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Investment Management

A CKNOWLEDGEMENT

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It gives us immense joy and pleasure to acknowledge the help of
all the people who have helped me complete this project.

I owe more than it can say to the experience and the guidelines of
my College and the excellent faculty and staff of.

I’am greatly indebted to my project guide Prof.


for his enthusiastic support and co-operation as also for his
constant encouragement throughout the making of this project.

D ECLARATION

i students of of hereby declare that I have completed the Project


titled “INVESTMENT MANAGEMENT” for the subject for the
academic year 2010-11.

C ERTIFICATE

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I ________________________________hereby certify that the following
student of of has completed the project titled “INVESTMENT
MANAGEMENT” for the academic year 2010-11.

Contents
Sr. Topics
no Pg.no
01. Introduction 06-07

02. Investment Management: Who does it? 08

03. Investment Management: What does it involve? 09

04. Returns From Investment 10-11

05. Calculation Of Returns 12-14

06. Comparison Between Various Rate Of Returns 15-17

07. Uses Of ROI 18-19

08. Cash Or Potential Cash Returns 20-21

09. Investment Risks 22-28

10. Measurement Of Risks 29-31

11. Returns When Capital Is At Risk 32-33

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12. Total Returns 34-36

13. Conclusion 37

14. Bibliography 38

Introduction
• Definition:-

Investment Management:-

Investment management is the professional management of


various securities (shares, bonds and other securities) and assets
(e.g., real estate), to meet specified investment goals for the
benefit of the investors. Investors may be institutions (insurance
companies, pension funds, corporations etc.) or private investors
(both directly via investment contracts and more commonly via
collective investment schemes e.g. mutual funds or exchange-
traded funds) .

The term asset management is often used to refer to the


investment management of collective investments, (not
necessarily) whilst the more generic fund management may refer
to all forms of institutional investment as well as investment
management for private investors. Investment managers who
specialize in advisory or discretionary management on behalf of

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private investors may often refer to their services as wealth
management or portfolio management often within the context of
so-called "private banking".

The provision of 'investment management services' includes


elements of financial statement analysis, asset selection, stock
selection, plan implementation and ongoing monitoring of
investments.

Investment management is a large and important global industry


in its own right responsible for caretaking of trillions of dollars,
euro, pounds and yen. Coming under the remit of financial
services many of the world's largest companies are at least in part
investment managers and employ millions of staff and create
billions in revenue.

Fund manager (or investment adviser in the United States) refers


to both a firm that provides investment management services and
an individual who directs fund management decisions.

Investments are important in the context of of present day


conditions. An investor is surrounded by many factors in this
consideration of making investments. He is interested in
minimizing risk adnd maximizing returns. He has to follow certain
methods.

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Investment
Management: Who
does it?
The professional management of assets, such as real estate, and
securities, such as equities, bond and other debt instruments, is called
investment management. Investment management services are sought
by investors, which could be companies, banks, insurance firms or
individuals, with the purpose of meeting stated financial goals.

The need for investment management arises due to:


• The existence of a large number of complex financial products
• Financial market volatility
• Changes in regulatory requirements

Every individual practices investment management to some degree,


including budgeting, saving, investing and spending. However, an
investment manager is one who specializes in placing money in diverse
instruments in order to accomplish predetermined goals. Investment
managers are also widely known as fund managers. Investment managers
may specialize in advisory or discretionary management. When an
investment manager can take action in managing portfolios without
requiring client approval, it is called "discretionary" investment
management.
Investment management is often used synonymously with fund
management. Moreover, terms like asset management, wealth
management and portfolio management are used, with a thin line
differentiating them. Asset management is often used for the management
of collective investments, which refers to investing money on behalf of a
large group of clients in a wide range of investment options. An example of
this is mutual funds. Investment management that involves managing the
investments of high net worth individuals is often referred to as wealth

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management. Asset management and wealth management are also called
portfolio management.

Investment
Management:

Process
The process of investment management involves the following:-

Setting investment objectives:Investment goals are different for individuals,


financial institutions, banks, insurance companies and pension and mutual
funds. For instance, the objective of a bank could be to achieve a minimum
interest spread, while that for an individual investor could be to increase
return on investment.

Formulating the investment plan:After setting the objective, the investment


plan is formulated based on investor-related constraints, such as financial

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capacity and risk profile, as well as environmental constraints, such as
government regulations, market conditions and the state of the economy.

Establishing the portfolio strategy:Based on the objectives and constraints,


the ideal mix of asset classes is identified. These asset classes could include
equities, fixed income securities, foreign securities, debt, real estate and/or
currencies.

Selecting the assets:This involves selecting the individual options within the
wide asset classes.

Measuring and evaluating performance: Investment management is an


ongoing process. It is critical to consistently evaluate the performance of the
portfolio and to improve it continuously.

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Returns From
Investment
Return means the profit earned on the capital invested in the business. It
is expressed as a percentage. The return on an investment is the profit
required to establish and maintain the investment. Investors invest their
funds to make a profit which is known as a return. The goal of the
investment is to maximize the investor’s utility and maximizing expected
return.

Return On Investment – ROI:-

What Does Return On Investment - ROI Mean?

A performance measure used to evaluate the efficiency of an investment or


to compare the efficiency of a number of different investments. To calculate
ROI, the benefit (return) of an investment is divided by the cost of the
investment; the result is expressed as a percentage or a ratio.

The return on investment formula:-

Return on investment is a very popular metric because of its versatility and


simplicity. That is, if an investment does not have a positive ROI, or if there
are other opportunities with a higher ROI, then the investment should be not
be undertaken.

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Keep in mind that the calculation for return on investment and, therefore
the definition, can be modified to suit the situation -it all depends on what
you include as returns and costs. The definition of the term in the broadest
sense just attempts to measure the profitability of an investment and, as
such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing


the revenue that each product has generated by its respective marketing
expenses. A financial analyst, however, may compare the same two
products using an entirely different ROI calculation, perhaps by dividing the
net income of an investment by the total value of all resources that have
been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily


manipulated to suit the user's purposes, and the result can be expressed in
many different ways. When using this metric, make sure you understand
what inputs are being used.

Rate Of Return:-
In finance, rate of return (ROR), also known as return on investment
(ROI), rate of profit or sometimes just return, is the ratio of money
gained or lost (whether realized or unrealized) on an investment relative to
the amount of money invested. The amount of money gained or lost may be
referred to as interest, profit/loss, gain/loss, or net income/loss. The money
invested may be referred to as the asset, capital, principal, or the cost basis
of the investment. ROI is usually expressed as a percentage rather than a
fraction.

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Calculation Of
Returns
The initial value of an investment, Vi, does not always have a clearly
defined monetary value, but for purposes of measuring ROI, the initial value
must be clearly stated along with the rationale for this initial value. The final
value of an investment, Vf, also does not always have a clearly defined
monetary value, but for purposes of measuring ROI, the final value must be
clearly stated along with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an


average over multiple periods.

(a) Single-period:-

(i) 1] Arithmetic return:-

The arithmetic return is:-

rarith is sometimes referred to as the yield. See also: effective interest rate,
effective annual rate (EAR) or annual percentage yield (APY).

(ii) 2] Logarithmic or continuously compounded return:-

The logarithmic return or continuously compounded return, also


known as force of interest, is defined as:-

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It is the reciprocal of the e-folding time.

(b) Multiperiod average returns:-

(i) 1] Arithmetic average rate of return:-

The arithmetic average rate of return over n periods is defined as:-

(ii)

(iii) 2] Geometric average rate of return:-

The geometric average rate of return, also known as the time-


weighted rate of return, over n periods is defined as:-

The geometric average rate of return calculated over n years is also known
as the annualized return.

(iv) 3] Internal rate of return:-

Main article: Internal rate of return

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The internal rate of return, also known as the dollar-weighted rate of
return, is defined as the value(s) of that satisfies the following equation:

where:

• NPV = net present value of the investment

Ct = cashflow at time t

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Comparisons
Between Various
Rates Of Returns
(c)

(d) Arithmetic and logarithmic return:-


For both arithmetic returns and logarithmic returns, an investment is
profitable when either or > 0, and unprofitable when either or
< 0.

The value of an investment is doubled over a year if the annual ROR


or . The value falls to zero when
or .

Arithmetic and logarithmic returns are not equal, but are approximately
equal for small returns. The difference between them is large only when
percent changes are high. For example, an arithmetic return of +50% is
equivalent to a logarithmic return of 40.55%, while an arithmetic return of
-50% is equivalent to a logarithmic return of -69.31%.

Logarithmic returns are often used by academics in their research. The main
advantage is that the continuously compounded return is symmetric, while
the arithmetic return is not: positive and negative percent arithmetic returns
are not equal. This means that an investment of $100 that yields an
arithmetic return of 50% followed by an arithmetic return of -50% will result
in $75, while an investment of $100 that yields a logarithmic return of 50%
followed by an logarithmic return of -50% it will remain $100.

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Comparison of arithmetic and logarithmic returns for initial investment of
$100
Initial investment, Vi $100 $100 $100 $100 $100
Final investment, Vf $0 $50 $100 $150 $200
Profit/loss, Vf − Vi -$100 -$50 $0 $50 $100
Arithmetic return, rarith -100% -50% 0% 50% 100%
Logarithmic return, rlog -69.31% 0% 40.55% 69.31%

(e)

(f) Arithmetic average and geometric average rates of


return:-
Both arithmetic and geometric average rates of returns are averages of
periodic percentage returns. Neither will accurately translate to the actual
dollar amounts gained or lost if percent gains are averaged with percent
losses. A 10% loss on a $100 investment is a $10 loss, and a 10% gain on a
$100 investment is a $10 gain. When percentage returns on investments
are calculated, they are calculated for a period of time – not based on
original investment dollars, but based on the dollars in the investment at
the beginning and end of the period. So if an investment of $100 loses 10%
in the first period, the investment amount is then $90. If the investment
then gains 10% in the next period, the investment amount is $99.

A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss
and gain occurs does not affect the result. A 50% gain and a 50% loss is a
25% loss. An 80% gain plus an 80% loss is a 64% loss. To recover from a
50% loss, a 100% gain is required. The mathematics of this are beyond the
scope of this article, but since investment returns are often published as
"average returns", it is important to note that average returns do not always
translate into dollar returns.

Example #1 Level Rates of Return


Year 1 Year 2 Year 3 Year 4
Rate of Return 5% 5% 5% 5%
Geometric Average at End of Year 5% 5% 5% 5%
Capital at End of Year $105.0 $110.2 $115.7 $121.5

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0 5 6 5
Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55
Compound Yield 5% 5.4%
Example #2 Volatile Rates of Return, including losses
Year 1 Year 2 Year 3 Year 4
Rate of Return 50% -20% 30% -40%
Geometric Average at End of
50% 9.5% 16% -1.6%
Year
$150.0 $120.0 $156.0
Capital at End of Year $93.60
0 0 0
Dollar Profit/(Loss) ($6.40)
Compound Yield -1.6%
Example #3 Highly Volatile Rates of Return, including losses
Year 1 Year 2 Year 3 Year 4
Rate of Return -95% 0% 0% 115%
Geometric Average at End of Year -95% -77.6% -63.2% -42.7%
Capital at End of Year $5.00 $5.00 $5.00 $10.75
($89.25
Dollar Profit/(Loss)
)
Compound Yield -22.3%

(g)

(h) Annual returns and annualized returns:-


Care must be taken not to confuse annual and annualized returns. An
annual rate of return is a single-period return, while an annualized rate of
return is a multi-period, geometric average return.

An annual rate of return is the return on an investment over a one-year


period, such as January 1 through December 31, or June 3 2006 through
June 2 2007. Each ROI in the cash flow example above is an annual rate of
return.

An annualized rate of return is the return on an investment over a period


other than one year (such as a month, or two years) multiplied or divided to
give a comparable one-year return. For instance, a one-month ROI of 1%
could be stated as an annualized rate of return of 12%. Or a two-year ROI of
10% could be stated as an annualized rate of return of 5%. **For GIPS

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compliance: you do not annualize portfolios or composites for periods of less
than one year. You start on the 13th month.In the cash flow example below,
the dollar returns for the four years add up to $265. The annualized rate of
return for the four years is: $265 ÷ ($1,000 x 4 years) = 6.625%.

Uses Of ROI
• ROI is a measure of cash generated by or lost due to the investment. It
measures the cash flow or income stream from the investment to the
investor, relative to the amount invested. Cash flow to the investor can
be in the form of profit, interest, dividends, or capital gain/loss. Capital
gain/loss occurs when the market value or resale value of the investment
increases or decreases. Cash flow here does not include the return of
invested capital.

Cash Flow Example on $1,000 Investment


Year 1 Year 2 Year 3 Year 4
Dollar Return $100 $55 $60 $50
ROI 10% 5.5% 6% 5%
• ROI values typically used for personal financial decisions include
Annual Rate of Return and Annualized Rate of Return. For nominal risk
investments such as savings accounts or Certificates of Deposit, the
personal investor considers the effects of reinvesting/compounding on
increasing savings balances over time. For investments in which capital
is at risk, such as stock shares, mutual fund shares and home
purchases, the personal investor considers the effects of price volatility
and capital gain/loss on returns.

• Profitability ratios typically used by financial analysts to compare a


company’s profitability over time or compare profitability
between companies include Gross Profit Margin, Operating Profit
Margin, ROI ratio, Dividend yield, Net profit margin, Return on equity,
and Return on assets.

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• During capital budgeting, companies compare the rates of return of
different projects to select which projects to pursue in order to
generate maximum return or wealth for the company's stockholders.
Companies do so by considering the average rate of return, payback
period, net present value, profitability index, and internal rate of return
for various projects.

• A return may be adjusted for taxes to give the after-tax rate of return.
This is done in geographical areas or historical times in which taxes
consumed or consume a significant portion of profits or income. The
after-tax rate of return is calculated by multiplying the rate of return by
the tax rate, then subtracting that percentage from the rate of return.
• A return of 5% taxed at 15% gives an after-tax return of 4.25%

0.05 x 0.15 = 0.0075


0.05 - 0.0075 = 0.0425 = 4.25%

• A return of 10% taxed at 25% gives an after-tax return of 7.5%

0.10 x 0.25 = 0.025


0.10 - 0.025 = 0.075 = 7.5%

Investors usually seek a higher rate of return on taxable investment returns


than on non-taxable investment returns.

• A return may be adjusted for inflation to better indicate its true value
in purchasing power. Any investment with a nominal rate of return less
than the annual inflation rate represents a loss of value, even though
the nominal rate of return might well be greater than 0%. When ROI is
adjusted for inflation, the resulting return is considered an increase or
decrease in purchasing power. If an ROI value is adjusted for inflation,
it is stated explicitly, such as “The return, adjusted for inflation, was
2%.”

Many online poker tools include ROI in a player's tracked statistics, assisting
users in evaluating an opponent's profitability.

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Cash Or Potential
Cash Returns
(i) Time value of money:-
Investments generate cash flow to the investor to compensate the investor
for the time value of money.

Except for rare periods of significant deflation where the opposite may be
true, a dollar in cash is worth less today than it was yesterday, and worth
more today than it will be worth tomorrow. The main factors that are used
by investors to determine the rate of return at which they are willing to
invest money include:

• estimates of future inflation rates


• estimates regarding the risk of the investment (e.g. how likely it is
that investors will receive regular interest/dividend payments and the
return of their full capital)
• whether or not the investors want the money available (“liquid”) for
other uses.

The time value of money is reflected in the interest rates that banks offer
for deposits, and also in the interest rates that banks charge for loans such
as home mortgages. The “risk-free” rate is the rate on U.S. Treasury Bills,
because this is the highest rate available without risking capital.

The rate of return which an investor expects from an investment is called


the Discount Rate. Each investment has a different discount rate, based on

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the cash flow expected in future from the investment. The higher the risk,
the higher the discount rate (rate of return) the investor will demand from
the investment.

(j) Compounding or reinvesting:-


Compound interest or other reinvestment of cash returns (such as interest
and dividends) does not affect the discount rate of an investment, but it
does affect the Annual Percentage Yield, because
compounding/reinvestment increases the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD)


that paid an annual interest rate of 4%, compounded quarterly, the CD
would earn 1% interest per quarter on the account balance. The account
balance includes interest previously credited to the account.
Compound Interest Example
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
Capital at the
beginning of the $1,000 $1,010 $1,020.10 $1,030.30
period
Dollar return for the
$10 $10.10 $10.20 $10.30
period
Account Balance at
$1,010.00 $1,020.10 $1,030.30 $1,040.60
end of the period
Quarterly ROI 1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the
beginning of the year, the investor took $1,000 out of his pocket (or
checking account) to invest in a CD at the bank. The money was still his, but
it was no longer available for buying groceries. The investment provided a
cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the
investor got $1,040.60 back from the bank. $1,000 was return of capital.

Once interest is earned by an investor it becomes capital. Compound


interest involves reinvestment of capital; the interest earned during each
quarter is reinvested. At the end of the first quarter the investor had capital
of $1,010.00, which then earned $10.10 during the second quarter. The
extra dime was interest on his additional $10 investment. The Annual

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Percentage Yield or Future value for compound interest is higher than for
simple interest because the interest is reinvested as capital and earns
interest. The yield on the above investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot


lose their capital. Investors/Depositors lend money to the bank, and the
bank is obligated to give investors back their capital plus all earned interest.
Because investors are not risking losing their capital on a bad investment,
they earn a quite low rate of return. But their capital steadily increases.

Investment Risks
On ground of assurance of the return, there are two kinds of Investments -
Riskless and Risky. Riskless investments are guaranteed, but since the
value of a guarantee is only as good as the guarantor, those backed by the
full faith and confidence of a large stable government are the only ones
considered "riskless." Even in that case the risk of devaluation of the
currency (inflation) is a form of risk appropriately called "inflation risk."
Therefore no venture can be said to be by definition "risk free" - merely very
close to it where the guarantor is a stable government.

Types of risk:-
Depending on the nature of the investment, the type of investment risk
will vary.

A common concern with any investment is that you may lose the money you
invest - your capital. This risk is therefore often referred to as "capital risk."

If the assets you invest in are held in another currency there is a risk that
currency movements alone may affect the value. This is referred to as
"currency risk."

Many forms of investment may not be readily saleable on the open market
(e.g. commercial property) or the market has a small capacity and may

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therefore take time to sell. Assets that are easily sold are termed liquid;
therefore this type of risk is termed "liquidity risk."

The risk that there may be a disruption in the internal financial affairs of the
investment, thereby causing a loss of value, is called "financial risk." A
prime example of that form of risk was experienced by the investors in
Enron, or one of the "dot-com" stocks that really never did have a profitable
financial footing. Many of the employees of Enron experienced both liquidity
and financial risk as the price decline in the stock of that company occurred
just as there was a "freeze" on stock liquidation in their retirement plans.

Perhaps the most familiar but often least understood form of investment risk
is "market risk." In a highly liquid market like the collective stock exchanges
in the United States and across the developed world, the price of securities
is set by the forces of supply and demand. If there is a high demand for a
given issue of stock, or a given bond, the price will rise as each purchaser is
willing to pay more for the security than the last one. The reverse of that
occurs when the sellers want to rid themselves of an issue more than the
buyers want to buy it. Each seller is willing to receive less than the last one
and the market price, or valuation, declines.

The same form of risks apply to a house, an issue of stock, a mutual fund, or
a bond. Some forms of investment risk can be insured against. For example,
the risk that an investment rental property might burn down, or the
custodian of your stock and bond investments might go out of business.
Most of the forms of risk that we concern ourselves with, financial risk,
market risk, and even inflation risk, can at least partially be moderated by
forms of diversification.

For example, a person investing $10,000.00 for one year may desire a gain
of $1,000.00, or a 10% return, providing a total investment of $11,000 after
one year. In reality, investing, as opposed to saving, rarely provides such a
neat solution. For example, the average annual compound return of the
broad American stock market over the time period from 1926 to 2006 was
just over 10% per year. During that eighty year period though, there were
more than a few times when massive declines in market value were
experienced by investors in that same stock market. From early in the year
2000 through the fall of the year 2002 for example, the broad measures of
market valuation, such as the S&P 500 Stock Index fell over 50%. For an

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investor in 2006 to have seen that average compounded 10% return in the
S&P 500 Index, he or she would have had to invest in 1994. The 15%
average annual rate or return was there, it just took twelve years of patient
waiting to see it.

At least the investor in a S&P 500 Index Fund has some degree of assurance
that if he or she waits long enough a positive return is very likely to occur.
The investor who elected to invest everything in Enron is left only with the
assurance that the investment was a complete loss. Enron, as a stock issue,
was a part of the S&P 500, and its loss did have a temporary effect on that
index, but the effect was not permanent or, in the long run, of any
significance. That is the value of diversification. Further diversification away
from the large capitalization stocks that make up the S&P 500 Index has
historically tended to further reduce market and financial risk.

Given below are a few types of investment risks:-

1] Credit risk:-

Credit risk is the risk of loss due to a debtor's non-payment of a loan or


other line of credit (either the principal or interest (coupon) or both).

Most lenders employ their own models to rank potential and existing
customers according to risk, and then apply appropriate strategies. With
products such as unsecured personal loans or mortgages, lenders charge a
higher price for higher risk customers and vice versa. With revolving
products such as credit cards and overdrafts, risk is controlled through the
setting of credit limits. Some products also require security, most commonly
in the form of property.

Lenders will trade off the cost/benefits of a loan according to its risks and
the interest charged. But interest rates are not the only method to
compensate for risk. Protective covenants are written into loan agreements
that allow the lender some controls. These covenants may:

• limit the borrower's ability to weaken their balance sheet voluntarily


e.g., by buying back shares, or paying dividends, or borrowing further.

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• allow for monitoring the debt requiring audits, and monthly reports
• allow the lender to decide when he can recall the loan based on
specific events or when financial ratios like debt/equity, or interest
coverage deteriorate.

A recent innovation to protect lenders and bond holders from the danger of
default are credit derivatives, most commonly in the form of a credit default
swap. These financial contracts allow companies to buy protection against
defaults, from a third party, the protection seller. The protection seller
receives a periodic fee (the credit spread) as compensation for the risk it
takes, and in return it agrees to buy the debt should a credit event
("default") occur.

Credit scoring models also form part of the framework used by banks or
lending institutions grant credit to clients. For corporate and commercial
borrowers, these models generally have qualitative and quantitative
sections outlining various aspects of the risk including, but not limited to,
operating experience, management expertise, asset quality, and leverage
and liquidity ratios, respectively.

2] Financial risk:-

Financial risk is normally any risk associated with any form of financing.
Risk is probability of unfavorable condition; in financial sector it is the
probability of actual return being less than expected return. There will be
uncertainty in every business; the level of uncertainty present is called risk.

Depending on the nature of the investment, the type of 'investment' risk will
vary. High risk investments have greater potential rewards, but also have
greater potential consequences.

A common concern with any investment is that the initial amount invested
may be lost (also known as "the capital"). This risk is therefore often
referred to as capital risk.

If the invested assets are being held in another currency, there is a risk that
currency movements alone may affect the value. This is referred to as
currency risk.

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Many forms of investment may not be readily salable on the open market
(e.g. commercial property) or the market has a small capacity and may
therefore take time to sell. Assets that are easily sold are termed liquid:
therefore this type of risk is termed liquidity risk.

The risk that a company or project will not have adequate cash flow to meet
financial obligations; thus causing the business to file for bankruptcy.

Financial risk is the additional risk a shareholder bears when a company


uses debt in addition to equity financing. Companies that issue more debt
instruments would have higher financial risk than companies financed
mostly or entirely by equity.

Bilateral barter can depend upon a mutual coincidence of wants. Before any
transaction can be undertaken, each party must be able to supply
something the other party demands. To overcome this mutual coincidence
problem, some communities had developed a system of intermediaries who
can warehouse and trade goods. However, intermediaries often suffered
from financial risk.

Whilst higher risk normally implies higher overall rewards, this is not always
the case. For example a high risk mortgage client may be required to pay a
higher interest rate on their mortgage repayments in order to be accepted
as a bank's customer. However, this higher mortgage rate will in itself
increase the risk to the bank that the customer cannot meet their interest
payments, further increasing the risk.

3] Interest rate risk:-

Interest rate risk is the risk (variability in value) borne by an interest-


bearing asset, such as a loan or a bond, due to variability of interest rates.
In general, as rates rise, the price of a fixed rate bond will fall, and vice
versa. Interest rate risk is commonly measured by the bond's duration,

Interest rate risk analysis is almost always based on simulating movements


in one or more yield curves using the Heath-Jarrow-Morton framework to
ensure that the yield curve movements are both consistent with current
market yield curves and such that no riskless arbitrage is possible. The

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Heath-Jarrow-Morton framework was developed in the early 1990s by David
Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert
A. Jarrow of Kamakura Corporation and Cornell University.

There are a number of standard calculations for measuring the impact of


changing interest rates on a portfolio consisting of various assets and
liabilities. The most common techniques include:

1. Marking to market, calculating the net market value of the assets and
liabilities, sometimes called the "market value of portfolio equity"
2. Stress testing this market value by shifting the yield curve in a specific
way. Duration is a stress test where the yield curve shift is parallel
3. Calculating the Value at Risk of the portfolio
4. Calculating the multiperiod cash flow or financial accrual income and
expense for N periods forward in a deterministic set of future yield
curves
5. Doing step 4 with random yield curve movements and measuring the
probability distribution of cash flows and financial accrual income over
time.
6. Measuring the mismatch of the interest sensitivity gap of assets and
liabilities, by classifying each asset and liability by the timing of
interest rate reset or maturity, whichever comes first.

4] Liquidity risk:-

In finance, liquidity risk is the risk that a given security or asset cannot be
traded quickly enough in the market to prevent a loss (or make the required
profit).

Liquidity risk arises from situations in which a party interested in trading an


asset cannot do it because nobody in the market wants to trade that asset.
Liquidity risk becomes particularly important to parties who are about to
hold or currently hold an asset, since it affects their ability to trade.

26
Manifestation of liquidity risk is very different from a drop of price to zero. In
case of a drop of an asset's price to zero, the market is saying that the asset
is worthless. However, if one party cannot find another party interested in
trading the asset, this can potentially be only a problem of the market
participants with finding each other. This is why liquidity risk is usually found
higher in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might


lose liquidity if its credit rating falls, it experiences sudden unexpected cash
outflows, or some other event causes counterparties to avoid trading with or
lending to the institution.

Liquidity risk tends to compound other risks. If a trading organization has a


position in an illiquid asset, its limited ability to liquidate that position at
short notice will compound its market risk. Suppose a firm has offsetting
cash flows with two different counterparties on a given day. Should it be
unable to do so, it too will default. Here, liquidity risk is compounding credit
risk.

Asset liquidity - An asset cannot be sold due to lack of liquidity in the


market - essentially a sub-set of market risk. This can be accounted for by:

• Widening bid/offer spread


• Making explicit liquidity reserves
• Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities:

• Cannot be met when they fall due


• Can only be met at an uneconomic price
• Can be name-specific or systemic

5] Market risk:-

Market risk is the risk that the value of a portfolio, either an investment
portfolio or a trading portfolio, will decrease due to the change in value of
the market risk factors. The four standard market risk factors are stock
prices, interest rates, foreign exchange rates, and commodity prices. The
associated market risk are:

27
• Equity risk, the risk that stock prices and/or the implied volatility will
change.
• Interest rate risk, the risk that interest rates and/or the implied
volatility will change.
• Currency risk, the risk that foreign exchange rates and/or the implied
volatility will change.
• Commodity risk, the risk that commodity prices (e.g. corn, copper,
crude oil) and/or implied volatility will change.

As with other forms of risk, the potential loss amount due to market risk
may be measured in a number of ways or conventions. Traditionally, one
convention is to use Value at Risk. The conventions of using Value at risk is
well established and accepted in the short-term risk management practice.

However, it contains a number of limiting assumptions that constrain its


accuracy. The first assumption is that the composition of the portfolio
measured remains unchanged over the specified period. Over short time
horizons, this limiting assumption is often regarded as reasonable. However,
over longer time horizons, many of the positions in the portfolio may have
been changed. The Value at Risk of the unchanged portfolio is no longer
relevant.

In addition, care has to be taken regarding the intervening cash flow,


embedded options, changes in floating rate interest rates of the financial
positions in the portfolio. They cannot be ignored if their impact can be
large.

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Measurement Of
Risks
Risk concerns the expected value of one or more results of one or more
future events. Technically, the value of those results may be positive or
negative. However, general usage tends focus only on potential harm that
may arise from a future event, which may accrue either from incurring a
cost ("downside risk") or by failing to attain some benefit ("upside risk").

There are many definitions of risk that vary by specific application and
situational context. The widely inconsistent and ambiguous use of the word
is one of several current criticisms of the methods to manage risk.

In Risk Management the term risk is commonly misused in place of a


hazard. This is not correct, Risk simply put is the probability of something
happening, whether good or bad. In Risk Management the Risk Matrix has
become used for determining levels of risk, however this must be done with
care because the term "risk" is no longer a probability, rather it becomes a
number or factor for determining a relative risk level. This has nothing to do
with probability.

One set of definitions presents risks simply as future issues which can be
avoided or mitigated, rather than present problems that must be
immediately addressed. E.g. "Risk is the unwanted subset of a set of
uncertain outcomes." (Cornelius Keating)

More formally (and quantitatively), risk is proportional to both the results


expected from an event and to the probability of this event. E.g. "Risk is a
combination of the likelihood of an occurrence of a hazardous event or
exposure(s) and the severity of injury or ill health that can be caused by the
event or exposure(s)" (OHSAS 18001:2007). Mathematically, risk often
simply defined as:-

29
Or more generally,

One of the first major uses of this concept was at the planning of the Delta
Works in 1953, a flood protection program in the Netherlands, with the aid
of the mathematician David van Dantzig. The kind of risk analysis pioneered
here has become common today in fields like nuclear power, aerospace and
the chemical industry.

There are more sophisticated definitions, however. Measuring engineering


risk is often difficult, especially in potentially dangerous industries such as
nuclear energy. Often, the probability of a negative event is estimated by
using the frequency of past similar events or by event-tree methods, but
probabilities for rare failures may be difficult to estimate if an event tree
cannot be formulated. Methods to calculate the cost of the loss of human
life vary depending on the purpose of the calculation. Specific methods
include what people are willing to pay to insure against death, and
radiological release (e.g., GBq of radio-iodine).

There are many formal methods used to assess or to "measure" risk,


considered as one of the critical indicators important for human decision
making.

Financial risk is often defined as the unexpected variability or volatility of


returns and thus includes both potential worse-than-expected as well as
better-than-expected returns. References to negative risk below should be
read as applying to positive impacts or opportunity (e.g., for "loss" read
"loss or gain") unless the context precludes.

In statistics, risk is often mapped to the probability of some event which is


seen as undesirable. Usually, the probability of that event and some

30
assessment of its expected harm must be combined into a believable
scenario (an outcome), which combines the set of risk, regret and reward
probabilities into an expected value for that outcome.

Thus, in statistical decision theory, the risk function of an estimator δ(x) for
a parameter θ, calculated from some observables x, is defined as the
expectation value of the loss function

L,

In information security, a risk is written as an asset, the threats to the asset


and the vulnerability that can be exploited by the threats to impact the
asset - an example being: Our desktop computers (asset) can be
compromised by malware (threat) entering the environment as an email
attachment (vulnerability).

The risk is then assessed as a function of three variables:

1. the probability that there is a threat


2. the probability that there are any vulnerabilities
3. the potential impact to the business.

The two probabilities are sometimes combined and are also known as
likelihood. If any of these variables approaches zero, the overall risk
approaches zero.

The management of actuarial risk is called risk management.

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Returns When
Capital Is At Risk
(a)

(b) Capital gains and losses:-


Many investments carry significant risk that the investor will lose some or all
of the invested capital. For example, investments in company stock shares
put capital at risk. The value of a stock share depends on what someone is
willing to pay for it at a certain point in time. Unlike capital invested in a
savings account, the capital value (price) of a stock share constantly
changes. If the price is relatively stable, the stock is said to have “low
volatility.” If the price often changes a great deal, the stock has “high
volatility.” All stock shares have some volatility, and the change in price
directly affects ROI for stock investments.

Stock returns are usually calculated for holding periods such as a month, a
quarter or a year.

32
Reinvestment when capital is at risk: rate of return and
yield:-

Example: Stock with low volatility and a regular quarterly dividend,


reinvested
End of: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Dividend $1 $1.01 $1.02 $1.03
Stock Price $98 $101 $102 $99
Shares
0.010204 0.01 0.01 0.010404
Purchased
Total Shares
1.010204 1.020204 1.030204 1.040608
Held
Investment
$99 $103.04 $105.08 $103.02
Value
Quarterly ROI -1% 4.08% 1.98% -1.96%

Yield is the compound rate of return that includes the effect of reinvesting
interest or dividends.

To the right is an example of a stock investment of one share purchased


at the beginning of the year for $100.

• The quarterly dividend is reinvested at the quarter-end stock price.


• The number of shares purchased each quarter = ($ Dividend)/($ Stock
Price).

33
• The final investment value of $103.02 is a 3.02% Yield on the initial
investment of $100. This is the compound yield, and this return can be
considered to be the return on the investment of $100.

To calculate the rate of return, the investor includes the reinvested


dividends in the total investment. The investor received a total of $4.06 in
dividends over the year, all of which were reinvested, so the investment
amount increased by $4.06.

• Total Investment = Cost Basis = $100 + $4.06 = $104.06.


• Capital gain/loss = $103.02 - $104.06 = -$1.04 (a capital loss)
• ($4.06 dividends - $1.04 capital loss ) / $104.06 total investment =
2.9% ROI

The disadvantage of this ROI calculation is that it does not take into account
the fact that not all the money was invested during the entire year (the
dividend reinvestments occurred throughout the year). The advantages are:
(1) it uses the cost basis of the investment, (2) it clearly shows which gains
are due to dividends and which gains/losses are due to capital gains/losses,
and (3) the actual dollar return of $3.02 is compared to the actual dollar
investment of $104.06.

Since all returns were reinvested, the ROI might also be calculated as a
continuously compounded return or logarithmic return. The effective
continuously compounded rate of return is the natural log of the final
investment value divided by the initial investment value:

• Vi is the initial investment ($100)


• Vf is the final value ($103.02)

Total Returns
This section addresses only total returns without the impact of U.S. federal
individual income and capital gains taxes.

34
Mutual funds report total returns assuming reinvestment of dividend and
capital gain distributions. That is, the dollar amounts distributed are used to
purchase additional shares of the funds as of the reinvestment/ex-dividend
date. Reinvestment rates or factors are based on total distributions
(dividends plus capital gains) during each period.

Total Return = ((Final Price x Last Reinvestment Factor) - Beginning


Price) / Beginning Pri

Average annual total return:-


Average Annual Return (geometric) US mutual funds are to compute total
return as proscribed by the U.S. Securities and Exchange Commission (SEC)
in instructions to form N-1A (the fund prospectus) as the average annual
compounded rates of return for 1-year, 5-year and 10-year periods (or
inception of the fund if shorter) as the "average annual total return" for each
fund. The following formula is used:

35
P(1+T)n = ERV

Where:

P = a hypothetical initial investment of $1,000.

T = average annual total return.

n = number of years.

ERV = ending redeemable value of a hypothetical $1,000 payment made at


the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-
year periods (or fractional portion).

(i) Example
Example: Mutual Fund with low volatility and a regular annual dividend,
reinvested at year-end share price, initial share value $100
End of: Year 1 Year 2 Year 3 Year 4 Year 5
Dividend $5 $5 $5 $5 $5
Capital Gain
$2
Distribution
Total Distribution $5 $5 $7 $5 $5
Share Price $98 $101 $102 $99 $101
Shares Purchased 0.05102 0.04950 0.06863 0.05051 0.04950
Shares Owned 1.05102 1.10053 1.16915 1.21966 1.26916
Reinvestment Factor 1.05102 1.05203 1.07220 1.05415 1.05219
• Total Return = (($101 x 1.05219) - $100) / $100 = 6.27% (net of
expenses)
• Average Annual Return (geometric) = (((28.19)/100)+1) ^ (1/5)) – 1) x
100 = 5.09%

Using a Holding Period Return calculation, after 5 years, an investor who


reinvested owned 1.26916 share valued at $101 per share ($128.19 in
value). ($128.19-$100)/$100/5 = 5.638% return. An investor who did not
reinvest received total cash payments of $27 in dividends and $1 in capital
gain. ($27+$1)/$100/5 = 5.600% return.

Mutual funds include capital gains as well as dividends in their return


calculations. Since the market price of a mutual fund share is based on net
asset value, a capital gain distribution is offset by an equal decrease in

36
mutual fund share value/price. From the shareholder's perspective, a capital
gain distribution is not a net gain in assets, but it is a realized capital gain.

Conclusion

37
In a financial context, risk is a synonym for uncertainty – the possibility
that the actual outcome will differ from the mean expected outcome. It is
therefore a neutral rather than a negative concept. Investors are risk-averse
in the sense that they require more return for taking on more risk. Risk itself
is measured by the standard deviation of actual returns around the mean
expectation. In the real world, investment risk is created by a number of
different factors that affect the certainty of returns in different ways and to
different extents. The financial markets, and in particular the stock market,
play a crucial role in the control and diversification of risk. They provide a
means whereby investors can get their money back by selling on their
interests to other investors. This resolves a conflict of interest between firms
(which want to keep the use of resources for as long as possible) and
investors (who accept a lower return if they can see the opportunity for an
early exit).

Having established a fair return for a particular investment (in terms of time
preference rate, allowance for inflation and risk premium), we can use this
as a discount rate for establishing the present value of expected cash flows.
If this exceeds the price demanded by the market, the investment offers a
positive net present value and should be acquired. If the present value is
less than the price demanded, the investment is relatively expensive and
should be passed over. This rule of positive net present value is the
dominant rule in financial decision-making.

Bibliography
1] Articles from:-

⇒ www.wikipedia.com

38
⇒ www.narachinvestment.com
⇒ www.visioninvestment.com
⇒ www.articlesbase.com
⇒ www.investorwords.com
⇒ www.openlearn.ac.uk

2] Additional Reference Sites:-

⇒ www.scribd.com
⇒ www.rci.rutgers.edu
⇒ www.work911.com
⇒ www.economywatch.com

⇒ www.beginnermoneyinvesting.com
⇒ www.sharemarketbasics.com
⇒ www.ehow.com
⇒ www.investopedia.com
⇒ www.thefreelibrary.com

3] e-books [books.google.co.in]:-

⇒ Peter L. Bernstein, Aswath Damodaran - 1998 - Business &


Economics.

4] Statistics:-

⇒ en.wikipedia.org

5] Images [Cover page]:-


images.google.com

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