Risk-Return Relationship,Measurement of Risk .pptx

Risk: Definition - Systematic versus Non-systematic Risk- Risk and Expected Return - Measurement of Risk - Risk-Return Relationship of different stock - Portfolio and Security Returns - Return and Risk of Portfolio

1. UNIT II

2. Risk and Return Risk : Definition - Systematic versus Non-systematic Risk- Risk and Expected Return - Measurement of Risk - Risk-Return Relationship of different stock - Portfolio and Security Returns - Return and Risk of Portfolio.  

3. RISK – DEFINITION Risk in investment refers to the possibility of deviation from expected returns, including the potential for losing part or all of the investment . It reflects uncertainty in future outcomes. Risk is directly related to return – higher risk typically offers the potential for higher returns. Example : Investing in equity shares is riskier than fixed deposits, but can offer higher returns.

4. Definition of Risk Risk refers to the possibility of variation in the actual return from an investment compared to the expected return. It indicates uncertainty and the potential for loss . Formula (Basic Risk Concept): Risk = Actual Return – Expected Return

5. Broad Classification of Risk A . Systematic Risk (Market-related risk) Affects the entire market . Cannot be diversified away. Caused by macroeconomic factors. B . Unsystematic Risk (Company-specific risk) Affects individual companies or industries . Can be reduced through diversification .

6. Types of Systematic Risk Type of Risk Description 1. Market Risk Caused by fluctuations in the stock market due to economic or political events. 2. Interest Rate Risk Arises when interest rates change, affecting bond prices and returns. 3. Inflation Risk Risk that inflation will erode the real return on investments. 4. Reinvestment Risk Risk of reinvesting cash flows at lower rates than the original investment. 5. Currency Risk Arises from fluctuations in foreign exchange rates for international investors. 6. Political Risk Risk due to changes in government policy, taxation, or political instability.

7. Types of Unsystematic Risk Type of Risk Description 1. Business Risk Risk due to poor management, bad products, or operational inefficiencies. 2. Financial Risk Risk due to a firm’s high debt levels and inability to meet obligations. 3. Operational Risk Arises from internal failures like system errors, fraud, or process breakdowns. 4. Legal/Regulatory Risk Risk from lawsuits, fines, or changes in regulations affecting a company. 5. Liquidity Risk The risk that an investment cannot be sold quickly without loss in value. 6. Credit Risk Risk that a borrower or bond issuer will default on payments.

8. Non-Systematic Risk (Unsystematic Risk) This type of risk is specific to a company or industry and can be eliminated through diversification . Characteristics : Arises from internal factors within a firm or industry. Can be reduced by holding a well-diversified portfolio. Also called diversifiable risk or specific risk . Examples: Poor management decisions Labour strikes Product recalls Legal problems Competitive pressures

9. Systematic vs Non-Systematic Risk – Differences Basis Systematic Risk Non-Systematic Risk Scope Affects the entire market Affects specific firms/sectors Diversification Cannot be eliminated Can be reduced/eliminated Causes External/macroeconomic factors Internal/industry-specific Examples Interest rates, inflation Business failure, strikes Alternate Name Market or non-diversifiable risk Specific or diversifiable risk

10. Market Risk Also known as equity risk . Meaning : Risk arising from overall market fluctuations due to investor sentiments, global events, wars, etc. Example: A stock market crash causes the prices of almost all shares to fall, even for companies with strong fundamentals.

11. 2. Interest Rate Risk Meaning: Risk arising due to fluctuations in interest rates set by the central bank (like RBI). When interest rates rise , bond prices fall . When interest rates fall , stock markets may rise . Example: If RBI increases repo rate, borrowing becomes expensive, affecting corporate profits and stock prices

12. 3. Inflation Risk Also called purchasing power risk . Meaning: Risk that the real return on investment will decrease due to rising inflation . Inflation reduces the value of future cash flows from investments. Example: A bond giving 6% return may yield negative real return if inflation is 7%

13. 4. Currency/Exchange Rate Risk Meaning: Risk arising from fluctuations in foreign exchange rates . Mainly affects exporters, importers, and international investors . Example: If INR depreciates against USD, Indian companies importing from the U.S. will have to pay more in rupee terms.

14. 5. Reinvestment Risk Meaning: Risk that future cash inflows (like interest or dividends) will have to be reinvested at lower rates . Example: If you invest in a bond yielding 8%, but after maturity, similar bonds offer only 6%, the reinvestment risk has materialized.

15. Type of Systematic Risk Description Example Market Risk Fluctuation in overall market Stock market crash Interest Rate Risk Due to changes in interest rates RBI changes repo rate Inflation Risk Decrease in purchasing power High inflation erodes real returns Exchange Rate Risk Currency value changes affecting returns INR depreciates vs. USD Reinvestment Risk Inability to reinvest at previous high returns Falling interest rates after bond maturity

16. Non-Systematic Risk – Overview Non-systematic risk (also called unsystematic , specific , or diversifiable risk) refers to the risk specific to a company, industry, or sector . 🔸 It can be reduced or eliminated through diversification .

17. 1. Business Risk Meaning : Risk due to internal problems in the company or poor business operations . Causes: Poor management decisions Low demand for the product Ineffective marketing strategies Example : A car manufacturer loses market share due to a faulty product design.

18. 2. Financial Risk Meaning: Risk arising from a company’s capital structure , particularly high debt levels . High leverage = higher fixed interest payments = higher risk of default. Example : A company heavily financed by loans may struggle to repay if revenues decline

19. 3. Operational Risk Meaning : Risk due to failures in internal systems , human errors, or technical issues. Examples: IT system failure Supply chain disruption Power outage affecting production

20. 4. Legal/Regulatory Risk Meaning : Risk of legal actions , penalties, or non-compliance with regulations . Example : A pharmaceutical company being sued for harmful side effects of a drug.

21. 5. Strategic Risk Meaning: Risk from wrong business strategies or poor market positioning. Example: A company investing in a failed product line that drains resources. 6. Human Resource Risk Meaning: Risk arising from employee-related issues . Examples : Strikes or labor unrest Loss of key employees Lack of skilled workforce

22. Measurement of Risk in Investment Management 1. Introduction Risk is the possibility that the actual return on an investment may differ from the expected return. In finance, risk is usually measured quantitatively using statistical tools.

23. Measurement of Risk 1. Standard Deviation ( σ) Measures total risk/volatility Shows deviation from average return High σ = High risk 2. Variance (σ²) Square of standard deviation Measures dispersion of returns Used in portfolio risk calculation

24. 3. Beta ( β) Measures systematic (market) risk β = 1 → Market-level risk β > 1 → More volatile than market β < 1 → Less volatile than market 4. Coefficient of Variation (CV) Formula: CV = σ / Average Return Measures risk per unit of return Lower CV = Better risk-return trade-off

25. 5. Value at Risk ( VaR ) [Advanced] Estimates potential maximum loss Uses probability and time horizon Popular in portfolio/institutional risk 4. Value at Risk ( VaR ) Definition : Estimates the maximum potential loss over a given time period at a certain confidence level. Example : "95% VaR of ₹10,000 means there's a 5% chance the loss will exceed ₹10,000."

26. Alpha (α) Definition : Measures excess return of an investment relative to the return predicted by its beta (as per CAPM). Positive alpha = Better performance than expected.

27. Measure What it Shows Indicates Standard Deviation Total risk (volatility) Overall fluctuation of returns Variance Square of standard deviation Dispersion of returns Beta Systematic risk vs. market Sensitivity to market changes Value at Risk (VaR) Max probable loss Risk of extreme loss Coefficient of Variation Risk per unit of return Efficiency of return Sharpe Ratio Excess return per unit of risk Risk-adjusted performance Alpha Excess return over expected return Outperformance (or not)

28. Risk and Expected Return Expected Return – Meaning Expected Return is the average return an investor anticipates from an investment over a period, based on probabilities of different outcomes. Formula: Expected Return (ER)=∑( Pi×Ri ) Where: Pi = Probability of outcome i Ri ​ = Return in outcome i

29. Example Outcome Probability (PiP_i) Return (RiR_i) Good Market 0.6 12% Bad Market 0.4 4% ER=(0.6×12%)+(0.4×4%)=7.2%+1.6%=8.8%​

30. 2. Risk – Meaning Risk in investment refers to the possibility of actual returns deviating from the expected return . Higher the deviation, higher the risk. 3. Measurement of Risk Risk is often measured by standard deviation or variance of returns. Formula : Standard  Deviation  (σ)=∑Pi​×(Ri​− ER)2 It shows how much returns deviate from the expected return .

31. 4. Risk-Return Tradeoff There is a direct relationship between risk and expected return: Higher Risk → Higher Expected Return Lower Risk → Lower Expected Return Investors demand risk premium for taking higher risks . Types of Investors and Risk-Return Preference: Investor Type Risk Appetite Return Expectation Risk Averse Low Stable/Moderate Risk Neutral Medium Return focused Risk Seeking High High return expectation

32. ^ | ● Aggressive Assets | ● R | ● E | ● T | ● U |● Low-Risk Assets ( Govt Bonds) R |___________________________________> LOW RISK HIGH

33. Expected Return is the average anticipated return. Risk is the uncertainty or variability of returns. Standard deviation is a key measure of investment risk . Risk-Return tradeoff suggests higher returns are possible only by accepting higher risk.

34. What is Risk-Return Relationship? It means: Higher the risk, higher the possible return – and vice versa. Some stocks give more profit but can go up and down a lot (high risk). Some stocks are safer but give lower returns (low risk)

35. Type of Stock Risk Return Easy Example Blue-Chip Stocks Low to Medium Moderate Big companies like Reliance or TCS – safe and stable Growth Stocks High High Fast-growing companies – can give big profits, but risky Defensive Stocks Low Low Companies that sell daily needs – like ITC – steady always Cyclical Stocks Medium/High Varies Stocks that rise in good economy and fall in bad – like Tata Motors Penny Stocks Very High Very High Very cheap stocks – can give huge returns, but very risky

36. Penny Stocks Meaning : Very low-priced stocks of small or unknown companies. Risk : Very high Return : Can be very high, but very risky too. Example : Unknown small company stocks trading below ₹10–₹20. Note : Prone to manipulation, low liquidity, and high chance of loss.

37. 2. Growth Stocks Meaning : Stocks of companies that are growing fast and reinvest profits to expand. Risk : High Return : High (if the company performs well) Example : Tech companies or startups with high future potential. Note : They usually don’t pay dividends because profits are reinvested.

38. 3. Cyclical Stocks Meaning : Stocks that rise and fall with the economy . Risk : Medium to High Return : Varies (good in booming economy, fall in recession) Example : Auto, real estate, airline, steel companies. Note : Sensitive to business cycles.

39. 4. Blue-Chip Stocks Meaning : Stocks of large, well-known, financially strong companies. Risk : Low to Medium Return : Moderate, stable Example : Reliance, Infosys, TCS, HDFC Bank. Note : These are safe for long-term investing , often give dividends.

40. 5. Defensive Stocks Meaning : Stocks of companies that sell essential products like food, medicines, etc. Risk : Low Return : Low to Moderate (but stable) Example : ITC, Hindustan Unilever, Dabur. Note : These perform well even during bad times like recession or inflation.

41. 1. Security Return – Meaning A security return is the profit or loss made from an individual investment like a stock or bond. It is usually expressed as a percentage of the investment . Formula: Return (R)=Income+(Ending Price−Beginning  Price) * 100 Beginning   Example: Bought a share at ₹100 Sold at ₹120 Received ₹5 dividend Return=5+(120− 100)\100×100=25

42. 2. Portfolio Return – Meaning A portfolio return is the combined return from all investments (securities) in the portfolio, considering their weights (i.e., how much money is invested in each). ✅ Formula: Portfolio Return ( Rp )=∑( wi×Ri ) Where: wi = Weight of each security in the portfolio Ri ​ = Return from each security

43. Example: Investment Amount Invested Return (%) Weight (w) Stock A ₹50,000 10% 0.5 Stock B ₹30,000 12% 0.3 Stock C ₹20,000 8% 0.2 Rp =(0.5×10)+(0.3×12)+(0.2×8)=5+3.6+1.6=10.2%​

44. Term Meaning Security Return Return on a single investment (e.g., a stock or bond) Portfolio Return Overall return from a group of investments, based on how much is invested in each Weighted Average Portfolio return is a weighted average of individual security returns

45. Helps investors track overall performance. Used to compare portfolios or make investment decisions. Helps in calculating risk-adjusted returns .