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Sa ii

  1. Risk-Return Trade-off Introduction: Financial decisions incur different degree of risk. Investment in government Bonds has less risk, the risk of default is very less. On the other hand, you would incur more risk, to invest your money in shares, as return is not certain. In other words; we can expect low return from government bond and higher from shares. Risk Free Securities are Government Securities, IVP, KVP, Fixed Deposits. Risk Premium Securities are Equity shares, Mutual Funds etc. Therefore, the financial manager has to maintain a balance between Risk and Return the ultimate objective is maximize the share price as well as value of the firm.
  2. Components of Risk Introduction: Any rational investor, before investing wealth in the stock, analysis the risk associated with the particular stock. The actual return he receives from a stock may vary from his expected return and the risk is expressed in terms of variability. Investor in general would like to analyze the risk factors and a thorough knowledge of the risk helps him to plan his portfolio in such a manner so as to minimize the risk associated with the investment. Definition: The dictionary meaning of risk is the possibility of loss or injury; the degree or probability of such loss. In risk, the probable outcomes of all the possible events are listed. Risk consists of 2 components, the systematic risk and unsystematic risk. The systematic risk is caused by factors external to the particular company and uncontrollable by the company. The systematic risk affects the market as whole. In the case of unsystematic risk the factors are specific, unique and related to the particular industry or company.
  3. Risk Components Systematic Risk Un-Systematic Risk Market Risk Interest Rate Risk Purchasing Power Risk Business Risk Financial Risk Internal Business Risk External Business Risk -Fluctuations in the sales Social and Regulatory Factors -Research and Development Political Risk -Personnel Management Business cycle -Fixed cost -Single product
  4. Systematic Risk • The systematic risk affects the entire market. Often we read in the news papers that the stock market is in the bear hug or in the bull grip. This indicates that the entire market is moving in a particular direction either downward or upward. The systematic risk is further sub-divided into: – Market risk – Interest rate risk – Purchasing power risk
  5. Market risk • “Jack Clark Francis has defined market risk as that portion of total variability of return caused by the alternating forces of bull and bear markets. When the security index moves upward haltingly for a significant period of time, it is known as bull market. In the bull market, the index moves from a low level to the peak. Bear market is just a reverse to the bull market; the index declines haltingly from the peak to a market low point called bear market. During this period 80 percent of the securities prices rise or hall along with the stock market indices.
  6. Minimizing the Market Risk • A) The investor has to study the price behavior of the stock • B) The standard deviation and beta indicate the volatility of the stock. The national stock exchange new bulletin provides this information. Looking at the beta value, the investor can gauge the risk factor and make wise decision according to his risk tolerance • C) The investor should be careful in the timings of the purchase and sale of the stock. He should purchase it at the lower level and should exist at a higher level.
  7. Interest rate risk • Interest rate risk is the variation in the single period rates of return caused by the fluctuations in the interest rate. It has affects the price of bonds, debentures and stocks. The fluctuations in the interest rates are caused by the changes in the government monetary policy and the changes that occur in the interest rates of treasury bills and government bonds. If higher interest rates were offered by the government securities, investor would like to switch his investments from private sector bonds to public sector bonds to public sector bonds. • Ex: April 1996 most of the initial public offerings of many companies remained undersubscribed but IDBI and IFC bonds oversubscribed because the rate of return attracted the investors.
  8. Protection against interest rate risk • A) The investor can also buy treasury bills and bonds of short maturity. • B) Another suggested solution is to invest in bonds with different maturity dates. When the bonds mature in different dates, reinvestment can be done according to present climate.
  9. Purchasing power Risk • Variation in the returns is caused also by the lost of purchasing power of currency. Inflation is the reason behind the loss of purchasing power. Purchasing power risk is the probable loss in the purchasing power of the returns to be received. The rise in price penalizes the returns to the investor, and every potential rise in price is a risk to the investor. • Real Rate of Return= (1+r/1+Q)-1 – R=Nominal future value – Q=Inflation rate
  10. Protection against inflation • A) The general opinion is that bond yield vary would provide hedge against the inflation • B) Another way to avoid the risk is to have investment in short-term securities and to avoid long term investment. • C) Investment diversification can also solve this problem to a certain extent.
  11. Unsystematic Risk • Unsystematic risk is Unique and peculiar to a firm or an industry. Unsystematic risk stems from managerial inefficiency, technological change in the production process, and non- availability of raw materials, changes in the consumer preference and labor problems. Unsystematic risk broadly classified into a) Business Risk and b) Financial risk
  12. Business risk • It is the portion of the unsystematic risk cause by the operating environment of the business. A variation that occurs in the operating environment is reflected on the operating income and expected dividends. • Protection against business risk: – A) To guard against the business risk, the investor has to analyze the SWOT to which the company belongs – B) Analyzing the profit trend of the company is essential. The calculation of standard deviation would yield the variability of the return.
  13. Financial Risk • It refers to the variability of the income to the equity capital due to the debt capital. It is associated with the capital structure of the company fixed interest securities like debenture and preference shares are the commitment of the company. Increasing debt content in the capital structure increasing the return to the shareholders is known as financial leverage.
  14. Protection against financial risk • Analyzing the capital structure of the company. If the debt-equity ration is higher, the investor should have a sense of caution. Along with the capital structure analysis, he should also take into account of the interest payment. In a boom period, the investor can select a highly levered company but in a recession.
  15. Problem: (1) Calculation of Real Rate of Return • Problem: X expects to earn a nominal rate of 10% return on his investments next year. If the rate inflation is expected to be 6% next year what expected real rate of return would be earn? • Solution: rr =  1r1Q   1 100 R=Nominal Rate of Return Q=Inflation Rate = 1.1010.061100 =3.77%
  16. Problem: 2 (Real Rate of Return) • Problem: Rs.500 debentures earn a coupon rate of 15% per annum. Inflation rate expected in the covering one-year period is 12%. Compute the real rate of return. – Solution: 10.1510.121100 – Answer: 2.7%.
  17. Problem: 3 (Risk and Return) • Problem: Equity share of Rs.10/- promises a dividend of 20% and it is expected that the price of the share rise from the current level of Rs.60/- to Rs.80/- in a year time. Inflation during the next year is estimated at 14%. What is the real rate of return of the equity? • Solution: Nominal Rate= Expected Price–Current Price+DividendCurrent Price100 80-60+2/60) X100 = 36.66% rr = (1+.367/1+.14)-1 X 100 = 19.9%
  18. Problem: 4 (Risk and Return) • Problem: The returns on securities A and B are given below Probability Security-A Security-B 0.5 4 0 0.4 2 3 0.1 0 3 Give the security of your preference. The security has to be selected on the basis of Risk and Return. • Solution:  = R-RP R = RP A Security R = 0.5X4 + 0.4X2 + 0.1X0 = 2.8 B Security R = 0.5X0 + 0.4X3 + 0.1X3 = 1.5 A Security  = (4-2.8)² 0.5 + (2-2.8)²0.4 + (0-2.8)²0.1 = 1.33 B Security  =  (0-1.5) ²0.5 + (3-1.5) ²0.4 + (3-1.5) ²0.1 = 1.5 The above problem: A Security will be acceptable because the higher return and lower risk.
  19. Problem: 5 (Risk and Return) • Problem: The two companies A and B to calculate Risk and Return: • Company-A Company-B Probability Return Probability Return 0.10 6 0.10 4 0.25 7 0.20 6 0.30 8 0.40 8 0.25 9 0.20 10 0.10 10 0.10 12 • Answer: A Company Expected Return= 8 R¯ B Company Expected Return= 8 R¯ σA= 1.14 σB = 2.19
  20. Problem: 6 (Risk and Return) Problem: A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell for at the end of the year with the respective probabilities as follows: • Price Probability • 115 0.10 • 120 0.10 • 125 0.20 • 130 0.30 • 135 0.20 • 140 0.10 Calculate the expected return and Standard Deviation. Solution: (Today’s’ Price-Yesterdays’ price/Yesterdays price) x 100 (115-120/120) x 100= -4.17 (120-120/120) x 100= 0 (125-120/120) x 100=4.17 (130-120/120) x 100=8.33 (135-120/120) x 100=12.50 (140-120/120) x 100=16.67 Rֿ= 7.083 and = 5.91%