RISK ANALYSIS

 By
 Barun Jit Maitra


 Roll No-04
 PGDM 09-11
 What is RISK?

Risk is generally defined as

return volatility, or the degree
of ups and downs of returns.

Risk is the chance that your

actual return will be less than
you expected.
• Depending on the nature of the investment, the
type of investment risk will vary.
• A concern with any investment is that you may
lose the money you invest - your capital. This
risk is therefore often referred to as "capital
risk."
• If the assets you invest in are held in another
currency there is a risk that currency
movements alone may affect the value. This is
referred to as "currency risk."
• Many forms of investment may not be readily
saleable on the open market (e.g. commercial
property) or the market has a small capacity and
may therefore take time to sell. Assets that are
easily sold are termed liquid; therefore this type
of risk is termed "liquidity risk."
• The risk that there may be a disruption in the
internal financial affairs of the investment,
 Market Risk V/s Unique Risk
• Market Risk is also • Unique Risk is also
called systematic called
or non- unsystematic or
diversifiable risk. diversifiable risk
• General factors • Specific factors
affecting all affecting only
• Growth rate of this firm
GNP, inflation • Development of
Rate, Interest new product,
rate structure, strike, liquidity
o ta lrisk = M a rke t R iskcrunch,
government + U nnewiq u e R isk
spending. competitor
 SYSTEMATIC RISKS

Outlined below are several systematic



risks an investor faces.

• Market-volatility risk
• Inflation risk
• Business-cycle risk
• Liquidity risk
• Interest rate risk
• Marketability risk

Market-volatility risk
• The market as a whole is up at times and
down at others. If several companies in a
related field are doing poorly, that could
bring down the value of other companies
in the same field just by that association
alone.
Inflation risk

• This is the risk that your money will lose

buying power to price increases; also
known as inflation. In essence this means
that a dollar next year will buy you slightly
less than what it will buy you today. 
Business cycle risk
• You may have heard terms like recession or expansion
on the news. In general the economy has periods
where it is growing and periods when it does not.
The exact duration of these periods is not preset
and will be affected by many things. Most
businesses are affected by these general
movements in the economy. Some businesses are
less affected by these movements; for example
regardless of the business cycle people are going to
need to pay for certain expenses that cannot be
cut, diapers is one example, utilities are another.
Their value may be less sensitive to changes in the
business cycle.
Liquidity risk

• Liquidity is the speed and ease at which an asset can

be converted into cash. Money in a savings account
or checking account is extremely liquid as you can
go to your bank or an ATM and withdraw the money
instantaneously.  Stocks and bonds are less liquid
than money in a savings or checking account. You
can sell your stocks and bonds in one day but it
may take several days before you have access to
the cash from the sale. Further, since prices
Interest rate risk
• As with the overall business cycle, interest
rates fluctuate. Typically if interest rates
increase, the value of stocks and bonds
decreases.  If interest rates decrease, the
value of stocks and bonds increase.  In both
situations however, interest rate risk is
more closely associated with bonds than
stocks.
Marketability risk

• This risk occurs if you have to sell a particular

asset quickly, you may not get the market
price for that asset.   An easily understood
example would be if you needed to sell
your home in a hurry.  In order to do so you
would probably have to lower the asking
price considerably.  If you were not in such
a hurry to sell, you could afford to wait
longer and ask for a fair market price.
 
 Expected return of a
portfolio
• E(Rp)= w1 E(R1) + w2 E(R2)
E(R ) is the expected return of the
p
portfolio
w
1 is th e p ro p o rtio n o f p o rtfo lio
in ve ste d in se cu rity 1 .
E(R ) is the expected return of security
1
1
w
2 is the proportion of portfolio
invested in security 2
 Behavior of Returns Over
Time
RETURNS

TIME Risky

Security

Conservative

Market
 Effect Of Diversification
State of Probability Return Return On Return on
Economy on A (%) B (%) Portfolio
1 0.25 15 -5 5(%)

2 0.25 -5 15 5

3 0.25 35 5 20

4 0.25 25 35 30
•
•
• Expected return on stock A, E (A) =
0.25(15%) + 0.25(-5%)+0. 25(35%)
+0. 25 (25%)  =    17.5% 
•
• Expected return on stock B, E (B)
=0.25(-5%) +0 .25(15%)+.0 25(5%)
+0.25 (35%) = 12.5%


• Expected return on portfolio, =

0.25(5%) +0.25(5%)+0. 25(20%)+0.
25 (30%)= 15%
• Standard Deviation on stock A, = 25(15-
17.5) 2+ .25(-5-17.5) 2 +. 25(35-17.5) 2+
. 25 (25-17.5) 2
                                                  = √218.75

= 14.79%
• Standard Deviation on stock B,= 25(-5-
12.5)2 + .25(15-12.5)2+. 25(5-12.5) 2 +.
25 (35-12.5) 2
                                                    = 

√218.75 =14.79%
• Standard Deviation on portfolio, A and B
=25(5-15)2 + .25(5-15)+. 25(20-15)2+.
25 (30-15)2
                                                             = 

√87.5 = 9.35 %
• So, from the above as we can interpret
 Relationship between
diversification and risk
 Market Risk Measurement
• The sensitivity of a security to market
movements is called beta (β)
• Measure of the extent to which the
return on a security fluctuates with
the return on market portfolio
• By definition, the beta for the market
portfolio is 1
• A security which has a beta of 1.5 is
experiences greater fluctuation
than the market portfolio
 Calculation of Beta


• Rjt = αj + βj RMt +ej

• Rjt is the return of security j in period t,
• αj is the intercept term
• Βj is the regression coefficient
• RMt is the return on market portfolio in
period t
• ej is the random error

 •
β =Cov(R , R ) / σ 2
• j j M M
• Cov is the covariance between the
return on security j and return on
market portfolio M
• σ2M is the variance of return on the
market portfolio
•
 The Security Market Line
• The x-axis represents the risk (beta), and
the y-axis represents the expected return.
The market risk premium is determined
from the slope of the SML.
• The relationship between β and required
return is plotted on the security market
line (SML) which shows expected return as
a function of β. The intercept is the nominal
risk-free rate available for the market, while
the slope is E(Rm)− Rf. The security market
line can be regarded as representing a
single-factor model of the asset price,
where Beta is exposure to changes in value
of the Market. The equation of the SML is
thus:
•
 Graphical Representation
30

20, 27.5

25 15, 25

20

15 15, 15

10
Return on asset

Slope = Beta = 1.5

5

0
-15 -10 -5 0 5 10 15 20 25

-5, -5 -5

-10

-5, -15 -15

-10, -17.5

-20
Return on market
• Determinants of Beta
•  
• 1. Cyclicality of revenues – How responsive are revenues
to changes in the business cycle?
• Does the firm produce normal goods or inferior goods?
• Highly cyclical  high covariance with the market  high
beta.
•  
•  2. Operating Leverage (Degree of Operating
Leverage) – Degree to which costs are fixed.
• High FC relative to VC  high operating leverage
•  
• Contribution margin = Price – VC = incremental profit from
an additional sale
•  
• Low Contribution margin = low FC & high VC = low DOL –
example is grocery store
• High Contribution margin = high FC & low VC = high DOL –
example is airline
• High Operating Leverage  profits are more responsive to
•  3. Financial Leverage – similar to operating leverage if
we think of debt as a FC
•  
• Equity = Equity beta = beta of a firm’s stock. This is
what we have been measuring and looking at thus far.
It is a measure of both the firm’s business risk and its
financial risk.
•  
• Asset = Asset beta = weighted average of the betas of
all a firm’s securities (common stock, debt and
preferred stock). This is a measure of the firm’s
business risk only.
•  
• Asset = Debt (D) + Equity (E)
• D+E D+E
•  
• If a firm has no debt, Asset = Equity
• So, we can think of Asset as what Equity would be if the
firm had no debt – if it is an unlevered firm.
•  
 To Summarize
• Securities are risky because their returns
are variable
• The most commonly used measure of
risk is σ
• Risk of a security-------Unique and Market
• Unique------Firm specific factors
• Market------ Economy wide factors
• Portfolio Diversification washes away
Unique risk
• The risk of a fully diversified portfolio is
its Market Risk
• Contribution of a security to the risk of a
fully diversified portfolio is beta
 


 THANK YOU