1. MBA & MBA – Banking and Finance (Term-IV) Course : Security Analysis and Portfolio Management Unit I : Introduction to Security analysis Lesson No. 1.2- Risk – Types and Measurement

2. CONCEPT OF RISK Risk means variation in between actual return and expected return of a security. It refers to the possibility that realized return of securities will be less than the return that were expected. Assessing risk and incorporating the same in the final decision is an integral part of financial analysis. The objective in decision making is not to eliminate or avoid risk, but to properly assess it and determine whether it is worth bearing or not. Efforts are also made to minimize the risk.

3. TYPES OF RISK 1. Systematic risk - It affects the entire market. 2. Unsystematic risk – It is unique and peculiar to a firm or an industry.

4. SYSTEMATIC RISK Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. These forces are uncontrollable, external and broad in their effect. Economic, political and sociological changes are sources of systematic risk. For example, recession in the economy, war, change in government. etc.

5. UNSYSTEMATIC RISK It is that portion of total risk that is unique to a firm or industry. The sources of unsystematic risk are controllable internal factors and peculiar to industries and/or firms, For example, management capability, consumer preferences and labour strikes etc.

6. TYPES OF SYSTEMATIC RISK 1. MARKET RISK Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk. 2. INTEREST RATE RISK It 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.

7. TYPES OF SYSTEMATIC RISK 3. PURCHASING POWER RISK It refers to the uncertainty of the purchasing power of the amounts to be received (or alternately, it refers to the impact of inflation or deflation on an investment).

8. TYPES OF UNSYSTEMATIC RISK 1. BUSINESS RISK – It is that portion of the unsystematic risk which is caused by the operating environment of the business. 2. FINANCIAL RISK – It is associated with the way in which a company finances its activities, i.e. the proportion of debt and equity in its capital structure.

9. Assigning Risk Allowances (Premiums) r = i +p + b +f +m +o Where: r = required rate of return i = real interest rate (risk less rate) p= purchasing power risk-allowance b = business risk-allowance f = financial risk-allowance m= market risk -allowance o = allowance for other risk

10. Computation of Risk The expected return, variance, and standard deviation of outcomes can be computed as: n R = ∑ P i O i i=1 n σ 2 = ∑ P i ( O i – R ) 2 i=1 σ = √ σ 2

11. Where : R = expected return σ 2 = variance of expected return σ = standard deviation of expected return P = Probability O = Outcome n = total number of different outcomes

12. Components of Risk The total risk of an investment consists of two components: diversifiable (unsystematic) risk and non diversifiable (systematic) risk. The relationship between total risk, diversifiable risk, and non diversifiable risk can be expressed by the following equation: Total risk = Diversifiable risk + Non Diversifiable risk

13. Beta Coefficient Beta shows how the price of a security responds to market forces. The beta coefficient is the slope of the regression line with security return as dependent variable and market return as independent variable and thus it is a measure of the sensitivity of the stock return to movements in the market’s return.

14. Systematic and Unsystematic Risk To analyze the riskiness of common stocks in terms of systematic and unsystematic components requires a model of the returns- generating process. R s = α + ß s R m + e Where : R s = return on security α = estimated return on security ß s = measure of systematic volatility of security R m = Return on the market index e = Random error term generating unsystematic return

15. Contd. The above mentioned equation explains that the return on any stock is related to the return on the market index in a linear fashion. It is commonly referred to as The Market Model.

16. Calculation of Alpha and Beta coefficients for estimating the return on security. Return on security can be calculated with the help of following equation: Y e = α + ß X Where; Y e = Expected return on Security Y α = Intercept ß = Beta Coefficient X = Market Return

17. Contd. Where; α = Y - ß X ß = n ∑XY – (∑X)(∑Y) n∑X 2 – (∑X) 2 Residual Variance (Unsystematic Risk) e 2 = ∑Y 2 - α ∑Y- ß ∑XY n Coefficient of Correlation r = n ∑XY – (∑X)(∑Y) √n∑X 2 – (∑X) 2 √ n∑Y 2 – (∑Y) 2

18. Variance The total variance of the return on stock, σ 2 (R s ), is equal to the sum of the variances associated with the various terms on the right hand side. Since α is constant, its variance is zero; thus we are left with the following expression: σ 2 ( R s ) = ß s 2 σ 2 ( R M ) + σ 2 (e i ) Where: σ 2 ( R M ) = variances of the market σ 2 (e i ) = unsystematic components of return.

19. ASSIGNMENT NO. 1 Q 1. Three Securities and the National Index have had the following annual returns for the past ten years: YearNationalSecurities Index X Y Z 10.81.0 -0.51.0 21.21.5 -1.01.0 31.91.7 2.01.0 4-2.0-1.0 3.02.0 51.83.0 0.52.0 60.91.0 0.52.0

20. Contd. YearNationalSecurities Index X Y Z 70.30.5 1.02.1 80.51.0 1.02.2 9-1.0-0.5 4.0-2.3 100.51.0 0.51.5 (a) What is the ten-year average annual return for each security and the National Index? (b) What is the standard deviation of each security and of the National Index?

21. Contd. ( c) Rank each security on the basis of its total return and risk. (d) Rank each security by its beta. (e) Rank each security by its alpha. (f) Which security is the most volatile, and why?

22. Q 2. Below is given daily prices of the Reliance stock and the NSE index for the period 3 rd Oct, 2004 to 14 th Oct, 2004: DateNSE Index (X)Reliance Stock (Y) 3 Oct904.95597.80 4 Oct845.75570.80 5 Oct874.25582.95 6 Oct847.95559.85 7 Oct849.10554.60 10 Oct835.80545.10 11 Oct816.75519.15 12 Oct843.55560.70 13 Oct835.55560.95 14 Oct839.50597.40 Calculate alpha and beta coefficient of the above data.

23. Q 3. The following is the data relating to market return and stock return:- Month/Yr. Market Return (X)Stock Return (Y) January 042.01.9 February5.212.1 March1.32.8 April5.10.3 May1.3-9.5 June2.94.5 July-1.0-4.9 August-1.9-5.2 September3.110.0 October -2.6 5.9 November1.63.8 December-1.3-1.6

24. Contd. Month/Yr. Market Return (X)Stock Return (Y) January 05-1.0-4.2 February-3.1-4.2 March0.34.3 April1.40.1 May-6.3-6.8 June1.69.5 July1.86.1 August7.14.7 September-0.5-3.3 October0.1 6.8 November0.1-2.0 Calculate alpha and beta coefficient.