Risk & Return Analysis-2020

RISK AND RETURN
ANALYSIS
RISK AND RETURN ANALYSIS
• What is the risk of investment in each

category of stock?
• What is the return to an investor because

of such investment?
RISK
As per Dictionary meaning:
 Risk means the possibility of loss / injury.
 Risk means the degree probability of such
loss.
As per Financial meaning:
 Risk means actual return less than the
expected return.
 Risk means the variance of return /
variability of return.
CATEGORIZATION OF RISK
Systematic Risk Unsystematic Risk
* Non diversifiable * Diversifiable
* Unavoidable * Avoidable

Market Risk
Interest rate Risk

Purchasing power Risk

Business Risk Finance Risk

Internal Business Risk External Business Risk

Systematic Risk
(Non- diversifiable risk / unavoidable risk)
•Systematic risk is the risk created by the factors, which are external
to the company and which is uncontrollable & unavoidable.
•External factors are:
Economic condition, Political situation,
Sociological changes etc.
•This risk affects the market as a whole & not to a particular
company.
•Fundamentally these factors in the market cannot be controlled
that’s why we can say that the systematic risk unavoidable.
•Systematic risk divided into 3 categories
Market Risk, Interest rate Risk, Purchasing power Risk
Market Risk
•According to Jack Clark, Market Risk is the portion of
total risk or it is the portion of deviation of return,
which is caused by the alternating forces of the Bull &
Bear markets.
• Factors affecting the market may be:
* Tangible – Earth quake, Tsunami, cyclone etc.
* Intangible – fall of govt. social factors etc.
Interest Rate risk
• Increase in interest rate on borrowing leads to
more payment of interest out of the profit. It will
ultimately decrease the return on investment.
Actually interest rates fluctuated because of
• Change of Government monetary policy
• Change in interest rate on govt. Treasury bill.
• Change in interest rate on govt. bonds.
Purchasing Power Risk
•Purchasing power means purchasing power of currency
i.e. how much dollar we can purchase by expending Re1
or for acquiring 1 dollar how many rupees we have to
expend
•It deals with currency conversion / time value of money.
If there is inflation naturally our return will be less than
out expected return. Inflation results in loss of our
purchasing power.
Unsystematic Risk
(Diversifiable risk / Avoidable risk)
•Unsystematic risks are the risks due to certain factors, which are
unique, specific and are related to a particular company/to a
particular industry.
•It will only affect that particular company / industry but it will not
affect the whole market.
•Unsystematic risks generally arise due to the following factor:
Managerial Efficiency, Technological Changes, Change in
production process etc.
•The nature & extent of such risk varies from company-to-
company or industry-to-industry as per the involvement & impact
of the above factors.
•Unsystematic risk can be broadly classified into two categories
Business risk, Finance risk
Business Risk
• Risk caused by the operating environmental of the
business.
• This is due to the inability of a company / industry
to maintain competitive edge & the growth or
stability of earnings. I.e. we can say that if the
actual operating earnings is less than the expected
operating earning then it can be said as, due to
business risk.
• Business risk is of 2 categories:
Internal risk
External risk
Internal risk
Internal business risk is totally depended on the operating
efficiency of a company. We know operating efficiency varies
from company to company. So internal business risk also varies
from company-to-company or industry-to-industry.
 Factors affecting the internal business risk are :
• Fluctuation in sales
• Research & development
• Personal management
• Fixed cost
• Single product / diversification of products.
External risk
This risk is due to operating condition of a company /

industry i.e. the environment in which the company /
industry operates. So fluctuation in operating
conditions may fluctuate the expected earning.
Factors affecting the external business risk are:
Social factors
Political factors
Business cycle etc
Finance Risk
• Financial risk is associated with the capital structure of
company.
• Capital structure can be equity capital & debt capital.
• The presence of debt & preference capital imposes a
liability to pay interest or a fixed dividend. These
payments affect the returns that are available to the
equity stock holders.
• So, company having higher debt capital will reduce the
expectation of return of common stock holders. More
risk is there in a company in which there is maximum
interest leverage.
Methods of Risk Measurement
To assess & express in quantitative
/ Statistical form
Standard deviation
Co-efficient of variation
Characteristic regression line.
Standard Deviation
Standard Deviation is the deviation of
actual return from the expected return
n 
   (r
i 1
i  r ) xPi
2
Kk
Co-efficient of Variation
Co-efficient is a measure of relative dispersion i.e.
it is a measure of risk per unit of return. It converts
standard deviation of the expected value into
relative value to enable comparison of risk
associated with assets having different expected
values.

CV 
r
Characteristic Regression Line
(CRL)
CRL represents comparison of a particular
stock against the market index
Ri = Return from the

ith Stock
 i = Intercept
Ri   i   i Rm  ei  i = Slope of ith stock
Rm = Market Return
ei = Error factor
involved
BETA  i
• It is the slope of CRL
• Describes the relationship between the stock return
and the market return
n XY  X  Y

n X    X 
2 2
Y = Stock return = Today’ s price – Yesterday’ s price

100
Yesterday’ s price
Today’ s index – Yesterday’ s index
X = Market Return = 100
Yesterday’ s index
Stock Return 
Market Return
Interpretation of Beta
• Beta = 1: If market return changes by 1%
then stock return also changes by 1%.
• Beta > 1: If market return changes by 1%
then stock return also changes more than
1%. More volatile stock
• Beta < 1: If market return changes by 1%
then stock return also changes less than 1%.
Less volatile stock
Alpha 
• Intercept of CRL
• It is distance between  Y  X
the intersection and
the horizontal axis. Y 
Y
• Indicates that the stock No.ofdays
return is independent
on market return. X 
X
No.ofdays
Correlation Co-efficient (r)
• Measures the nature and extent of relationship between the
stock market index return and stock return in a particular
period.
• The square of correlation co-efficient is the co-efficient of
determination. It gives the variation in the stock’s return
explained by the variation in the market’s return. 2
r
n XY  X  Y
r
n X    X  n Y    Y 
2 2 2 2
Case: Is this the Right Stock…?
• Select a Stock of a particular sector.
• Download the stock price and the SENSEX value
from BSE website for one year (daily price).
• How much market movement can affect the stock
price?
• What will happen if there is a downturn in the
market?
• Will the uptrend reward more than the market
return?

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RISK AND RETURN

• What is the risk of investment in each

• What is the return to an investor because

Interest rate Risk

This risk is due to operating condition of a company /

To assess & express in quantitative

Standard Deviation is the deviation of

actual return from the expected return

Ri = Return from the

Y = Stock return = Today’ s price – Yesterday’ s price

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