Risk Management


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Risk Management

  1. 1. Risk Presented By – Ashish Kumar Barnwal Pankaj Kumar XIDAS,Jabalpur
  2. 2. Introduction <ul><li>Any rational investor, before investing his/her investible wealth in stock, analyses the risk associated with particular stock. Actual rate of return may vary from his expected return and risk is expressed in terms of variability of return. </li></ul>
  3. 3. Why the Risk is needed to be calculated??? <ul><li>Risk may cause by several factor 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. </li></ul>
  4. 4. Investment Return <ul><li>The rate of return on an investment can be calculated as follows: </li></ul><ul><li>(Amount received – Amount invested) </li></ul><ul><li>Return = ________________________ </li></ul><ul><li>Amount invested </li></ul><ul><li>For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: </li></ul><ul><li>($1,100 - $1,000) / $1,000 = 10%. </li></ul>
  5. 5. Return <ul><li>Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. </li></ul><ul><li>Required Return - the return that an investor requires on an asset given its risk . </li></ul><ul><li>Realized Return – the return that was actually earned during some past period. </li></ul><ul><li>Average Return - the average annual realized return earned during the last n years _ </li></ul>
  6. 6. Expected Return <ul><li>State of Probability Return </li></ul><ul><li>Economy (P) X Y </li></ul><ul><li>Recession .20 4% -10% </li></ul><ul><li>Normal .50 10% 14% </li></ul><ul><li>Boom .30 14% 30% </li></ul><ul><li>For each firm, the expected return on the stock is just a weighted average : </li></ul><ul><li>k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(kn)*kn </li></ul>
  7. 7. Expected Return <ul><li>State of Probability Return </li></ul><ul><li>Economy (P) X Y </li></ul><ul><li>Recession .20 4% -10% </li></ul><ul><li>Normal .50 10% 14% </li></ul><ul><li>Boom .30 14% 30% </li></ul><ul><li>k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(kn)*kn </li></ul><ul><li>k (X) = .2 (4%) + .5 (10%) + .3 (14%) = 10% </li></ul>
  8. 8. Expected Return <ul><li>State of Probability Return </li></ul><ul><li>Economy (P) X Y </li></ul><ul><li>Recession .20 4% -10% </li></ul><ul><li>Normal .50 10% 14% </li></ul><ul><li>Boom .30 14% 30% </li></ul><ul><li>k = P(k 1 )*k 1 + P(k 2 )*k 2 + ...+ P(kn)*kn </li></ul><ul><li>k (Y) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14% </li></ul>
  9. 9. <ul><li>Based only on your expected return calculations, which stock would you prefer? </li></ul>
  10. 10. <ul><li>Have u considered </li></ul><ul><li>RISK ? </li></ul>
  11. 11. Definition <ul><li>Risk is an uncertain outcome or chance of an adverse outcome. </li></ul><ul><li>Concerned with the riskiness of cash flows from financial assets. </li></ul><ul><li>Risk = Probability of event X Cost of event. </li></ul><ul><li>Risk = Possibility of loss or injury. </li></ul><ul><li>e.g </li></ul>
  12. 12. <ul><li>Two types of investment risk </li></ul><ul><ul><li>Stand-alone risk </li></ul></ul><ul><ul><li>Portfolio risk </li></ul></ul><ul><li>Investment risk is related to the probability of earning a low or negative actual return. </li></ul><ul><li>The greater the chance of lower than expected or negative returns, the riskier the investment. </li></ul><ul><li>Stand Alone Risk: Single Asset </li></ul><ul><ul><li>relevant risk measure is the total risk of expected cash flows measured by standard deviation . </li></ul></ul><ul><li>Portfolio Context: A group of assets. Total risk consists of: </li></ul><ul><ul><li>Diversifiable Risk (company-specific, unsystematic) </li></ul></ul><ul><ul><li>Market Risk (non-diversifiable, systematic) </li></ul></ul>
  13. 13. Risk Component <ul><li>Systematic Risk : Non diversifiable, unavoidable, uncontrollable by company. Due to economic condition, political situation & sociological changes. </li></ul><ul><ul><ul><li>Market Risk. </li></ul></ul></ul><ul><ul><ul><li>Interest Rate Risk. </li></ul></ul></ul><ul><ul><ul><li>Purchasing Power Risk. </li></ul></ul></ul>
  14. 14. <ul><li>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 market. </li></ul><ul><ul><ul><li>The forces effect the stock market is tangible event (earthquake, war, political uncertainity) or intangible events (market psychology). </li></ul></ul></ul><ul><ul><ul><li>Pokhran Blast on May13, 1998.-----bear---. </li></ul></ul></ul><ul><ul><ul><li>In 1994, liberalization and FII’s investment----Bull. </li></ul></ul></ul><ul><ul><ul><li>Snowballing effects. </li></ul></ul></ul>
  15. 15. <ul><li>Interest rate risk : variation in single period rates of return caused by fluctuation in the market interest rate. Mostly it effects price of Bonds and Debentures . </li></ul><ul><ul><ul><li>Due to changes in govt. monetary policy, which occurs in interest rate of treasury bill and govt. bonds (risk free). </li></ul></ul></ul><ul><ul><ul><li>Higher interest rate of loan/bonds  private to public. </li></ul></ul></ul><ul><ul><ul><li>In depressed situation of stock market subscription of public offering?? </li></ul></ul></ul><ul><ul><ul><li>the rise/fall , will affect the cost of borrowing. </li></ul></ul></ul><ul><ul><ul><li>High interest rate of borrowing also affect the corporate bodies. </li></ul></ul></ul>
  16. 16. <ul><li>Purchasing Power Risk : Inflation is the reason in loss of purchasing power. The level of inflation proceeds faster than the increase in capital value. </li></ul><ul><ul><ul><li>Demand-Pull, the demand for goods and services is higher than its supply. and </li></ul></ul></ul><ul><ul><ul><li>Cost-Push, producer cost  consumer cost  Inflation. </li></ul></ul></ul><ul><ul><ul><li>Cost-Push has spiraling effect on price level. </li></ul></ul></ul>
  17. 17. Risk Component <ul><li>Unsystematic Risk : Firm specific risk or diversifiable . </li></ul><ul><ul><ul><li>It is unique and peculiar to a firm and industry due to debt-equity . </li></ul></ul></ul><ul><ul><ul><li>The nature & mode of raising finance and paying back loans. </li></ul></ul></ul><ul><ul><ul><li>It is due to managerial inefficiency, technological change in the production process, availability of raw material, changes in consumer preferences and labor problems . e.g </li></ul></ul></ul><ul><ul><ul><ul><ul><li>A company’s labor force goes on strike. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>A company’s top management dies in a plane crash. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>A huge oil tank bursts and floods a company’s production area. </li></ul></ul></ul></ul></ul>
  18. 18. <ul><li>Business Risk : Operating environment of business. Business risk arises from the inability of a firm to maintain its competitive edge and the growth or stability of the earnings. </li></ul><ul><ul><ul><li>Variation in operating environment  operating income and expected dividend. </li></ul></ul></ul><ul><ul><ul><li>Business risk is higher in A’s company as there is high variability in operating income. </li></ul></ul></ul><ul><ul><ul><li>Business Risk = Revenue – EBIT. </li></ul></ul></ul><ul><ul><ul><li>Business risk can be internal and external. </li></ul></ul></ul>Company A Company B Operating Income ( at higher level) 15% 12% Operating Income (at lower level) 7% 9%
  19. 19. <ul><li>Internal Business Risk : Operational efficiency of firm. Achievement of pre set goals and fulfillment of promises to its investors. </li></ul><ul><ul><ul><ul><li>Fluctuation in sales : sales  customers  operational income. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>R&D : In house R&D. short sighted cutting in R&D would reduced the operational efficiency of any firm. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Personnel Management : strike & lock out, retention rate, solve at table level, encouragement at floor level. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fixed cost : fixed cost component has to be kept always in a reasonable size. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Single product : PLC, product diversification. </li></ul></ul></ul></ul>
  20. 20. <ul><li>External Business Risk : Social and regulatory factors, monetary & fiscal policies of govt., business cycle and general economic environment . e.g sugar, fertilizer , textile. </li></ul><ul><ul><ul><li>Social and regulatory factors: price control, volume control, import/export control and environment control reduce the profitability by the firm. eg. public utility sector. (tanning, CESC power tariff). </li></ul></ul></ul><ul><ul><ul><li>Political risk: rules and regulation of govt. with the change in the ruling party, the policy also changes. </li></ul></ul></ul><ul><ul><ul><li>Business Cycle: Fluctuation in business cycle  Fluctuation in earnings. (recession and boom) </li></ul></ul></ul>
  21. 21. <ul><li>Financial Risk : variability of income to the equity capital to the debt capital. </li></ul><ul><ul><li>Capital structure of company consist of equity funds and borrowed funds. </li></ul></ul><ul><ul><li>Presence of debt & preference capital result in a commitment of paying interest or fixed rate of dividend. Residual is for equity share holders. </li></ul></ul><ul><ul><li>The debt financing increases the variability of returns to the common stock holders and affects their expectation regarding the returns. </li></ul></ul><ul><ul><li>The use of debt with the own funds to increase the returns to the stakeholders is known as financial leverage. </li></ul></ul>
  22. 22. Company A 2006 2007 2008 Company B 2006 2007 2008 Equity capital Rs 10/share 20,00,000 20,00,000 20,00,000 Equity capital Rs 10/share 10,00,000 10,00,000 10,00,000 Debt fund (10% int) 10,00,000 10,00,000 10,00,000 Debt fund (10% int) 20,00,000 20,00,000 20,00,000 Operating income 3,00,000 4,00,000 2,00,000 Operating income 3,00,000 4,00,000 2,00,000 EPS 1.0 1.5 0.5 EPS 1.0 2.0 NIL
  23. 23. Minimizing Risk Exposure <ul><li>Every investor wants to guard himself from the risk. This can be understanding the nature of the risk and careful planning. </li></ul>
  24. 24. <ul><li>Market Risk Protection : </li></ul><ul><ul><ul><li>Study the price behaviour of the stock.(IT, textile) </li></ul></ul></ul><ul><ul><ul><li>it is better to avoid cyclic stocks . </li></ul></ul></ul><ul><ul><ul><li>The σ and β indicate volatility of stock. This is available in NSE news bulletin provides this information. </li></ul></ul></ul><ul><ul><ul><li>Hold the stock for period of time. Enter at low level and exit at higher level. </li></ul></ul></ul><ul><li>Protection Against Interest Rate Risk: </li></ul><ul><ul><ul><li>Hold the investment till maturity . </li></ul></ul></ul><ul><ul><ul><li>Investor can also buy treasury bills and bonds of short maturity. Money can be reinvested in the market to suit the prevailing interest rate. </li></ul></ul></ul><ul><ul><ul><li>Invest in bonds with different maturity date for maturity diversification can yield the best results. </li></ul></ul></ul><ul><li>Protection against Inflation: </li></ul><ul><ul><ul><li>Investment in short term security. </li></ul></ul></ul><ul><ul><ul><li>Investment diversification  in real estate, precious metal, arts and antiques along with the investment in securities. </li></ul></ul></ul>
  25. 25. <ul><li>Protection Against Business and Financial Risk: </li></ul><ul><ul><ul><li>Analyze the strength and weakness of industry. If weakness due to govt. interference, try to avoid it. </li></ul></ul></ul><ul><ul><ul><li>Analyze the profitability, calculation of SD yields the variability of the return. Invest in stock of consistent track record. </li></ul></ul></ul><ul><ul><ul><li>Analyze the financial structure of the company, debt equity ratio etc. </li></ul></ul></ul><ul><li>Diversification : </li></ul><ul><ul><ul><li>Investing in more than one security to reduce risk. </li></ul></ul></ul><ul><ul><ul><li>If two stocks are perfectly positively correlated, diversification has no effect on risk. </li></ul></ul></ul><ul><ul><ul><li>If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified. </li></ul></ul></ul>
  26. 26. Conclusion <ul><li>Having knowledge and consideration of Risk is not sufficient. It is needed to expressed in quantitative terms. Mathematical expression makes it comparable with other stock. </li></ul><ul><li>So we need to study the measurement technique of Risk. </li></ul><ul><ul><ul><ul><li>Standard Deviation; </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The Characteristic Regression Line (CRL): </li></ul></ul></ul></ul><ul><ul><ul><ul><li>beta; and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Correlation. </li></ul></ul></ul></ul>