Chapter

5
RISK

5.1 Bac kgr oun d of Risk and Ret urn

5.2 Risk
5.3 Sys tem atic Risk
5.4 Uns yste mat ic Risk
5.5 Qua ntit ativ e Ana lysi s of Risk
Ret urn
5.6 Inv esto r's Att itud e tow ard s Risk and

I5.1 BACKGROUND OF RISK AND RETURN I

defi ned by Amling
retur ns are depe ndan t on the vary ing degr ees of risk. A func tiona l defi nitio n as
The or real ass,l
ed as the purc hase by an indiv idual or insti tutio nal inve stor of a finan cial
"Inv estm ent may be defin nt peri od". I Fisc her ani
risk assu med over som e futu re inve stme
that prod uces a return prop ortio nal to the mad e in the expe ctati on
desc ribe it in a simi lar man ner - ''An Inve stme nt is a com mitm ent of fund s
Jord an com men sura te 111
tive rate of return. If the inve stme nt is properly unde rtak en, the retu rn will be
som e posi 2
the risk the investor assumes".
cate gori zed as tM
three elem ents of inve stme nt and can be
Thes e definitions of inve stme nts bring forth
following:
• Return,
• Relationship of retur n and risk and
• Time factor.
1. Return
rn or a reword
ts in orde r to earn retu rns on them . Retu
Investors may buy and sell financial asse by the incr ease or dee
and capital gain s or losse s which arise
investments includes both current income
Inc., Engle wood C
1. st Mana geme nt (Fifth Editio n), Prent ice Hall
mling, , 1F.9· 8, 41nue
AJeney ments - An Introduction to Analysis and
Ip, 3 •
Inc., Engle wood
2
· AscJ
eney ,°
her, 1 9 • 83E,, &
p .
rd
J4o. an, R.J., Security Analysis and Portfolio
Mana geme nt (Third Edition), Prent ice Hall
100
 81 th~ security prices. The capital gains or the income earned are then treated as a percenta ~e of~
~il'ritifnl trc
as a pe:rrerita
capital gain
investment. Return, th erefore, maybe expresse d as the total annual income and
of investme nt.
be satisfied bg, nt
Satisfac_t~ry returns are differen t for different people. Two rational investor s may
are risk averse. They try to
levels ?f anh~ipat_e_d return a nd estimate d risk. Rational investors like return. but • m uti/tty •.
maximize their uhhty by buying ' hold"mg or a d"Justing . their . portfolio to achieve 'maximu
of the stock divided
Return, in ot~e_r wo rcls, is the 'yield' on a security. Yield of the stock will be the price
nd There is no compou nding of returns. The annual
int~ th e c_urrent ~ivide · This is known as current yield.
For example , if an investor receives ' 2
capital gai~s a_re_ included on a stock price to find out their returns. of
and has an average investm ent
per share m divide nd s and earns { 3 per share per year in capital gains
{ 20, the return on the stock would be 25%.
maturity date is very
While return in stocks is not related to a maturity date in bond investm ents the
~ver its life. This is referred
important. Yield is the compou nd rate of return on the purch~se price of the bond
Stock yields and bond
to as 'yield to maturity '. Return, therefor e, includes interest and capital gains or losses.
. Method s of measurement
yields should be carefully compar ed since the method to measure them is different
of return are presente d in this chapter as well as in the next.
2. Relationship of Risk and Return
outdate d approach to
Risk and return are insepara ble. To ignore risk and only expect returns is an
aspects - risk and return. Return
investments. The investm ent process must be consider ed in terms of both
is measura ble also. Risk is not
is a precise statistica l term; it is not a simple expectat ion of investor 's return but
keep the risk associat ed
a precise statistica l term but we use statistica l terms to quantify it. The investor should
believed that higher the risk,
with the return proport ional as risk is directly correlate d with return. It is generall y
At a given level of return
the greater the reward but seeking excessiv e risk does not ensure excessive return.
of estimati ng return and risk for individu al
each security has a differen t degree of risk. The entire process
securities is called 'Securit y Analysis '.
meets his preferen ces for
The ultimate objectiv e of the investor is to derive a portfolio of securitie s that
risk-free debt instrum ents
risk and expecte d return. Securiti es represen t a spectrum of risks ranging from virtually
the investor will select tho
to highly speculat ive bonds, common stocks and warrants . From this spectrum ,
ing two function al areas. Fi
securities that maximiz e his utility, managin g securitie s may be viewed as compris
ned. These estimate s must be used
the risk and return co-incid ent with individu al securitie s must be determi
'.trade- off' between risk f;tj
form portfolio s that best meet the needs of the investor. This decision involves the
and ask certain question s
expected return. To arrive at this trade-of f the investor has to constant ly review
contain only bonds or
find solution s to the problem s. Some of the posers are: Should the portfolio
combina tion of the two kin
common stock? In case, it is decided to have a mix what should be the
ally, the decision s are a
securities? What part of it should contain stocks and what part bonds? Addition
investor may also consid
to predict market behavio ur in order to improve the return of the investor. The
several differen t policies may havEl;
value of time in his investm ents. If investm ent timing is consider ed,
considered.
3. Time
of action. It may-
Time is an importa nt factor in investm ents. Time offers several differen t courses
It may also cons
~nd range from trading to buying and selling at major turning points in t~e mark~t.
rm. Time period depends on the
hme period of investm ent such as long-ter m, interme diate or short-te
and return are measu1,1
of the investor. As investm ents are examin ed over the time period, expecte d risk
and risk. Since, ~q.uity
investor usually selects a time period and return that meet expecta tions of return
and analyze to make successf ul dec1s1ons
be consider ed the investor can follow a 'buy and bold' policy
are best t~ anal_yze
the longer-t erm framewo rk. Some professi onal analysts think that three year periods
security prices.
and bonds as it is long enough to elimina te the effects of business and market cycle on
product s, new develop ments and new id
a Period is also just right to achieve econom ics results from new
As time moves on, analys ts believ e that ·condi tions chang e and invest
for each invest ment. ors re-eva luate expec ted retunt'
-~.,
\ 5.2 RISK \
What is risk? This chapte r discus ses system atic and unsyst
ematic risk compa res
purpo se is two-fo ld:
• To specifi cally discus s the differe nt kinds of risks in holdin
g securi ties and
• To make an attemp t to measu re risk.
Risk and uncert ainty are an integra l part of an invest ment
decisio n. Techni cally, 'risk, can be defined
a situati on where the possib le conseq uences of the decisio
n that is to be taken are known . 'Unce rtaint y
genera lly define d to apply to situati ons where the probab ilities
canno t be estima ted. Howev er, risk and uncertai
are used interch angeab ly.
Risk is compo sed of the deman ds that bring in variati ons in
return of incom e. The main forces contributi
to risk are price and interes t. Risk is also influen ced by extern
al and interna l consid eration s. Extern al risks a
uncon trollab le and broadl y affect the investm ents. These extern
al risks are called system atic risk. Risk due
intern al enviro nment of a firm or those affecti ng particu lar
indust ry are referre d to as unsyst ematic risk.
1. Syste matic Risk
System atic risk is non-di versifi able risk and is associ ated with
the securit ies marke t as well as the economic,
sociolo gical, politic al, and legal consid eration s of .the prices
of all securit ies in the econom y. The effect of these
factors is to put pressu re on all securit ies in such a way
that the price of all stocks will move in the same
directi on. For examp le, during a boom period prices of all
securit ies will rise and indicat e that the econom y
is movin g toward s prospe rity. This is based on the forces of
deman d and supply . It is uncont rollabl e; it can be
reduce d but not elimin ated becaus e it is an extern al risk.
2. Unsys temat ic Risk
It is unique to a firm or industr y. It does not affect an averag
e investo r. Unsys temati c risk is caused by
factors like labour strike, irregul ar disorg anized manag ement
policie s and consum er prefere nces. These factors
are indepe ndent of the price mecha nism operat ing in the securit
ies market . The proble ms of both systematic
and unsyst ematic risk are inhere nt in indust ries dealin g with
basic raw materi als as well as in consum er goods
industr ies.
3. Identi ficatio n of Risk
Those indust ries produc ing industr ial produc ts and dealing
with basic raw materi als follow the level of
econo mic activit y and the price levels of the securit ies market
s. High degree of system atic risk can be discerned
in such indust ries and low degree of unsyst ematic risk. Some
of the industr ies cited as an examp le ar~ steel,
glass, rubber and autom obile industr y.
Indust ries produc ing consum er goods are not depen dent in
their prices on the stock market . Their sales,
profits and stock prices depen d on the consum ers and the kind
of produc ts that they manuf acture . Consequently,
they presen t a high degree of unsyst ematic risk. Examp les of
such industr ies are foodstu ffs, toys, telephones
Other indust ries supply ing basic necess ities to consum ers also
have the proble ms of unsyst ematic risk inherent
in the industr y. The electric ity and power industr ies may
be pointe d out as suitabl e examp les por
unsyst ematic risk.
System atic and unsyst ematic risks can be further classifi ed. System
atic risk covers marke t
and unsyst ematic risk contain s busine ss and financi al risk.
Every industr y and its s
system atic and unsyste matic risk. The system atic portion results
from overall market influeq
portio n results from compa ny and industr y influen ces. System
atic and unsyst ematic
analyz ed separa tely.
 Systematic
Economic Unsystematic
Sociological Industry Risks
Political
Legal Risks

Risk of
Unique Risks
Securities Market
Labour Strikes
Economy
Weak Managerial Policies
Consumer Preferences
I
External Environmental Risks Internal Risks
Market Risk Business Risk
Interest Rate Risk Financial Risk
Purchasing Power Risk

Fig. 5.1: Classification of Risks

I 5.3 SYSTEMATIC RISK I
Market risk, interest rate risk and purchasing power risk are grouped under systematic risk.
1. Market Risk
Market risk is referred to as stock variability due to changes in investor's attitudes and expectations. The
investor's reaction towards tangible and intangible events is the chief cause affecting 'market risk'. The first set,
that is the tangible events, has a 'real' basis but the intangible events are based on a 'psychological' basis or
reaction to expectations or realities.
Market risk triggers off through real events comprising political, social, economic reasons. The initial
decline or 'rise' in market price wil-1 create an emotional instability of investors and cause a fear of loss or create
an undue confidence, relating possibility of profit. The reaction to loss will culminate in excessive selling and
pushing prices down and the reaction to gain will bring in the activity of active buying of securities. However,
investors are more reactive towards decline in prices rather than increase in prices.
Market risks cannot be eliminated while financial risks can be reduced. Through diversification also,
market risk can be reduced but not eliminated because prices of all stocks move together and any equity stock
investor will be faced by the risk of a downwards market and decline in security prices.
Investors can try and eliminate market risk by being conservative in framing their portfolios. They can time
their stock purchases and also choose growth stocks only. These methods will reduce their risk to some degree
but as explained earlier market risk will not be completely eliminated because falling markets would bring down
the prices of all stocks. Obviously the decline in some stock will be more than in others. With a w!se combination
of stocks on the portfolio, to some extent, the risk will be reduced. While the impact on an individual security
varies, experts in investment market feel that all securities are exposed to market risk. Market risk includes such
factors as business recessions, depressions and long-run changes in consumption in the economy.
2• Interest Rate Risk
There are four types of movements in prices of stocks in t~e ~arket. These may be termed as: (a) l~ng-
term, (b) cyclical (bull and bear markets), (c) intermediate or w1thm the cycle and (d) short-te:m. T~e prices
of securities will rise or fall, depending on the change in interest rates. The longer the maturity_ period of a
security the h' h th e y1e . Id . tment and lower the fluctuations in prices. Shorter-term interest rates
1g er on an mves .
fluctuate at d d volatile than long-term securities but their changes have a simi1ar
a great spee an are now more
effect on price. Traditiohally, investors could attempt to forecast cyclical s~ings ~n interest. rat!
merely by forecasting ups and downs in general business activity. However, m l~di~ a combination
have produced a situation where it is difficult to accurately find out the changes m interest rates.
factors that are responsible for complicated analysis are the differences between actual a nd expected I
monetary policies and industrial recessions in the economy. If interest rates could be calculated and p
accurately, investors would buy and sell securities with confidence.
Interest rates continuously change for bonds, preferred stock and equity stock. Interest rate risk
reduced by diversifying in various kinds of securities and also buying securities of different maturity da
Interest rate risk can also be reduced by analyzing the different kinds of securities available for inves
A government bond or a bond issued by the financial institution like IDBI is a risk-less bond. Even if gover
bonds give a slightly lower rate of interest, in the long-run they are better for a conservative investor be
he is assured of his return. Moreover, government bonds are made more attractive by additional advanta
of tax benefits. Therefore, one way to avert interest rate risk would be to purchase government securities. Th
the price of securities in the private corporate sector will fall and interest rates will irycrease. This process
create a chain reaction in the securities. This is rarely possible in the real world situation.
The direct effect of increase in the level of interest rates will raise the price of securities. High interest ratea
usually lead to stock prices because of a diminished demand by speculators who purchase and sell by using
borrowed funds and maintaining a margin.
The effect of interest can be different for lending institutions and borrowing institutions. Term lending
banks and financial institutions may find it attractive to lend during the prevailing high rates of interest
Consequently, the borrowing institutions and corporate organizations will be paying a high interest amount
during the high rates of interest. Therefore, investors should during times of high rate of interest purchase
indirect securities of financial institutions and avoid purchasing securities of the corporate sector in order to
reduce the rate of risk on securities. This switching over of securities is not practical in the actual practice of
making investments. The brokers and speculators can, however, use this as a hedge against possible occurrences
of loss.
3. Purchasing Power Risk
Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods
and services and technically it covers both inflation and deflation periods. During the last two decades it has
been seen that inflationary factors have been continuously affecting the Indian economy. In India, purchasing
power risk is associated with inflation and rising prices in the economy.
Inflation in India has been either 'cost push' or 'demand pull'. This type of inflation has been seen
when costs of production rise or when there is a demand for products but there is no smooth supply and
consequently prices rise. In India, the cost push inflation has led to enormous problems as the rise in prices
of raw materials has greatly increased costs of production. The increase in costs of production has shown a
rising trend in 'wholesale price index' and 'consumer price index'. A rising trend in price index reflects
a price spiral in the economy.
The consumers who wa_nted to forego their present consumption level to purchase commodities in futu
found that_ they coul~ not adJu~t their budgets because they were faced with rising prices and shortage off
for allocation according to their preferences.
All investors should .have an approximate estimate in their minds before investing their funds of
expected return after making an allowance for purchasing power risk. The allowance for rise in prices can
made th rough a check list of the 'cost of living index'. If a cost of living index has a base 100 and th4t
year shows 105 , the rate of increase in inflation is (105-100) 100 or 5%. If the index rises further in the
year to 108, the rate is (108-105) 105 or 2.8%.
for a The i~portance of purchasing power risk can be equated to a simple example. If z, lends , l
if ihe promis~ to be repaid ' 110 at the end of the year, the rate of return is 10%. This effect bece
prices m the country increase. Assuming that the prices rise from 100 base index to 112 f)
 ~ the end of the year has purchasin g power value of only 88% of , 110 or 96.80. A rate of
2% should be
charged in the beginnin g (10% + 12% expected inflation} to allow for this.
have a
The behaviou r of purchasin g power risk can in some ways be compare d to interest rate risk. They
in a country shows
systematic _influence on the prices of both stocks and bonds. If the consume r price index
will also have
a consta~t mcrea~e of 4 % and suddenly jumps to 5% in the next year the required rates of return
st 1th an upward revision. Such a change in process will affect governm ent securities , corporate
to be adJu ed w
bonds and equity shares.
are the
The explanati on of systemat ic risk shows that market, interest rate risk and purchasin g power risk
environm ent
princi_pal so~rces of systemati c risk in securities. The unsystematic risk which affects the internal
a company 's
of a firm or mdu~try although peculiar ~o a particular industry also causes variability of returns for
risk and financial risk'. The
stock. The two kmds of unsystem atic risks in a business organizat ion are 'business
characteristics of these forms of risks are explained below.

I5.4 UNSYSTEMATIC RISK I

industry
The importan ce of unsystem atic risk arises out of the uncertain ty surround ing a particula r firm or
ties directly
due to factors like labour strike , consume r preferences and managem ent policies. These uncertain
atic risks can owing to these considera tions
affect the financing and operating environm ent of the firm. Unsystem
be said to complem ent the systemati c risk forces.
1. Business Risk
profit and
Every corporate organizat ion has its own objectives and goals· and aims at a particula r gross
income to its sharehold ers. It also
operating income and also expects to provide a certain level of dividend
the degree of variation from
hopes to plough back some profits. Once, it identifies its operating level of earnings,
to be 15% in
this operating level would measure business risk. For example, if operating income is expected
income
a year, business risk will be low if the operating income varies between 14% and 16%. If the operating
is as low, as 10% or as high as 18% it would be said that the business risk is high.
and those
Business risk is also associate d with risks directly affecting the internal environm ent of the firm
risk and the latter as external
of circumstances beyond its control. The former is classified as internal business
business risk. Within these two broad categorie s of risk the firm operates.
its
Internal business risk may be represent ed by a firm's limiting environm ent within which it conducts
from the
business. It is the framewo rk within which the firm conducts its business drawing its efficiency largely
degrees in each firm and the
constraints within which it functions . Internal business risk will be of differing
efficiency.
degree to which each firm achieves its goals and attainmen t level is reflected in its operating
the control
Each firm also has to deal with specific external factors. Many a time, these factors are beyond
of the business
of a firm as they are responsiv e to specific operating environm ental condition s. External risks
are due to many factors. Some of the factor's that can be summariz ed are:
counter-
• Busines s cycle: Some industries move automatic ally with the business cycle, others move
cyclically;
race;
• Demogr aphic factors: Such as geograph ical distributi on of populatio n by age, group and
the
• Political policies : Change in decisions , toppling of State Governm ents to some extent affect
working of an industry;
may
• Monetar y ollcy: Reserve Bank of India's policies with regard to monetary and fiscal policies
also affect !venues through an effect on cost as well as availability of funds. When the RBI controls
· 1·n a way that money asset becomes, expensive , people postpone their purchaseds
1·ts mone tary po 1·1c1es . . . •
1s restricte ,
and the impact of such factors can be seen in retailers showroom s. As buying activity
. sales slide down;
t Enulronment: The economi c environm ent of the economy also influence s the firm and cos~ ~
revenues;
 Internal Business Risk can be identified through rise and decline of total revenues as indicate~
earnings before interest and taxes. A firm which has high fixed costs has large internal risk because
would find it difficult to curtail its expenses during a sluggish market. Even when market conditions
a firm with a high fixed cost would be unable to respond to changes in the economy because it would
be burdened with a certain fixed cost factor.
A firm can reduce its internal business risk both by keeping its fixed expenses low and through other
One of the methods of reducing internal business risk is to diversify its business cycle others will be
profitable. Internal risk can be reduced to this extent because a decline in revenue from one product line
be offset by an increase in another, leaving total revenue unchanged. Other methods to reduce risk are tQ
costs of production through other techniques and skills of management.
2. Financial Risk
Financial risk in a company is associated with the method through which it plans its financial structu
If the capital structure of a co mpa ny tends to make earnings unstable , the company may fail financially. Ho
a company raises funds to finance its needs and growth will have an impact on its future earnings a
consequently on the sta bility of ea rni ngs . Debt fina ncing provides a low cost source of funds to a company,
at the same time provid ing financi a l leve rage fo r the equity sha re holders. As long as the earnings of the
company are higher than the cost of bo rrowed funds , the earnings pe r share of equity share are increased.
Unfortunately, large amounts of debt financing also increases the variability of the returns of the equity share'
holders and thus increases their risk. It is foun~ that variation in returns for shareholders in levered firms
(borrowed funds company) is higher than in un-levered firms. The variance in returns is the financial risk.
Financial risk and business risk are somewhat related. While business risk is concerned with an analysis
of the income sta te me nt between-revenues and earnings before interest and taxes (EBIT), financial risk can be
stated as being be twee n earnings before interest and taxes (EBIT) a nd earnings before taxes (EBT). If the
revenue , cost and EBIT of a firm is variable, it implies that there is business risk and in this situation borrowed
funds can magnify risk especially in unprofitable years. Debt in modest amounts is desirable. Excessive debt
is to be avoided as the long range profitability of the company can be depressed. The company should
constantly test its debt to fixed assets, debts to net worth, debts to working capital, and give coverage of interest
charges and preferred dividends by net income after taxes. These methods will check imbalance in the firm's
financing method and help to reduce risk.
The various fo rce of risk both systematic and unsystematic cause variations in retu rns for individual
securities or classes of securities. These risk forces ma y move individually or collective ly or at cross currents
to bring variations in return. Risk can be measured scie ntifically through probability d istributions and through
statistical measures of sta ndard deviation and beta . Risk and return have a relationship. Investors are aware
that there is uncerta inty in returns because the re is risk associated with it. Ge ne ra l awareness of investors ls
not enough. Risk must be quantified. The next cha pter explains the method of quantifying return. This chaptet
explains the kinds of risk a comp a ny is surrounded with. Now, we turn to the different ways in which risk call
be quantified and its relatio nship with return. To qua ntify systematic and unsyste matic risk separately is rather
a difficult task because the ir effects a re involved. An attempt is made to try a nd measure risk in such a wa'/
that all the qualitative factors are take n together as a single measure .

Is.s QUANTITATIVE ANALYSIS OF RISK , ..

To measure risk, an investor should first understand the fact that risk cannot be measured accura
because it is surrounded with complex environment factors such as social, economic and political forces.
uncertainties make the measurement of risk an approximation or a fairly accurate estimation. The analyst
be very cautious while making predictions because much depends on his accuracy in predicting risks,
quantification of risk ensures comparison as well as uniformity in measurement, analysis and interpreta
eliminate guesses and haunches in measurement is possible by finding out the difference between ac~
and estimated return that is the dispersion around the expected return. Discussion as to how p
distributions are framed will be made, in the next chapter while discussing returns. These distrlb
 ceiculawd through 'standard deviations' and 'variances'. They are used for quantifying risk. Fischer and Jordan'
describe risk in the following manner.
"The variability of return around the expected average Is thus a quantitative description of
rlak"•
eans. 1. standard Deviation and Variance
quite The most useful method for calculating the variability is the standard deviation and variance. Risk arises
can out of variability. If we compare the stocks of Company-A and Company-B in the following example (Table 5.1),
cut we find that the expected returns for both the companies are same but the spread is not the same· Company-
A is riskier than Company-B because returns at any particular time are uncertain with respect to its stock.
The average stock for Company-A and B is 12 but appears riskier than B as future outcomes are to be
considered.
ture.
How Another example may be cited here (Table 5.2) of probability distributions to specify expected return as
and
well as risk. The expected return is the weighted average of returns. When each return is multiplied by the
associated probability and added together the result is termed as the weighted average return or in other words
any,
expected average returns, for example:
f the
sed. , , , , , - COMPARING RISK OF STOCKS OF COMPANY A & B

s~%: Company-A(Stock) Company-B (Stock)

sk.
12 11
~lysis
n be
16
4
12
13
f the 20 10
8 14
Lx = 60 Lx = 60
60
Arithmetic mean = 5 = 12

Stocks of Company-A and Company-B have identical expected average returns. But the spread is different.
The range in Company-A is from 8 to 12 and for Company-B it ranges between 9 and 11 only. The range does
not imply greater risk. The spread or dispersion can be measured by standard deviation.
The following example (Table 5.2) calculates return and risk through probability distribution and standard
deviation and variance method of two companies.

■§ijffi (COMPANY A & B)

Company-A

Weighted Deviation· Deviation Weighted Deviation

Possible Return Probability Squared
(2 X 3) Rk - E1 Squared
Outcome Rk K k(Rk - E1)2
kRk (Rk - E1)2
k
0.010 -0.075 0.005625 0.001406
1. 0.04 (4%) 0.25 0.000025 0.000013
0.060 0.005
2. 0.12 (12%) 0.50 0.065 0.004225 0.001056
0.25 0.045
elY ~
3, 0.18 (18%) 0.002475
he
0 st
he
--- Expected Return
= 0.115
= (11.5%)
ro El
= .fo (Rk -E2)2
rn Standard Deviation =8
itY
re
---------
3· Op. cit., p. 121, Fischer and Jordan.
 = ./0.002475
I\• Return = 0.049 or (4.9%)
me • Probabthty = 92 or Variance 0.002475
Weighted probability and Return nkRk

Company-8

Po..lble Return Probablllty Weighted Deviation Deviation Weigh

Outcome Rk K (2 X 3) Rk - E2 Squared
k kRk (Rk - E2)2 k( k

1 0.05 (5%) 0.25 0.0125 -0.040 0 001600 0.

2 0.09 (9%) 0 50 0.0450 0.0000 0.000000 0 00
3 0.18 (13%} 0 25 0. 0325 0 040 0 00 1600 0.000400
0.0900 0.000800
Expected Return O 0900
0 .jk (Rk -E..) 0.000800 = 0.028 (2.8%)
or Va riance = 02 = 0.000800
Comparison of return and risk for stocks of Company-A and Company-8 with standard deviation 4 9%
Company-A and 2.8% of Company-B.
The standard deviations and probability distributions show that stock of Company-A has a higher expecte
return end a higher level of risk as measured by tandard deviation. In Figure 5.2 are plotted probab11i
distributions, expected returns and standard dev1al1on of returns. Company-B's stocks arc symmetrical abo
its expected return, Company A's not. This diagram al o highlights important properties o f s ta ndard devlaho
and variance. The deviations are squared and added on both sides of expected return Ma ny inves tors a
contented when deviations in return are higher than expected. Standard deviation and variance is the b
method for ca lculations in upward returns but when deviations are below the expected return, then instead
standard deviation, the investors or the security analysts should use semi-variance as a measu rement of
as it reflects only downside variations in return.
R, R,

60
2
60-
50 -
2
50 -
40 -
30
20 - 1
,~ .,,.
T-4.9 % T -4 9%
3
40 -
30
20
-
-
1 A T -2.8% T-2.8%
3

10 •I .10 I,. •I,. •I

0 0
2 4 6 8 10 12 16 18 20
14 2 4 6 8 10 12 14 16 18 20
RETURN , Rk (%)
RETURN, Rk (%)
COMPANY-A
COMPANY-a
Fig. 5.2: Risk
Standard deviation measures risk for both individual assets and for portfo
WIMlOn about expected return. Another example of risk through standard dev
__ .. An example is shown in the return chapter also. Given below
ABC and XYZ S w e relationah p between risk and re
 ~nship of risk and return is clearly established in this example. Ct>~
standard deviation than Company-XYZ and the return related to ri~ (st~~•~!lltw.i
~ Z which shows that the stock in ABC has performed better than XYZ but is s
Risk associated with individual stocks is as discussed earlier of two types, systematic or no~.i;4~ h 9':dilf
and unsystematic or dlverslflable. Systematic risk is often referred to as market risk and unsvstem~w;:.,.--
as financial risk. Return of all stocks consists of an element of both types of risks. While systematic 1.\$k~ •
correlated with the variability of overall stock market, the unsystematic risk is the remaining portion of the totiQI
variability of stock prices.
Table 5.3(a)
FINDING OUT RISK BETWEEN STOCKS OF TWO COMPANIES
COMPANY-ABC
- Annual Return Mean Average Stock Difference (1) - (2) Difference Squared
(1) (2) (3) (4)
0.10 0.06 0.04 0.0016
0.12 0.06 0.06 0.0036
0.24 0.06 0.18 0.0324
0.36 0.06 0.3 0.09
0.28 0.06 0.22 0.0484
0 .08 0.06 0.02 0.0004
0.14 0.06 0.08 0.0064
0 .2 0.06 0.14 0.0196
0 .24 0.06 0.18 0.0324
0 .24 0.06 0.18 0.0324
2/10 0.2672

~
Mean = 20% 10

Table 5.3(b) FINDING OUT RISK BETWEEN STOCKS OF TWO COMPANIES

Mean Average Stock Difference (1) - (2) Difference Squared

Annual Return
(2) (3) (4)
(1)
0.1 0.04 0.0016
0.06 0.0004
0.1 -0.02
0.08 0
0.1 0
0.1 0.0004
0.1 0.02
0.12 0.05 0.0025
0.15 0.1
-0.1 0.01
0 0.1
-0.06 0.0036
0.04 0.1
-0.18 0.0324
-0.08 0.1 0.0004
0.1 0.02
0.12 -0.25 0.0625
0.15 0.1 0.1138
0.44/10

l:n 2 - .Jo.1138
10
Mean = 4.4% 8 = 3.37%
 The risk of stocks in terms of systemati c and unsystema tic compoun ds is tested through
moder. According to the market model the return on any stock is related to the return on the
in a linear manner. 4
g risk
This widely accepted market model is based on 'Empirica l Testing'. This measure of quantifyin
modef 'N
referred to as Beta analysis or 'volatlllty '. The applicatio n of the Beta concept or market
through the use of statistical measurem ent through a regression equation. According to Amling,
Inves
Managem ent through this model is the following:
"Returns of stocks are regresse d against the return of the market Index". The
basic equa
for calculatin g risk can then be formulate d as:
Regressio n Equation
Y = ex + '3X + E .... Equation 7.1
Y = Return from the security in a given period.
a. = Alpha or the intercept (where the line crossed vertical axis.)
13 = Beta or slope of the regression formula.
E = Epsilon or Error involved in estimating the value of the stock.
2. Beta
between the
The most important part of the equation is 13 or beta. It is used to describe the relationsh ip
will be equal to
stock's return and market index's returns. If the regression line is at an exact 45° angle, Beta
+ 1.0. A 1 % change in the market index (horizontal axis) shows that it is on an average accompan ied by a 1%
regressed against
change in the stock on the vertical axis. The percentag e changes in the price of the 5stock are
index. S&P 500 Price Index Beta may be positive or
the percentag e changes in the price of a market
We rarely find a negative Beta which reflects a movemen t
negative. Usually Betas are found to be positive.
that the market index change of 1 % was reflected by a 0.5% price
contrary to the market. A 0.5 Beta indicates
reflect that whenever the market index rose or fell by 1 % the
change in stocks. Similarly, a 1.5 Beta would
stocks would rise and fall by 1.5%. Beta is referred to as systematic risk to the market and a. + E the
informatio n both for individual stock as well as portfolios , but as
unsystema tic risk. Beta is a useful piece of
the analysis of portfolios. Also Beta measures risk satisfactor ily for
a measure of risk it is better used in
portfolios. The concept of efficient and inefficien t portfolios will
diversified efficient portfolios but not inefficient
it may be said that Beta is a satisfacto ry measure for portfolios
be clarified later in the book. For the present
because risk other than that reflected by beta is diversified.
the length
Beta has certain limitation s within which it must be considere d. While calculatin g past Betas
future Betas, the markets expected return should also be estimated.
of time will affect Beta size. When estimating
also goes up as predicted the relationsh ip will work. On the
If high Beta is accurately predicted and the market
downward market will show that the Beta will drop much
contrary high Beta estimation and low market or
measure for individual stock as already explained should
faster than the market. Finally, its shortcomi ng as a
Beta along with
be realized while calculatin g stock. For the total portfolio Beta is effective. Figure 5.3 shows the
and Beta relationsh ip between the stock and the
alpha, Rho and Epsilon and Figure 5.4 establish the Alpha
This shows that the stock does have as
market. The stock has a Beta or systematic risk to the market at 99%.
Based on it, the stock in the past has
much risk as the market but it has a slightly higher unsystema tic risk.
provided a return and risk comparab le to the market.

3. Alpha
of the Al~
The distance between the inter-secti on and the horizontal axis is called (a.) Alpha. The size
market's return. If Alpha gf
exhibits the stock's unsystema tic return and its average return independ ent of the

Magee, Efficient Capital

4. For a greater detail on ~~viation of market model and its applications read Dyckman Downes,
New Jersey, 1975, p. 130.
and Account_lng - ~ Cnt,cal. Analysis, Prentice Hall Inc ., Englewood Cliffs,
Corporation (S & P) and
5. The two ma'.n publishers of industry and company information are the Standard and Poor's
op. cit., Jones Tutti.
invest or service (Moody's). Their ratings are considered to be accurate. For further details see p. 90,
 a positive value it is a healthy sign b t Al h
. d t k ith u P as expected value Is zero. The belief of many of the investors is
th 8 t they can fm s oc s w positive Al h d
fflclent market p T Al h P as an have a profitable return. It must be recalled, however, that
in aAnleh of st ck . °si ive P as cannot be predicted in advance. The portfolio theory also maintains that
the p as o s w1 11 average out to 0 · I .
Beta 1s
. Rh
o. m a proper Y diversified portfolio. The third factor besides Alpha and

4, Rho (p)
Rho (p) is the correlation coeffici t h" h d · • ·
. en w JC escnbes the dispersion of the observations around the regression
line. Th e corre Iahon coefficient expre I · • •
. . t Id b . sses corre ahon between two stocks, for example ; and J. The correlation
coe ff1c1en wou e + 1.0 1f an upward t•
h . C movemen m one security is accompanies by an upward movement o f
anot er sdecbunty. honversely, downward movement of one security is followed in the same direction, i.e.,
downwar Y anot er security· If the movem en t o f two stoc ks 1s
• not m • the same d"1rechon· the corre Ia t·10n
coefficient will be negative and would s how - 1.o. If there was no relahonsh1p
. • between the movements o f t he
two st0 cks th e correlation coefficient would be 0. The correlation coefficient can be calculated in the following
manner:
♦ Correlation Coefficient
Where,

~ Rxi -:- Ri Rxj - Rj

Pij = £.J
x=l 91 9i

Rxi = xth possible return for security i. (Pxij Equation 7.2)

Rxj = nth possible return for security j.
Rij = expected return ., for i and j .
Pxij = joint probability that Rxi and Rxj will occur simultaneously.
n = total number ~f joint possible returns.
This formula is normally calculated through the computer. The relationship or degree of correlation among
securities indicates that if there is perfect correlation, diversification will not reduce portfolio risk below the
lower of the two individual security risks. If the securities are negatively correlated portfolio risk can be greatly
reduced. If the relationship is to be drawn between two security returns portfolio risk can be eliminated. When
actual equity shares are analyzed it will be found that usually these stocks are highly correlated but not perfectly
correlated. Correlation coefficients also help in determining the extent to which a portfolio has eliminated
unsystematic risk. For example, if a correlation with the market index is +0.95 on squaring the correlation the
result is 0.9025 which means that 90% of the portfolios risk is now systematic and 10% of unsystematic risk
remains. Figure 5.3 shows correlation relationships in terms of scatter diagrams and regression lines.

5. Co-variance
While standard deviation is an excellent- measure for calculation of risk of individual stocks, it has its
limitations as a measure of a total portfolio. With the correlation the co-variance approach should also be
considered when there are 2 or 3 stocks on the portfolio. Co-variance can be used to achieve the highest
portfolio expected return for a predetermined portfolio variance level or the lowest portfolio return.
An individual security's expected return and variance express return and risk for portfolios of stocks, the
expected return is the weighted average of the expected return on the individual securities. This is weighted
according to each securities' rupee proportion in the portfolio. Since, stocks tend to cover or move together
Portfolio risk cannot be expressed for an individual stock. The formula for calculation of co-variance of two
stocks I and J and the co-variance of stocks with beta coefficients is shown in Figure 5.6.
 SECURITY
2
RETURN(%)

MARKET RETURN OR
(S & P 500%) INDEX

-3

Fig. 5.3: Regression Equation and Beta, Alpha, Rho and Epsilon

STOCK 4
RETURN(%)

2 4 6 8 10 12

2
y = .01 + .99x + E

-4 MARKET RETURN (%)

-6

-8

Fig. 5.4: Beta of Stock to Market

 /3-0.40
p-2.so

ALPHA 20%

MARKET RETURN

MARKET RETURN
Fig. 5.4(A): Low Systematic Risk High Fig. 5.4(8): High Systematic Risk, Low
Unsystematic Risk ' Unsystematic Risk

MARKET RETURN MARKET RETURN MARKET RETURN

(A) Perfect Positive Correlation (r •+1.0) (B) High Positive Correlation (r near+1.0) (C) Perfect Negative

MARKET RETURN MARKET RETURN

(E) Zero Correlation (r =0)
(D) Negative Correlation

Fi g. 5 . 5 (A . B , c, D and E): Correlation Relationships in Term of Scatter Diagrams

6• Co-variance Equation
Cov.ij = pij Si 0j (Equation 7 .3)
Pij = joint probability that ij will move simultaneously
8i = standard deviation of i.
0j = standard deviation of j.
 4

1
SHOWING COVARIANCE
0 BElWEEN STOCKS

-1

-2

-3

-3 -2 -1 0 2 3
Fig. 5.6: Regression Lines for 4 Stocks with + 1.0 Betas

Measurement of Systematic Risk

The formula used for calculation of Alpha ( a) and Beta (/3) is given below:
Y=a+{3X
where,
Y = Dependentvariab~.
X = Independent variable.
a and /j = are constants.
The formula used for the calculation of a and /3 are given below:
a=Y-px
ru:xy - (LX)(:EY)
p= n:EX2 - (LX)2

where,
n = Number of items.
y = Mean value of the dependent variable scores.
X = Mean value independent variable scores.
y = Dependent variable scores.
x = Independent variable scores.
Monthly return data (in percent) for Company A whose stock and the NSE index for a 8 month
presented below:
 4 3.41 1.64
5 9.25 6.67
6 2.36 1.21
7 -0.45 0.72
8 5.51 0.84

(a) Calcu late alpha and beta for th e C ompa ny A stock.

(b) .
Suppo se NSE mdex is expec ted to move up b Y 2 O per cent next month. How much return would you
expec t from Comp any A? ·
may be used.
Solut ion: Since alpha and beta of th e st oc k are to be calculated, the regression model
Calcu lation of a an d p 0 f stock

Comp any A return tfSE Index return x2 XY

y (R,) X (R,,)
0.75 0.45 0.20 0.3375
5.40 0.52 0.27 2.808
1.08 1.17 3.834
3.55
1.64 2.69 5.592 4
3.41
.6.67 44.49 61.69 75
9.25
1.2,1 1.46 2.855 6
2 .36
0.72 0.52 0.324
0.45
0.84 0.71 4.628 4
5.51
9.03 51.50 75.81
21.18

(8x75.81)-(9.03x21.l.8} 606.48-191.26 415.22 = 1256

nI:XY - (I:X)(I:X)
p (8x51.50)-(9.03) 2 - 412.00-81.54 = 330.46 ·
nI:X 2 -(I:X) 2

a=Y-PX

= / i
21 8 -(1.256) 9 3 :c 2.65- 1.42 = 1.23

moves up by 15 per cent can be calculated

The expec ted return from Comp any A stock when NSE index
from the regression equat ion which is R.I = 1.23' + 1.256
= 2.486 Rm
R1 = 1.23 + 1.256 (20) = 26.35
Subst itution the value of Rm as 20 in the equat ion, we get,

RISK AND RETURN

,, UDE TOWARDS
5.6 INVESTOR'S ATTIT
t let us turn back to the investor's attitude
Before concl uding the discus sion on risk and its measu remen
and return is funda menta l to the investment process
towards risk and return . Unde rstand ing and measu ring risk
investors are 'risk averse '. They must be aware.of
and increases an aware ness of the invest ment problem. Most low risk and the kinds of
e risks in differ ent invest ments wheth er they are confro nted with high, mode rate or
th . Table 5.4 gives a ready reference to the kinds-
risks investment are expos ed to before makin g their investments t.-,
the investor should be able to accep t the fact
of risks an invest or is expos ed to. To have a higher return
 INVESTMEN1'
116
he has to be faced with greater risks. In commercial bank and life insurance savings most of the risks
but purchasing power risk is high. Figure 5. 7 graphically establishes the attitudes of two investors ab
combination of risks and returns that they would be able to accept. The investor has to decide for
whether he would like to choose a group of securities which will give him 15% return with 10% risk or a
of 25% with 20% risk.
Table 5.4 RISK RETURN OF VARIOUS INVESTMENT ALTERNATIVES

Management Investment Mutual Business Interest

Decisions Risk Risk Risk
Required

H Growth Equity Shares H H L L

H Speculative Equity Shares H H L L
M Blue Chips (High Quality Equity Shares) M M L L
M Convertible Preferred Stock M M L L
L Convertible Debentures M M L L
L Corporate Bonds L L H H
L Government Bonds L L H H
L Short-term (Government Bonds) L L L H
L Money Market Funds L L L H
0 Life Insurance Savings L L L H
0 Commercial Banks L L L H
H = High L = Low M = Moderate

30

25

20

15

10

LOI/VER

5 5 0

Fig. 5.7: Attitude Towards Return and Risk

The curves 11,2,3 and J 1,2,3 show the attitudes of two different inv t .
they are willing to accept. The curves show th t . t eS ors about the return and risk com
I nd
return at point A (I) and B (J) The first . a l~ves ors a J are quite happy with combination of
securities at point A, that is the best the . mtves or can wi th all his efforts only obtain that comblna
more. The second investor J is willing t 0 mvesh Id
or can do within his j'1 ·t d b'l't h
. m1 e a 1 1 y, t e market will not o
take a higher risk for a higher return. s ou er greater nsk to earn a higher return. This investor
 ~Uni? the fr~mework of th~ analytical discussion on return and risk in Chapter 5 and 6 i5 P . ~
alerent kmds of mvestments with their special features In Chapter 7. After which we will take a'cfoseiloolJ
at the different approaches - fundamental, technical and modern portfolio theory.

( SUMMARY
□ st st
Mo inve ors are risk averse and attempt to maximize their wealth at the minimum risk.
□ Risk, it is e st ablished, can be reduced to a minimum but cannot be completely erased or eliminated.
□ Risk a
nd
r~turn are related. The higher the risk a person is willing to accept the better the returns he II
able to achieve.

□ Risks are of many kinds. They can be classified as systematic or unsystematic.

□ st
Sy ~matic risk~ cover the risks of market, interest rate risk and purchasing power risk, unsystematic risk
consists of business and financial risk.
a !h~ ~ystematic risk is, therefore, affecting the total environment and is outside the control of any one firm or
ind1v1dual. Unsystematic risk is inherent to the system.
□ It may be due to bad financial planning or wrong management decisions. These risks are internal and can
be avoided or controlled.
□ Risk is fundamental to the process of investment. Every investor should have an understanding of the various
pitfalls of investments.
a For the convenience of the investors analysts measure risks to be able to combine securities and to reach
that portfolio which suits the individual needs of an investor.
a Risk can be measured through probability distribution and finer statistical techniques like standard deviation,
regression analysis measured through Alpha and Beta tests and through correlation or Rho.
a This chapter also gives an array of investment alternatives from which to choose from and the risks associated
with it. It indicates which risk is high, moderate or low with each investment.

( OBJECTIVE TYPE QUESTIONS )

State whether the following statements are TRUE (T) or FALSE (F):
(i) The distance between intersection and horizontal axis is called Beta risk.
(ii) The most important part of the regression equation is Beta risk.
(iii) The relationship between stocks, returns and market Index's structures is called beta.
(lu) Correlation and co-variance techniques are complementary methods for calculation of risk.
(u) Rho describes the dispersion of the observations around the regression line.
(ui) Median is the statistical tool used to measure a company's risk.
(uii) Systematic risk is a cost incurred by market forces.
(viii) Unsystematic risk is ·environment risk of the economy.
(ix) Purchasing power risk is systematic risk.
(x) Beta is systematic risk.
Answers: (i) F {Ii) T (iii) T (iu) T (u} T _(ui} F (uii) T (uiii) F (ix) T (x) T.

( QUESTIONS

. nsk?
1. What 1s . How d o you di·st·1nguish between systematic and unsystematic risk?
. . b trolled but unsystematic risk can be reduced'. Elaborate.
2. 'Systematic nsk cannot e con . . .
. fmanc1al
3. What 1s . . ns• k?. I s t·t Possible to reduce it while planning an organization?
. nship of risk and return be established?
4. In what way can t h e re Ia t 10 . . . .
5. Discuss the usefulness o f regresst·on equation and correlation m measuring nsk.
6. 'Most investors are risk averse'. Elaborate. . . ,
. , , 'Al h , 'Rho' 'high systematic low unsystematic nsk , 'risk averse'.
7. Explain the terms Beta , P a, •