.
• The standard deviation and beta are available for the stocks that are
included in the indices.
• The National Stock Exchange News bulletin provides this information.
Looking at the beta values, the investor can gauge the risk factor and
make wise decision according to his risk tolerance.
• He should be careful in the timings of the purchase and sale of the stock.
He should purchase it at the lower level and should exit at a higher level.
 Protection from Interest Rate
Risk
• a. Often suggested solution for this is to hold the investment sells it in the middle
due to fall in the interest rate, the capital invested would experience tolerance.
• b. The investors can also buy treasury bills and bonds of short maturity. The
portfolio manager can invest in the treasury bills and reinvest the money in the
market to suit the prevailing interest rate.
• c. Another suggested solution is to invest in bonds with different maturity dates.
When the bonds mature in different dates, reinvestment can be done according to
the changes in the investment climate. Maturity diversification can yield the best
results.
 Protection from risk due to
Inflation
• The general opinion is that the bonds or debentures with fixed return
cannot solve the problem. If the bond yield is 13 to 15 % with low risk
factor, they would provide hedge against the inflation.
• Another way to avoid the risk is to have investment in short-term
securities and to avoid long-term investment.
• Investment diversification can also solve this problem to a certain extent.
The investor has to diversify his investment in real estates, precious
metals, arts and antiques along with the investment in securities.
• One cannot assure that different types of investments would provide a
perfect hedge against inflation. It can minimize the loss due to the fall in
the purchasing power.
 Protection from Business and
Financial Risk
• a. To guard against the business risk, the investor has to analyze the strength and
weakness of the industry to which the company belongs. If weakness of the industry is
too much of government interference in the way of rules and regulations, it is better to
avoid it.
• b. Analyzing the profitability trend of the company is essential. The calculation of
standard deviation would yield the variability of the return. If there is inconsistency in the
earnings, it is better to avoid it. The investor has to choose stock of consistent track
record.
• c. The financial risk should be minimized by analyzing the company’s capital structure. If
the debt equity ratio is higher, the investor should have a sense of caution.
Techniques of Risk
Measurement

• Following are the different types of statistical and financial

techniques, which are used to measure the degree of financial
risk:
• Range
• Standard Deviation
• Variance
• Coefficient of Variance
• Beta Value
Range and Coefficient of Range
X 10% 5% 6% 12% 18% 11% 4% 6% 25%
Y 12% 10% 8% 19% 21% 11% 8% 9% 22%
Range
• Range of X= H-L= 25%-5%= 20%
• Range of Y= H-L=22%-8%=14%
Coefficient of Range =H-L/H+L
Standard Deviation
• SD tells the deviation from mean.
• The Standard Deviation is a measure of how spread
out numbers are.
• Its symbol is σ (the greek letter sigma)
• The formula is easy: it is the square root of
the Variance.
 What is the Variance?
• The average of the squared differences from the Mean.
• To calculate the variance follow these steps:
1.Work out the Mean (the simple average of the numbers).
2.Then for each number: subtract the Mean and square the
result (the squared difference).
3.Then work out the average of those squared differences.
Years Return D=R- Square
% Average of
differenc
e
1 10 1 1
2 12 3 9
3 8 -1 1
4 7 -2 4
5 6 -3 9
6 8 -1 1
6 9 0 0
8 12 3 9
Total = Total of
72 Square of
• Variance = 34/8= 4.25
• SD
Years Return D= R- Square
(10%) AR of d
1 10 0 0
2 15 5 25
3 18 8 64
4 9 -1 1
5 10 AR 0 0
6 18 8 64
6 7 -3 9
8 15 5 25
Total of Total of Sum of
R= 102/ D=22 Square of
8 = 12.75 differenc
es = 188
• Variance = sum of square of differences / n – Whole
square of differences / whole square of n
• Variance= 188/ 8- 484/64= 23.5-7.56= 15.94.
• SD=
• Coefficient of variation = SD/ Average
• Average= AR+D/n= 10+22/8= 12.75
• CV= 3.992/ 12.75*100= 31.31%
• Variance = Sum of squared differences / n
• Variance = 34/ 8= 4.25
• SD = 2.06
Standard Deviation
• The rate of return of equity shares of ABC Co Ltd.,
for past six years are given below.
Year 2001 2002 2003 2004 2005 2006
Rate 12 18 -6 20 22 24
of
Retur
n (%)
Solution
• Calculation of Average rate of return (R)
• 12+18-6+20+22+24/6
Calculation of Average rate of return = 15%
 2
( R  R)

Solution
Years Rate of (R-Average Square of
return (%) Return ) Deviation
2001 12 -3 9
2002 18 3 9
2003 -6 -21 441
2004 20 5 25
2005 22 7 49
2006 24 9 81
Average = Total of Square of
90/ 6= 15% Deviation = 614
Solution
• Standard Deviation =
614

6

= 10.11
• CV= SD/ Average= 10.11/ 15*100
• CV= 67.4%
 Example 2
Amrita invested in equity shares of Infosys Ltd., its
anticipated returns and associated probabilities are
given below:
You are required to calculate the expected rate of
return and risk in terms of standard deviation.
Return -15 -10 5 10 15 20 30
(%)
Probab 0.05 0.10 0.15 0.25 0.30 0.10 0.05
ility
R

Solution
Return Probabili Rxp D=R- ER (R- ER)2 (R- ER)2 x
(R) ty (p) p
-15 0.05 -0.75 -24.5 600.25 30.0125
-10 0.10 -1 -19.5 380.25 38.025
5 0.15 0.75 -4.5 20.25 3.0375
10 0.25 2.5 0.5 0.25 0.0625
15 0.30 4.5 5.5 30.25 9.075
20 0.10 2 10.5 110.25 11.025

30 0.05 1.5 20.5 420.25 21.0125

ER=9.5 Σ(R-ER )2
x p=
112.25
 Standard deviation (

Solution
• Standard Devotion= 10.59

2
( R  R) p
Beta Coefficient
• A measure of the volatility, or systematic risk, of a
security or a portfolio in comparison to the market as a
whole.
• Beta is used in the capital asset pricing model (CAPM),
a model that calculates the expected return of an asset
based on its beta and expected market returns.
• Also known as "beta coefficient."
Beta Coefficient
• There are two basic approaches to estimating the
beta coefficient:
1. Using a formula (and subjective forecasts)
2. Use of regression (using past holding period
returns)
Beta Coefficient
• Beta is equal to the covariance of the returns of the
stock with the returns of the market, divided by
the variance of the returns of the market:

COVi,M  i , M  i
i  2 
σM M
Beta Coefficient
• Use of regression (using past holding period returns)
Beta Coefficient
• Where x is market Return
• And y company’s return
• N= Period
Beta Coefficient
• The beta of the market portfolio is ALWAYS = 1.0

• The beta of a security compares the volatility of its

returns to the volatility of the market returns:
Beta Coefficient

βs = 1.0 - the security has the same volatility as

the market as a whole

βs > 1.0 - aggressive investment with volatility

of returns greater than the market

βs < 1.0 - defensive investment with volatility

of returns less than the market

βs < 0.0 - an investment with returns that are

negatively correlated with the returns of the
market
• Historical prices of stocks and indices (moneycontr
ol.com)
• Historical - Indices (bseindia.com)
•Thank You !