DERIVATIVES

In finance, a derivative is a financial instrument (or, more simply, an agreement between two
parties) that has a value, based on the expected future price movements of the asset to which it is
linked—called the underlying asset—[1] such as a share or a currency. There are many kinds of
derivatives, with the most common being swaps, futures, and options. Derivatives are a form of
alternative investment.

A derivative is not a stand-alone asset, since it has no value of its own. However, more common
types of derivatives have been traded on markets before their expiration date as if they were
assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice
Exchange since the eighteenth century.[2]

Derivatives are usually broadly categorized by:

• the relationship between the underlying asset and the derivative (e.g., forward, option,
swap);
• the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,
interest rate derivatives, commodity derivatives or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-counter);
• their pay-off profile.

Uses of Derivatives

Derivatives are used by investors to:

• provide leverage (or gearing), such that a small movement in the underlying value can
cause a large difference in the value of the derivative;
• speculate and make a profit if the value of the underlying asset moves the way they
expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a
certain level);
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all
of it out;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.,
weather derivatives);
• create option ability where the value of the derivative is linked to a specific condition or
event (e.g., the underlying reaching a specific price level).
DERIVATIVES CONTRACT TYPES
The most commonly used derivatives contracts are forwards, futures and options, which
we shall discuss in detail later. Here we take a brief look at various derivatives contracts
that have come to be used.

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.
DIFFERENCE BETWEEN FORWARD AND FUTURE CONTRACTS

Forward Contract Futures Contract

Customized to customers need.
Standardized. Initial margin
Structure: Usually no initial payment
payment required.
required.
Opposite contract with same or
different counterparty.
Opposite contract on the
Method of pre-termination: Counterparty risk remains while
exchange.
terminating with different
counterparty.
Risk: High counterparty risk Low counterparty risk
Market regulation: Not regulated Government regulated market
A futures contract is a
A forward contract is an
standardized contract, traded on
agreement between two parties to
a futures exchange, to buy or
What is it?: buy or sell an asset (which can be
sell a certain underlying
of any kind) at a pre-agreed
instrument at a certain date in
future point in time.
the future, at a specified price.
Institutional guarantee: The contracting parties Clearing House
Depending on the transaction and
Contract size: the requirements of the Standardized
contracting parties.
Expiry date: Depending on the transaction Standardized
Negotiated directly by the buyer Quoted and traded on the
Transaction method:
and seller Exchange
No guranantee of settlement until Both parties must deposit an
the date of maturity only the initial guarantee (margin). The
Guarantees: forward price, based on the spot value of the operation is marked
price of the underlying asset is to market rates with daily
paid settlement of profits and losses.

About
A forward contract is an agreement between two parties to buy or sell an asset (which can be of
any kind) at a pre-agreed future point in time at a pre-agreed price. A futures contract is a
standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument
at a certain date in the future, at a specified price. So while the date and price are decided in
advance in forward contract, a futures contract is more unpredictable. They also differ in the
forms that a futures contract is standardized while a forward contract is made to the customer's
need.
Standardization and exchange based trading of futures is the underlying reason for most of the
differences between a forward and future transaction. Even though it may be intuitive that future
trades are more constrained than forward trades and should hamper efficient markets, the
standardization of the contracts stimulates futures market and enhances liquidity.

In contrast to forward contracts in which a bank or a brokerage is usually the counterparty to the
contract, there is a buyer and seller on each side of a futures trade. The futures exchange selects
the contract it will trade.

Procedure
A futures contract gives the holder the obligation to buy or sell, which differs from an options
contract, which gives the holder the right, but not the obligation.

Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller
delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from
the futures trader who sustained a loss to the one who made a profit. To exit the commitment
prior to the settlement date, the holder of a futures position has to offset their position by either
selling a long position or buying back a short position, effectively closing out the futures position
and its contract obligations.

A position can also settled by a method called ‘exchange of physicals’ where a trader finds
another trader with opposite position to his own and deliver the good, settling between them. This
is the sole exception to the federal law that requires all trade place on the exchange.

In a forward contract, one party agrees (obligated) to sell, the other to buy, for a forward price
agreed in advance. In a forward transaction, no actual cash changes hands(unlike margin
payments for a future trade). No asset of any kind actually changes hands, until the maturity of
the contract. The forward price of such a contract is commonly contrasted with the spot price,
which is the price at which the asset changes hands (on the spot date, usually two business days).
The difference between the spot and the forward price is the forward premium or forward
discount.

Trade
While futures are traded on an exchange and are standardized, forwards always trade over the
counter or they can be signed between two parties and are not rigid in their terms. Each forwards
contract is user customized and made to order. Both Forward and Future trades are either
delivered or cash settled. However, Future trades are easier to unwind as the market liquidity is
high.

Transaction Methodology
Forwards transact only when purchased and on the settlement date. Futures, on the other hand,
are rebalanced, or "marked to market". The marking to market involves each counterparty of a
futures trade put a margin amount in an account with the clearing house which is daily adjusted
for loss or profit.

Risk
While forward contracts are private agreements, there is always a chance that a party may default
on its side of the agreement and risk is always involved. Futures contracts have clearing houses
that guarantee the transactions, which drastically lowers the probability of default to almost
never.

Difference between Merchant Banking and Investment Banking

Merchant Banking
Merchant banks invest their own capital into corporate clients. A merchant bank will
assess the value of a company and invest its money into it, sometimes taking a very large
ownership interest in the company. Merchant banks specialize in international finance.
Multinational corporations use this expertise to facilitate their international transactions.

Investment Banking
Investment banks raise outside capital for corporate clients. They handle initial public
offerings, trade securities and facilitate mergers and acquisitions. They also perform
research to advise clients on financial matters prior to their making investment and
capitalization decisions.

Commonalities
Neither merchant nor investment banks serve the general public. Instead, both serve
publicly and privately held corporations. Both merchant and investment banks perform
underwriting functions for their corporate clients.

MERCHANT BANKING, ITS FUNCTION AND SERVICE OFFERED

MERCHANT BANKING
A merchant bank is a financial institution which unlike the commercial banks does not
allow deposits, but offers services with high risk and speculation. Strictly speaking, a
merchant bank is not a depository financial institution or a credit institution, but a
consulting firm whose income is derived from the fees it charges its customers. It
therefore has no conflict of interest with the activities of credit or funding - it is
independent.

FUNCTION OF MERCHANT BANK

• Underwriting connected with the public issue Management
Services acting like as Book Running

• Lead Manager/Lead Manager for the IPOs/FPOs/Right issues/Debt issues

• Managing advising on international offerings of dept / equity i.e.

GDR, ADR, bonds and other Instruments

• Private placements of securities

 Primary or satellite dealership of GOVT securities

 Corporate advisory services relate to securities market eg:

takeovers acquisitions and disinvestments

• Stocking broking

• Advisory services for projects and Project appraisals.

• Syndication of rupee term loans

• International financial advisory services.

• Project counseling and pre investment activities

• Undertaking Feasibility studies

• Issuing Project reports

• Design of capital structure

• Mobilization of funds from NRIs

• Foreign currency finance

• Mergers and takeovers

• Venture capital services

• Buy back and public deposits

• Refund Banker

• Monitoring Agency
 • Debenture Trustee

SERVICES OF MERCHANT BANKS IN DETAIL

Project Counseling:
Project counseling includes preparation of project reports, deciding upon the financing
pattern to finance the cost of the project and appraising the project report with the
financial institutions or banks. It also includes filling up of application forms with
relevant information for obtaining funds from financial institutions and obtaining
government approval.

Management of debt and equity offerings

This forms the main function of the merchant banker. He assists the companies in raising
funds from the market. The main areas of work in this regard include: instrument
designing, pricing the issue, registration of the offer document, underwriting support, and
marketing of the issue, allotment and refund, listing on stock exchanges.

Issue Management:
Management of issue involves marketing of corporate securities viz. equity shares,
preference shares and debentures or bonds by offering them to public. Merchant banks
act as an intermediary whose main job is to transfer capital from those who own it to
those who need it. After taking action as per SEBI guidelines, the merchant banker
arranges a meeting with company representatives and advertising agents to finalize
arrangements relating to date of opening and closing of issue, registration of prospectus,
launching publicity campaign and fixing date of board meeting to approve and sign
prospectus and pass the necessary resolutions. Pricing of issues is done by the companies
in consultant with the merchant bankers.

Managers, Consultants or Advisers to the Issue:

The managers to the issue assist in the drafting of prospectus, application forms and
completion of formalities under the Companies Act, appointment of Registrar for dealing
with share applications and transfer and listing of shares of the company on the stock
exchange. Companies can appoint one or more agencies as managers to the issue.

Underwriting of Public Issue:

Underwriting is a guarantee given by the underwriter that in the event of under
subscription, the amount underwritten would be subscribed by him. Banks/Merchant
banking subsidiaries cannot underwrite more than 15% of any issue.

Portfolio Management:
Portfolio refers to investment in different kinds of securities such as shares, debentures or
bonds issued by different companies and government securities. Portfolio management
refers to maintaining proper combinations of securities in a manner that they give
maximum return with minimum risk.
Restructuring strategies
A merger is a combination of two companies into a single company where one survives
and other loses its corporate existence. A takeover is the purchase by one company
acquiring controlling interest in the share capital of another existing company. Merchant
bankers are the middlemen in setting negotiation between the two companies. Merchant
bankers assist the management of the client company to successfully restructure various
activities, which include mergers and acquisitions, divestitures, management buyouts,
joint venture among others. To help companies achieve the objectives of these
restructuring strategies, the merchant banker participates in different activities at various
stages which include understanding the objectives behind the strategy (objectives could
be either to obtain financial, marketing, or production benefits), and help in searching for
the right partner in the strategic decision and financial valuation of the proposal.

Off Shore Finance:

The merchant bankers help their clients in the following areas involving foreign currency.
(a) Long term foreign currency loans
(b) Joint Ventures abroad
(c) Financing exports and imports
(d) Foreign collaboration arrangements

Non-resident Investment:
The services of merchant banker includes investment advisory services to NRI in terms
of identification of investment opportunities, selection of securities, investment
management, and operational services like purchase and sale of securities.

Loan Syndication:
Loan syndication refers to assistance rendered by merchant bankers to get mainly term
loans for projects. Such loans may be obtained from a single development finance
institution or a syndicate or consortium. Merchant bankers help corporate clients to raise
syndicated loans from banks or financial institutions.

Corporate Counseling and advisory services:

Corporate counseling covers the entire field of merchant banking activities viz. project
counseling, capital restructuring, public issue management, loan syndication, working
capital, fixed deposit, lease financing acceptance credit, etc. Merchant bankers also offer
customized solutions to their client’s financial problems. Like determining the right debt-
equity ratio and gearing ratio for the client; the appropriate capital structure theory is also
framed. Merchant bankers also explore the refinancing alternatives of the client, and
evaluate cheaper sources of funds. Another area of advice is rehabilitation and turnaround
management. In case of sick units, merchant bankers may design a revival package in
coordination with banks and financial institutions. Risk management is another area
where advice from a merchant banker is sought. He advises the client on different
hedging strategies and suggests the appropriate strategy.
What is an investment decision?
It is the process of selection of Investment Alternatives based on Risk & Return profiling.

Risk
It is the probability of “not happening of favorable an event”.
It is the inconsistency in historical returns
It is simply uncertainty.

Total Risks = Unique Risk + Market Risk

Unique Risk = With in Company, Diversifiable, Systematic

Market Risk = Uncontrollable, Not diversifiable, Unsystematic, For everyone in the market

Types Of General Risks For The Company

• Credit or Default Risk
• Country Risk
• Foreign Exchange Risk
• Interest Rate Risk
• Political Risk
• Market Risks
• Etc.

Major Business Risks

1. Financial Risk; Directly impacting Financial positions
2. Operational Risk; Indirectly impact financial outcomes
3. Strategic Risk; Impact Viability of Business

RISKS
External Factors
• Economic Condition
• Social, Legal & Regulatory Framework
• Political Climate
• Intergovernmental Agreements
• Marketing Agents Competition
• Fluctuation in Aggregate Demand
• Etc.

Internal Factors
• Corporate Culture
• Head count and HR Capability
• Capacity
• Systems & Technology
• Communication’s Effectiveness
• Leadership effectiveness
• Etc.

Risk Management
1-Identification of Risk
Past Experience, Market Information, Potential Risk Information

2-Measurement of Risk
Data Analysis, Simulations Sensitivity Analysis, Risk & Return of strategic alternatives,
Identifying priorities

3-Management of Risk (planning to control)

Risk Management Techniques, Strategic Choices, Tradeoffs

Return
• It is the compensation of RISK.
• It is the attraction of money that can be generated over cost.
• These are the inflows in future against outflows made today.

Return on Investment (ROI) = Net Profit / Total Amount of Investment

Instance; We made investment on project ABC of PKR 100,000 and in last five years (the life of
project we earn profit of 125,000.
So simply;

ROI = 125,000 / 100,000

ROI = 1.25 or 125%

Extensive Example R-1

Project A (life = 3 years)
Investment = PKR 150,000
Net Profit (Sales – Cost of Sales – Administrative Expenses – Marketing Expenses – General
Expenses – Depreciation – Financial Cost – Tax)
Year 0 = 15,000
Year 1 = 25,000
Year 2 = 45,000
Year 3 = 55,000
Total Net Profit in four years = 140,000
ROI = 140,000/150,000
ROI = 0.93 or 93%

Note: In Payback Period I never recommend my students to start from 0 start from year 1, so
year 1 means end of first year of project in pay back calculations.

Extensive Example
Problem with previous method is ignorance of TIME VALUE OF MONEY in ROI calculations
Consider Inflation 10% in year from year 1 to 4 every year. It means The value of money will be
declined by 10% every year as its purchasing power will be declining.

Example:
Purchasing Power of Rupee 25 in year 1 = 1 KG of Sugar
Purchasing Power of Rupee 25 in year 2 = 0.5 KG of Sugar
So in this example the decline of value of money is 50% because it has lost the purchasing power
over sugar to the extent of 50%. In real analysis we will calculate the purchasing power of money
over all commodities. It is the simplest analysis of money value.

DERIVATIVE
• Derivatives are financial contracts, or financial instruments, whose values are
derived from the value of something else (known as the underlying).

• The underlying value on which a derivative is based can be an asset (e.g.,

commodities, equities (stocks), residential mortgages, commercial real estate,
loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices,
consumer price index (CPI)), weather conditions, or other items.
• A derivative is a financial instrument that derives or gets it value from some real
good or stock.

• It is in its most basic form simply a contract between two parties to exchange
value based on the action of a real good or service.

• Typically, the seller receives money in exchange for an agreement to purchase or

sell some good or service at some specified future date.

LEVERAGE
• The largest appeal of derivatives is that they offer some degree of leverage.
• Leverage is a financial term that refers to the multiplication that happens when a
small amount of money is used to control an item of much larger value.

MORTGAGE
• A mortgage is the most common form of leverage.
• For a small amount of money and taking on the obligation of a mortgage, a person
gains control of a property of much larger value than the small amount of money
that has exchanged hands.

• Derivatives offer the same sort of leverage or multiplication as a mortgage.

• For a small amount of money, the investor can control a much larger value of
company stock then would be possible without use of derivatives.
• This can work both ways, though. If the investor purchasing the derivative is
correct, then more money can be made than if the investment had been made
directly into the company itself.
• However, if the investor is wrong, the losses are multiplied instead.

USE OF DERIVATIVES (RISK)

• Derivatives can be used to mitigate the risk of economic loss arising from changes
in the value of the underlying.
 • hedge risks;
• reflect a view on the future behavior of the market, speculate;
• lock in an arbitrage profit;
• change the nature of a liability;
• change the nature of an investment;
HEDGING
• Derivatives can be used to mitigate the risk of economic loss arising from changes
in the value of the underlying. This activity is known as hedging.

• Hedging also occurs when an individual or institution buys an asset (like a

commodity, a bond that has coupon payments, a stock that pays dividends, and so
on) and sells it using a futures contract.

• The individual or institution has access to the asset for a specified amount of time,
and then can sell it in the future at a specified price according to the futures
contract.

SPECULATION
• Derivatives can be used by investors to increase the profit arising if the value of
the underlying moves in the direction they expect. This activity is known as
speculation.

DERIVATIVE CONTRACT TYPES

• Forwards/Futures
• Options
• Swaps

FORWARDS/ FUTURES
• Futures/Forwards are contracts to buy or sell an asset on or before a future date at
a price specified today.
• A futures contract differs from a forward contract in that the futures contract is a
standardized contract written by a clearing house that operates an exchange where
the contract can be bought and sold, while a forward contract is a non-
standardized contract written by the parties themselves.

• A futures contract is a forward contract traded on an organized exchange.

FORWARD CONTRACTS
• The most basic forward contract.
 • It is a contract negotiated between two parties for the delivery of a physical asset
(e.g., oil or gold) at a certain time in the future for a certain price fixed at the
inception of the contract.
• No actual transfer of ownership occurs in the underlying asset when the contract
is initiated.
• Instead, there is simply an agreement to transfer ownership of the underlying asset
at some future delivery date.

• The party that has agreed to buy has a long position.

• The party that has agreed to sell has a short position.
•
Problem face in using Forward Contracts
• Biggest problems traders face in using forward contracts:
• credit risk exposure
• the difficulty of searching for trading partners,
• the need for an economical means of exiting a position prior to
contract termination
Searching Partner
• A second problem with a forward contract is that the heterogeneity of contract
terms makes it difficult to find a trading partner

Exiting A Position
• A third and related problem with a forward contract is the difficulty in exiting a
position, short of actually completing delivery.
•

FUTURE CONTRACTS
It is essentially a forward contract that is traded on an organized financial exchange

• Futures markets began with grains, such as corn, oats, and wheat, as the
underlying asset.
• Financial futures are futures contracts based on a financial instrument or financial
index.
• Foreign currency futures are futures contracts calling for the delivery of a specific
amount of a foreign currency at a specified future date in return for a given
payment of U.S. dollars.
• Interest rate futures take a debt instrument, such as a Treasury bill (T-bill) or
Treasury bond (T-bond), as their underlying financial instrument.

• With these kinds of contracts, the trader must deliver a certain kind of debt
instrument to fulfill the contract.
• In addition, some interest rate futures are settled with cash.
• Financial futures also trade based on financial indexes.
 • For these kinds of financial futures, there is no delivery, but traders complete their
obligations by making cash payments based on changes in the value of the index.

DIFFERENCES BETWEEN FORWARDS & FUTURES CONTRACTS

Forwards Futures

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-

the-market
Credit risk Depends on parties None [Clearing
House]
Market participants Large firms Wide variety

OPTIONS
• An option is the right to buy or sell, for a limited time, a particular good at a
specified price.

• For example, if IBM is selling at $120 and an investor has the option to buy a
share at $100, this option must be worth at least $20, the difference between the
price at which you can buy IBM ($100) through the option contract and the price
at which you could sell it in the open market ($120).

• Options are contracts that give the owner the right, but not the obligation, to buy
(in the case of a call option) or sell (in the case of a put option) an asset.

• The price at which the sale takes place is known as the strike price, and is
specified at the time the parties enter into the option.

• The option contract also specifies a maturity date.

• Options give the party with the long position one extra degree of freedom:
• she can exercise the contracts if she wants to do so; whereas the short party have
to meet the delivery if they are asked to do so. This makes options a very
 attractive way of hedging an investment, since they can be used as to enforce
lower bounds on the financial losses.
• In addition, options offer a very high degree of gearing or leverage, which makes
them attractive for speculative purposes too.
• Prior to 1973, options of various kinds were traded over-the-counter.

• In 1973, the Chicago Board Options Exchange (CBOE) began trading options on
individual stocks.

• Since that time, the options market has experienced rapid growth, with the
creation of new exchanges and many kinds of new option contracts.

CALL AND PUT OPTIONS

• call option gives the owner the right to buy a particular asset at a certain price,
with that right lasting until a particular date.

• Ownership of a put option gives the owner the right to sell a particular asset at a
specified price, with that right lasting until a particular date.

SWAPS

• Swaps are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies/exchange rates, bonds/interest rates,
commodities, stocks or other assets.

THE MARKET PARTICIPANTS

• Three kinds of dealers engage in market activities:
• Hedgers
• speculators
• Arbitrageurs

Each type of dealer has a different set of objectives

HEDGERS
• Hedging includes all acts aimed to reduce uncertainty about future [unknown]
price movements in a commodity, financial security or foreign currency.
• This can be done by undertaking forward or futures sales or purchases of the
commodity security or currency in the OTC forward or the organized futures
market.
• Alternatively, the hedger can take out an option which limits the holder's exposure
to price fluctuations.

SPECULATORS
• Speculation involves betting on the movements of the market and try to take
advantage of the high gearing that derivative contracts offer, thus making windfall
profits.
 • In general, speculation is common in markets that exhibit substantial fluctuations
over time.
• Normally, a speculator would take a ``bullish'' or ``bearish'' view on the market
and engage in derivatives that will profit her if this view materializes. Since in
order to buy, say, a European call option one has to pay a minute fraction of the
possible payoffs, speculators can attempt to materialize extensive profits.

ARBITRAGE
• In economics and finance, arbitrage is the practice of taking advantage of a price
differential between two or more markets:
• Striking a combination of matching deals that capitalize upon the imbalance, the
profit being the difference between the market prices.
• When used by academics, an arbitrage is a transaction that involves no negative
cash flow at any probabilistic or temporal state and a positive cash flow in at least
one state; in simple terms, a risk-free profit.

ARBITRAGEURS
• A person who engages in arbitrage is called an arbitrageur—such as a bank or
brokerage firm. The term is mainly applied to trading in financial instruments,
such as bonds, stocks, derivatives, commodities and currencies.

WHAT IS INVESTMENT DECISSION

Investments decisions are the very important decisions for any company and they are
made by the investors and the investment managers. Investments decisions are used to
perform the investment analysis and then by using some fundamental analysis, the best
decision is selected from various alternatives. There are various decision making tools
which are used to support the investment decisions.

In the investment decisions the companies carry out the risk and return analysis and come
up with the decision where they can minimize their risks and increase their returns. Some
investment decisions promise high rate of returns for very risky investments and
abnormal profits can be earned on such investments.

Therefore, the investors have to come up with various analysis to make an investment
decision. The investors who are risk averse do not go for risky investment decisions for
the sake of high returns but the investors who are risk takers always prefer risky
investment decisions

ROLE OF RISK AND RETURN IN INVESTMENT DECISSION

The entire scenario of security analysis is built on two concepts of security: Return and risk. The
risk and return constitute the framework for taking investment decision. Return from equity
comprises dividend and capital appreciation. To earn return on investment, that is, to earn
dividend and to get capital appreciation, investment has to be made for some period which in turn
implies passage of time. Dealing with the return to be achieved requires estimated of the return on
investment over the time period. Risk denotes deviation of actual return from the estimated
return. This deviation of actual return from expected return may be on either side – both above
and below the expected return. However, investors are more concerned with the downside risk.

The risk in holding security deviation of return deviation of dividend and capital appreciation
from the expected return may arise due to internal and external forces. That part of the risk which
is internal that in unique and related to the firm and industry is called ‘unsystematic risk’. That
part of the risk which is external and which affects all securities and is broad in its effect is called
‘systematic risk’.

The fact that investors do not hold a single security which they consider most profitable is enough
to say that they are not only interested in the maximization of return, but also minimization of
risks. The unsystematic risk is eliminated through holding more diversified securities. Systematic
risk is also known as non-diversifiable risk as this can not be eliminated through more securities
and is also called ‘market risk’. Therefore, diversification leads to risk reduction but only to the
minimum level of market risk.

The investors increase their required return as perceived uncertainty increases. The rate of return
differs substantially among alternative investments, and because the required return on specific
investments change over time, the factors that influence the required rate of return must be
considered.
Above chart-A represent the relationship between risk and return. The slop of the market line
indicates the return per unit of risk required by all investors highly risk-averse investors would
have a steeper line, and Yields on apparently similar may differ. Difference in price, and therefore
yield, reflect the market’s assessment of the issuing company’s standing and of the risk elements
in the particular stocks. A high yield in relation to the market in general shows an above average
risk element. This is shown in the Char-B