3.4 Return & Risk Problems

RETURN AND RISK
PROBLEMS
Systematic risk and unsystematic risk
Systematic Risk
• Refers to the variation in the returns on securities, arising due to

macroeconomic factors of business such as social, political or economic
factors. Systematic risk is caused by the changes in government policy, the
act of nature such as natural disaster, changes in the nation’s economy,
international economic components, etc. The risk may result in the fall of
the value of investments over a period. It is divided into three categories,
that are explained as under:
• Interest risk: Risk caused by the fluctuation in the rate or interest from
time to time and affects interest-bearing securities like bonds and
debentures.
• Inflation risk: Alternatively known as purchasing power risk as it adversely
affects the purchasing power of an individual. Such risk arises due to
a rise in the cost of production, the rise in wages, etc.
• Market risk: The risk influences the prices of a share, i.e. the prices will
rise or fall consistently over a period along with other shares of the market.
Unsystematic Risk
• The risk arising due to the fluctuations in returns of a company’s security due to
the micro-economic factors, i.e. factors existing in the organization, is known as
unsystematic risk. The factors that cause such risk relates to a particular security of
a company or industry so influences a particular organization only. The risk can be
avoided by the organization if necessary actions are taken in this regard. It has
been divided into two category business risk and financial risk, explained as under:
• Business risk: Risk inherent to the securities, is the company may or may not
perform well. The risk when a company performs below average is known as a
business risk. There are some factors that cause business risks like changes in
government policies, the rise in competition, change in consumer taste and
preferences, development of substitute products, technological changes, etc.
• Financial risk: Alternatively known as leveraged risk. When there is a change in
the capital structure of the company, it amounts to a financial risk. The debt –
equity ratio is the expression of such risk.
RETURN
SECURITY ANALYSIS
Measuring Individual Security Returns and Risk
WITHOUT PROBABILITY WITH PROBABILITY
RETURNS
RISK – STANDARD DEVIATION

√ = √
√ = √
using
Characteristic Line
• The risk and return, whether of an individual security or of a portfolio,
are based on two broad factors; the systematic and nonsystematic.
Such a bifurcation can be presented with the help of a graph. The line
that decomposes the risk and return into its components is called the
Characteristic Line. It is regression line that represents the relation
between return on portfolio security and return on market portfolio,
over time. It can be used to calculate estimated return of a security or
portfolio.
Formula for Characteristic Line
Diversification of Risk
• Diversification influences risk
• When compared - standard deviation of the portfolio return, is
lower than that of each stock individually
• Thus diversification reduces risk if returns are not perfectly
positively correlated.
• As more and more securities are added, the portfolio risk
decreases, but at a decreasing rate, and reaches a limit.
• The benefit of diversification, in the form of risk reduction, is
achieved by forming a portfolio of about ten securities.
Thereafter, the gain from diversification becomes negligible
• The relationship between diversification and risk is shown
graphically
•
Market Risk Versus Unique Risk
• Total risk = Unique risk + Market risk
• Unique risk/Diversifiable Risk/Unsystematic Risk –
• Relates to firm specific factors
• Unique risk of a stock can be reduced by combining it with other
stocks
• Market risk/Non-diversifiable Risk/Systematic Risk –
• Relates to macro economic factors
• Affect all firms to a greater or lesser degree
• Cannot avoid these risks, however diversified the portfolios may be

3.4 Return & Risk Problems

Uploaded by

Copyright:

Available Formats

3.4 Return & Risk Problems

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

3.4 Return & Risk Problems

Uploaded by

Copyright:

Available Formats

RETURN AND RISK

• Refers to the variation in the returns on securities, arising due to

RISK – STANDARD DEVIATION

You might also like