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39 views16 pagesChapter 5
Chapter 5
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rohan.goyal1211Copyright
© © All Rights Reserved
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/ 16
Risk in Securities —
Valuation and Mitigation
SYNOPSIS
"After studying this chapter, a student will be able to understand the following:
Risk in Securities ~ Meaning and Concept
Factors causing risk
Systematic risk
a, Market risk
b. Interest rate risk
c. Purchasing power risk
Unsystematic risk
a, Business risk
b. Financial risk
Difference between Systematic and Unsystematic risk
Measurement of total risk and systematic risk
Calculation and application of beta
Meaning of Risk Mitigation
Steps in Risk Mitigation
Techniques of Risk Mitigation
ajority of investors know that investing comes with risks as well as rewards, and that , overall, the
the risk, the bigger the potential reward. The main concern while making investment in any area
Risk is defined as variation of actual return from the expected return. It has already been
Bpltined that the areas which are inherited with high risk offers high return, But, any individual while
ing his funds tries to estimate the risk associated with his investment and make final decisions of
Yestment only if it falls within the level of risk which he can afford to take, All the investors does not
“NES fund to carn highest level of return. There are different categories of investors, There are certain
Hesors who are concerned with low return but does not want fo assume high risk whereas there are
REET set of investor who does not mind to take any level of risk but wants to earn the highest possible
#4) of return. Ibis therefore for an individual to estimate the amount of risk being undertaken by him
EF making investment decisions. ‘The important issue
ificatic tors which
(a) Identification of fact
® actual return from the expected return.
(0) Methods of caleutatinglestimating risk.
(c) Techniques of minimizing risk or risk mit
lead to creation of risk, ie, which are likely 4
Factors Causing Risk
‘The factors which can lead to deviation of actual return from expected returns can be bro,
a aly gi
‘into two parts-systematic risk and unsystematic risk
Systematic Risk or Non-Diversiflable
Systematicrisk are those risk which arises due to factors like economic, sociological, political si
ise factors which are beyond the control of any individual. As it is difficult to anticipate the
ofevents like outbreak of war, flood, earthquake, natural calamaties, the extent to whi
the ea lose value is difficult to be estimated. Further, the happening of such event have beatin
the entire market, Since they cannot be estimated itis difficult ts mitigate their impact on pont,
therefore, they are also called as ‘Non Diversitiable' risk ‘
The tisk which are normally covered under this category are:
(9) Market Risk: Market risk exists because of rice changes, Iti
Prices due to change in investor's attitudes and expectations,
situation or there is political instabs
tating
occu
(b)
Seer ic
strate can cr), Prices on account o
‘Wect the securities mark
rin ‘han equity shares
1m the ld be tempted t0
‘Onsequeny MtY market 0
* ©quity shares {iy The investor inthe stock market Which no
cur higher cost for funding their ma :
incur higher cost for g their margin requirements and th
iscouraged to borrow large amount of funds for thay \erefore they would be
crease in interest rate. Hence, they would
avoid their borrowing cost of funds as a res
decrease and therefore in the absence of an
mally trade by depo:
ty in the stock market would
the market would witness fall,
arises due to inf
ises when the ch
1y demand of shares,
Purchasing power risk
(© gnown as inflation tisk. Purchasing power risk ar
period
investor invest Rs 100 at the rate of 10% p.a. fort i 5 a
_ years he will be having Rs 100 + Rs 20 = Rs120, i t
index changes {rom 100 to 124, it implies that
1 ie enough to cover the change in prices
process is known as purchasing power risk.
the investment made by the investor was not
due to inflation. The risk which arises in such
systematic Risk or Diversifiable risk
contrast to systematic risk which impact the entire market and are beyond the control of any individual/
“corporate, there are certain risk which are specific to a company and does not impact the entire market,
“Sitch risks which are specific to a particular company are called “Unsystematic risk’.
due to factors associated to any given firm such as labour strike,
luc Fine, change in demand of product etc,. One can mitigate t
jayesible fund in stocks of different company ice. through divei
itis also called as ‘Diversifiable risk”.
These risk arises
change in management, change in
the impact of such risk by allocating
ication of funds. Itis because of this
siness risk is defined as the variability in the actual earnings of a firm from the
expected earning of the firm. For example, the firm expects to earn a net profit of 12% on the
pital employed but in actual the value turns out to be 8% or 16%, it is said that the firm is
exposed to business risk. The change in actual performance may vary from the expected
Performance due to number of reasons which can be either intemal to the firm or external to the
firm. Accordingly, they are referred as internal business risk or external business risk. Internal
business risk includes situations like discontinuity in production due to labour strike or shortage
of power supply etc, External business risk arises due to change in demand of the product or
change in price of raw material thereby affecting the profitability of the firm. Internal business
‘isk can be managed and reduced by a firm whereas external business risk cannot be easily
managed by a firm,
Pte Risk: Financial risk arise due to presence of debt in the capital structure of the firm. A
im
fi ‘ving higher debt content in its capital structure is considered to be more riskier | nae
icgat¥ing lower debt content in its capital structure, both having same amount of capital This
due to the fact the Presence of debt leads to fixed financial burden on the firm. If a firm Investing in
54
Stocy
|
interest on it irrespective ofthe fact y
ty way of debt twill have pay interest pu Lovaas the deer
raised capital by Hence, a firm has fixed financial com eres ni
or not, Henoe, a firm has ne s
any profit or not. equate amount of operat z FS
se the fl carn adequate a ? 2 ; ‘
fe ols a Tmt may be decared insolvent by the creditors, Thus, tna
intrest cost ofthe fi y
arise de to capital strdcture ofthe firm,
given below:
Systematic Risk Unsystematic Risk —~
These type of risk impact the entire These type of risk imp:
market
fact a stock ofa
particular company,
feo They cannot be easily diversified They can be diversifie
I
th -matic ris Unsystematic risk are summarized j,
The main differences between Systematic risk and Unsystematic risk are s1 ize theta
ie main di S s
d by forming wal
balanced portfolio of securities, |
| The magnitude of impact ofthese risk is [Tsmeesiude oF impact ofthese IC
| more onthe portfolio erosion !ess on the portfolio erosion, |
| 4] Sistemas risks estimate srt wine | UYSTematic isk is estimated by
| anus f any portotio or security wine
metstring residual part of the
crite change in market index. "the sul
total risk by
Diracting systematic risk from the total
| Coefficient of systematic risk iy risk,
Tepresented by beta,
| Rktmples ofthese risk inchs
| | Earthquake,
Flood, Outbreak of War, ete,
risk include : Strike of
+ Cancellation of Supply order,
EC OF FW materia ot
Methods of Calculating Risk
Risk in case
historical
Measuring the
thodology to
Above.In order
The m
TeXPlaineg
Wed ecw
a ;
esunt so ob1a
Valuation
gare ro
sess 8
and Mitigation
* gavestor purchased & hate fOr RS. 80 fiy
fe years ago. Durin,
ed is variance of security and itis represent
ional eget
jf variance is standard deviation and itis ce
calc presented as
“ek calculation would become clear from the fot ed as
lowing exarny
he
acta
rt q] 2
95 | 106 fi
si
ae exhibit followin}
var
FPprice (Rs) 0
inidend (Rs.) 3
5 3 ;
id tbe re
jam and tisk of investors using data above
erage price and declared dividend ws given ben LN Yes the
: helow
jon?
Year Price (Rs.) | Dividend (Rs.) | Return fora year (%. 7
; = y fe) | (R~R) |
1 95 5 25 1
2 106 3 16.84 a i
BI ul 8 12.26 a |
4 | 125 8 19,82 rn 35 |
3 140 8 18.4 t.0036
Total 92.32 85,6836 _|
35
Fing
Tis ang
Telum associated with the securiti
Return for a year = [
Average Return =
Standard Deviation = J17.1316
In some ¢:
nee probabilities of different situations are given, the procedure of
feces as has been explained below in example
: The return (in %) on securities, X and Y un
(P=Po) , Di
Sao" <1} x100
Py »
R =92.32/5=17.13672 %
14%
der different situations a
Teeurity ¥_]
7
Security X
calculating risk and
iven below!
|
| Investing
Solution: Security
Calculation of Expected Return
yh | RR
J 15 3.75
= 7.2
40 18
35 22 a |
EIR) 18.65% i
Rewm of Expected Return = E(R) = 18.65%
Caleutation of Ri
Py Ri IR, -E(R)] [Ri - EP PIR; ~ ER}
35 15 65 13.32 3.33
40 18 ~0.65 42 0.17
35 2 3.35 11.22 3.3 |
Total 24.96 743
73%
Security Y
Calculation of Expected Return
Calculation of Risk
——_-—____
Pr (i -Eay
235 as
40 22 0.55
35 24 2.55
The formula used above for meas
(Return) E (R) = EP, k,
(Risk in terms of standard deviation) ¢ = SPCR, yy 5.7
ation san absolute measure of risk, In or
ard devi der to have rel 7 i
a ormula shen ‘ave relative measure of risk, coefficient
os Risk
CV. = =e =x 100=—Risk_
ie FR) Return *1?
i pelpsis analysing risk in proportion to the return offered by securities, Conservative investors.
tock with low coefficient of variation,
‘
pe above concep! help in estimating (otal risk ofthe stock, However, if one intends to measure the
eesionsti0 of the stock vis-a-vis market index, one needs to calculate coefficient of systematic risk,
_efatio
ificance of Coeffi ‘ient of Systematic risk (Beta)
Jationship of the stock in terms of change in value of stock due to ch
sented by a coefficient , known as beta , This is also referred ae “a
plest way to calculate beta of stock is given below:
(%e change in p:
range in value of market index
‘efficient of systematic risk’.
¢ of stock for a given period
(% change in market index for a given period)
1 isa ratio of % change in price of stock for a given period to % change in market index for
esame period. For example, if the price of a stock is Rs 80 when Nifty index is at 7000 and the price
is Rs 72 when Nifly index is 6650. Therefore , beta of the stock will be
eta = (( 72 ~ 80)/80}/{ (6650 ~ 7000/7000} = 0.10.05 = 2
Beta(B) =
Higher magnitude of beta implies higher volatility of the stock with respect to any change in the
be of market index whereas low magnitude implies relatively less reaction on the price of the stock
to any change in value of market index. This implies , a stock having beta of 5 will have more
Aattion on its price in comparison to the stock having beta of 2 for
yy given change in the value of
s the relative directional movement of the stock vis-a-vis market index.
a is having positive sign, it implies stock will move in the same direction in which the market
Huld move, If the market index is increasing , the price of stock will also increase. Similarly, if beta
Ueving negative sign, it implies stock will move in the opposite direction in which the market would
eve: Ifthe market index is increasing , the price of stock will decrease. The practical application of
= has been explained in the section, ‘Techniques of Risk Mitigation’.
The follo
ng examples would help in understanding calculation and significance of beta :
Hott’ ©. An investor observes following movement in the price of stock and value of index at two
Mlerent point of time:
Particulars Timet=0 | Timet=1
Price of Stock of ANZ Ltd. 30 36
Value of Market Index 7000 7350,
stock and interpret the result.
Find the beta of th Solution: Calculation of beta
lying the formula 7
a = ¢ in value = {( Value at time t= — Value at time =0)/ Value at time 0), i
% chang :
(%e change in price of stock for a given period
(% change in market index for a given period)
Using the above data , we have
** Beta() =
Particulars
Price of Stock of ANZ Ltd,
Value of Market Index
Example §.2. An j
value of index
‘ment in the price of stock of A Ltd, and B Lids
at two different point of time:
Price of Stock oF A Lig,
Price of Stock of B Lig,
( When the markets are exy is
; Pected t0 rise, one
Sign so that the Proportionate increase in wealth wont ey Th
en the market
"¢ sign so that the
eta wi si
* Stock op ith positive
shall be purchased,
Ltd. shall
Prefer t0 be invest, In si
Would be less, The ohlow
fore,, 59
Mises of sk have heen discussed alongwith their measurement
the risks are anticipated and estimated, a security analyst ofthe portfolio manager
Npact Of such unforeseen ev ton the value of portfolio by
ation techniques. Therefore, it is a
and/or the likelihood of its occurre
arious techniques to minimize the
ppeopiate actions. These aetions are included in Risk Mii
tic reduction in the extent of exposure to a tisk
led as risk reduction
This also
jue include:
cknowledging the existence of a particular risk, and
instead of avoiding it. The portfolio manager should
probability of happening of such event,
king appropriate action to accept it
adapt the portfolio assuming cent percent
One should make proper change in their portfolio or investment strategy to eliminate or reduce
the risk, This adjustment could be accommodated by a change in funding pattern schedule af
investments, etc.
Implement actions to minimize the impact or likelihood of the risk,
{ Monitor the environment for chan;
hat affect the nature and/or the impact of the risk.
Each of these options requires developing a plan that is implemented and monitored for effectiveness.
nd their measurement techniques. Once the
lemtify the risk associated with his investments then he proceeds to
ize the risk by adopting various strategies which one may refer as risk mitigation techniques,
ving are some of the risk mitigation techniques:
Diversification of funds through creation of Portfolio of stocks: The total investible fund
“tall be invested in securities of different companies belonging to various industries preferably at
ditferemt point of time. This group of stocks purchased by an investor is referred as *Portfolio’.
‘This enables an investor to achieve diversification in terms of stock as well as time diversification,
The benefit of diversification is achieved when stocks for investment are thoroughly analysed and
{ier inter related movements with change in market index has been propery studied, For example,
when the price of petrol/diesel increases, though market tend to react negatively on tt
increase in petrol/diesel
‘marketing companies
the Stocks of Automol
Xow. if'an investor h
Suller greater loss as
hus, through divers
one May Prevent fo
s news as
Prices is likely to increase inflation in the long run but the stocks of oil
like BPCL, HPCL,ete are likely to witness positive movement, Whereas,
bile companies like Tata Motors Lid, Maruti ete would react negatively.
ud portfolio where proportion of Automobile industry stocks is more, it will
Compared to the portfolio having higher proportion of oil marketing companies
sification and proper adjustment in proportion of securities in the portfolio,
88 in the value of the total portfolio.
o nlversitication: The unsystematic risk of the stocks which is known diversifiable Ba
Make thes '"OUeh diversification of fund among stocks of different companies. In order to
Proeess more effective , one can buy stock of these companies at different interval of Investing
510
i
‘ 5 tl
in Stocg Wi
Sek MH “oe
It or after every tWo years. This w 7
e f each quarterly resu
time say after the release of
i r
uation of ena
te the seasonal or trend nature of business in valuation of por
investor to incorporate the seas
icipated changein interestrate ny
on iced against any anticipal Fate
2 Pariah revision Rik canbe era funds inthe portfolio between debt sects agg
swe Sey enn ona a Sa nite tema tsk occu
iseiaee aia Any change in interest rate may make Don es aka ot
: f : a
more valuable, and vice versa, This reduces the overall chang p ale
systematic changes, ; aig
4 Portfotio churning: Portfolio churning refers to the technique of portfolio revision in gf
Some stocks are sold out and the money realised through them is used for buying new Stocks
1
‘ient of variation 23
00=15.85% | Investing ing |
oe
2
For Security ¥ Tre t
