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Risk and Return

Return refers the amount of total monetary benefits a


investors receive from a security.
Return of a financial security consists two componentperiodical cash payments received at specified time
intervals.
And market appreciation/depreciation of the security value
over the investment time period.

Concept of Return
Return refers the amount of total monetary benefits a investors
receive from a security.
Return of a financial security consists two component-periodical
cash payments received at specified time intervals. And market
appreciation/depreciation of the security value over the
investment time period.
Ri

Cash Payment Re ceived Pr ice change over the period


purchase price of the sec urity

Ri

( Pt Pt 1 ) Div
Pt 1

Where, Pt is price of security in time period t, Pt-1 is price in


last time period, Div is dividends.

Return Calculation
Reliance Ind.
Time
Opening Price
Closing Price
May-07
1752.0
1760.0

Div.
10.0

(1760 1752) 10
Ri
100 1.07%
1752
It indicates that Reliance Ind. has offered 1.07% return to the investor on 7th of
May.
The Annualized return will be 1.07X365=390.55%.

Realized Return vs. Expected


Return
Realized return is the return which is realized by
the investor over the investment time period.
Expected return is the return which is expected to
earn over the investment time period by the
investor.

Historical Return
Historical return is that return which has been offered by the
security to the investors during the past.
Historical return of a security is used to analysis of risk and
return prospectus of that security. For example sensex
has offered -23.02 percent return in 2001, whereas in
2007 sensex has offered 56.13 percent return.
Year

Sensex return (%)

2001

-23.02

2002

-27.26

2003

84.283

2004

19.638

2005

48.421

2006

36.86

2007

56.13

Absolute Return
Absolute return refers the gross return which is
realized by the investor.
For example on 1 Jan 2010 the price of Infosys
stock was 1500 and it was 2500 on 30 June
2010.
So the absolute return is Rs 1000 (2500-1500).
And the relative return will be 66.7% (1000/1500).

Average or Airthematic Return


Average return is that return which is on average return
offered by a security to the investors over a particular period
of time. For e.g. in the last slide different level of annual
return is offered by BSE 100 from 1995 to 2007. But the
average return will be-

(22.53 10.60 5.28 4.50 97.14 23.02


1
Ri
13 27.20 84.28 19.63 48.42 36.37 56.13) 23.28%
The average return which is offered by BSE 100 from 1995 to 2007 to the
investors is 23.28%.

Annual Return Vs Annualized Return


Annual return refers the return which is obtained by the
inventor during a year.
For example, on Jan. 1, 2010 the price of the Infosys
stock was Rs 1000, and on Dec. 31, 2010 it is Rs
1300, and dividend in between is Rs 200, than annual
return is: 50%.
If Infosys price was Rs 1000 on Jan 2010, and 1050 on
Jan 31, 2010. It means the monthly return of Infosys
is: 5%.
Annualized return will be: 5x12=60%.

Risk in Investing Financial Security


Risk in the capital market refers the Variation in the mean
rate of return . Volatility in the stock market indicates risk
which affects the value of the stocks.

Risk is segregated into two Categories:

Systematic RiskSystematic risk refers to that portion of total


probability in return caused by factors affecting the
of all securities.

prices

Unsystematic RiskUnsystematic risk is the portion of total risk that is


unique to a firm or industry.

Total Risk

Systematic Risk

Unsystematic Risk

Market Risk

Business Risk

Purchasing Power Risk

Financial Risk

Interest Rate Risk

Forex Risk

Systematic Risk
Market RiskMarket risk refers to that portion of total variability in the
return caused by factors affecting the whole market.
Economic, political and sociological changes are sources
of this type risk.

Purchasing Power RiskPurchasing risk is associated with inflation and deflation.


If an investor gets 5 percent rate of return and prevailing
inflation is 5.5 percent, it means that investor is realizing
0.5 percent loss on the investment over the period of
time.

Systematic Risk..cont.
Interest Rate RiskInterest rate risk is associated with fluctuations in rate of
return caused by variation in general interest rate.
Interest rate risk is becoming prominent as not only
domestic interest rate but also interest rate prevailing in
the international market can cause volatility in the stock
market.

Foreign Exchange RiskForeign Exchange Risk is caused by changes in foreign


exchange rate.
Market risk can not be diversified by enlarging the
portfolio. This risk affects the market as a whole and each
stock seems to co-vary in the same direction with the
emergence of this risk.

Unsystematic Risk
Business RiskBusiness risk, emerges because of operating conditions,
variability in business conditions, dividend decisions etc.

Financial RiskFinancial risk caused by the way a firm finances its


activities or expansion plans. If a firm raises debt in the
market it increases its obligation to pay fixed amount of
fund, viz., interest to the debtors. Investors perceive it
risky to invest in those stocks whose debt equity ratio is
high.
Non-market risk is specific and associated with individual
stocks. This risk can be eliminated by enlarging and
diversifying the portfolio by holding different stocks of
different industries.

Measurement of Total Risk


Risk of financial security refers the variation in the rate of
return of that financial security.
Standard deviation is used to calculate the total risk of
any financial security.
SD

2
(
R

R
)

Where, R is return of the security, n is number of observations.

Measurement of Systematic Risk -beta


Systematic risk refers to that portion of total risk or variation
in rate of return which are caused by factors affecting the
prices of all securities.
Beta of financial securities is used to measure the
systematic risk. It indicatives the level of sensitiveness of
each security to the market.

n XR X R
n X X
2

Where, R is return on security, X is return on Market Index like


Sensex.
A high beta value is the indication of high risk, and low beta
value is the indication of low risk.

Measurement of Systematic Risk -beta


Beta value is widely used by the investors in analyze of the
stocks. A stock with high beta value indicates high risk of
the stock, on the other hand stock with low beta value is
the indication of the low risk of the stocks.
Investor who are looking capital gain should invest in stocks
with high beta value.
On the other hand investors which avoid to take high risk,
should invest in low beta value stocks.
If the beta value of Infosys is 0.16. It means if sensex goes to
1% either side. Infosys return will vary 0.16% accordingly.

Calculation of Alpha value


Alpha of any financial security indicates the minimum level
of return which an investor can expect from that
security.
The income looking investor can invest in the stocks with
high alpha values.

i R 2 X
Where, R is average return of the security,
average return of the stock.

is the beta of the stock,

is the

Coefficient of variation
Coefficient of variation measures how much variation in the
rate of return of a security comes due to variation in rate
of return of market index like sensex.
All the stocks are the part of the stock market. When there
will be any fluctuations in the rate of return of market
index like sensex, correspondingly fluctuations will occur
in the rate of return of the stock return.

C.V .

XR
( X R
2

Where, R is return on security, X is return on Market Index


like BSE 100.

Financial Market
Financial Market is the market from where short and long term financial
resources are raised. Financial market is divided in two sub marketscapital market and money market.
Capital market is that segment of money market from where long term
capital is raised from the investors by issuing the different financial
securities such as bonds, common equity shares and preference
shares.
Money market on the other hand is that segment of the market from
where short term capital is raised from the investors by issuing the
securities such as treasury bills, certificate of deposits, commercial
papers etc.

Organization of Indian Financial Market


Financial
Market

Capital
Market

Long Term
Loan

Money
Market

Stock
Market

Primary
Market

Organized
Banking
Sector

Secondary
Market

Unorganized
Banking
Sector

Call Money
Market

Sub
Markets

Treasury
Bills

Certificate
of Deposits

Commercial
Papers

PrimaryMarket
Primary Market is the market where a company issue its common
shares very first time to the investors through the any method given
below.
Public Issue through Prospectus (IPO)

Through Offer for Sale

Private Placement

Company

Right Issue

Book Building

Stock Option

Issue of Bonus Shares

Investors

Secondary Market

Secondary
Market

Primary
Market

Investors

BSE
&
NSE

Investors

Public Issue through Prospectus


Company directly issue a prospectus to the
investors.
Features
1.
2.
3.
4.
5.
6.

Names and addresses of the company promoters, managers,


board members, legal advisor, bankers etc.
The date of opening and closing of subscriptions.
Details regarding the project, plant location, technology,
collaboration, infracutures facilities.
Past performance of the company.
Management perception regarding the risk factors involved in the
project.
Credit rating obtained from recognized rating agency like, CRISIL,
ICRA, and CARE.

Offer for Sale


Company issue its shares through some intermediary such as
Issuing House or Stock Broker.

Company

Agreed Price

Stock Brokers

Investors

Placement of Securities
Under this system the shares are acquired by the issuing houses directly
from the issuing company at an agreed price, and then these are placed
only to selected investors.
Bank
Merchant Bank
Company

Agreed
Price

Institutional Investors
Broker

Parent Co.
Individual Investor-X
Individual Investor-Y
Individual Investor-Z

Advantages-

Disadvantages-

1. Economical

1. Concentration of power.

2. Effective decision making

2. Influence of share holders.

3. Easy to convenience to investors.

3. Less publicity of the company.

4. Speedy decision making.

4. Less possibility of market


appreciation of share value..

Right Issue
Right issue involves issuing of shares by an existing
company to its existing shareholders in proportion to the
number of shares already held by them.
Bank (10%)
Merchant Bank (25%)
Institutional Investors (20%)

Company

Parent Co. (20%)


Individual Investor-X (5%)
Individual Investor-Y (10%)
Individual Investor-Z (10%)

Issue of Fresh shares


in proportion to their share holding

Existing Share
Holders

Book Building
Book building is a process wherein company hire some merchant
banker or issuer house which further invites bids from investors
between a range of share price.

Company

Stock Brokers
Or
Merchant Banker

Investors

Bonus Shares
Issue of bonus shares does not result in raising of fresh capital. It is
process of conversion of dividends, and other reserves into share
capital.

Bank (10%)
Merchant Bank (25%)
Institutional Investors (20%)

Company

Parent Co. (20%)


Individual Investor-X (5%)
Individual Investor-Y (10%)
Individual Investor-Z (10%)

Issue of Fresh shares


in lie of their dividends

Existing Share
Holders

Stock Options
Stock option is a process wherein company
issue its shares only to its top executives.
Finance Manager
Marketing Manager

Company

HR Manager
Labour Union
Board of Directors

Money Market
Call money market is important segment of money market
from where borrowing and lending is done for a short time
period ranging from overnight to fortnight.
Call Moneywhen money is lent or borrowed for overnight.
Notice Moneywhen money is lent or borrowed more that one day
and upto fourteen days.

Treasury Bills
Treasury bills are the promissory notes or a kind of
financial bill issued by RBI on behave of central
government with discount for a fixed period, not
extending beyond one year.
TBs are issued with a promise to pay the amount stated
therein to the bearer of the instruments.
TBs are issued on discount basis.

Periodicity of TBs14 days TBs, 91 days TBs, 182 days TBs, 364
days TBs.

Commercial Papers
Commercial papers are debt instruments
issued by corporates for raising short term
resources from the money market. CPs
are unsecured debts-no provision is made
behind the CPs.
Corporates having approval from RBI are
eligible to issue CPs.
CPs are issued on interest/discount basis.

Certificates of Deposits
A certificate of deposit is a marketable document
of title to a time deposit for a specified period.
CDs is a receipt given to the depositor by a bank
or any other institution entitled to issue CD.
A CD is issued at a discount and it is negotiable
instrument.

Regulation of Indian Financial


Market
Regulation of Money Market
Money market is that market from where capital can be
raised for short time period.
Reserve bank of India (RBI) is the statutory body which is
authorized to regulate the Indian money market.

Regulation of Capital Market


Capital market is that market from where capital can be
raised for long time period.
Securities and Exchange Board of India (SEBI) is the
statutory body which is authorized to regulate the Indian
capital market.

Euro Market/International
Market
Euro market refers raising capital from international market
by issuing the financial securities denominated in the
foreign currencies.
These financial securities which are denominated in the
foreign currency are commonly called euro issue. Some
of the euro issues are:
ADR (American Depository Receipt)
European Depository Receipt)
Global Depository Receipt)
Foreign bonds
Euro bonds

International Bond Investing


Bonds are a debt instrument which are issued for a certain
period of time and promises to give fixed yield.
In international market mainly two types of bonds are
available.

1.Foreign Bond2. Euro Bond-

1. Bonds in International Market-

I. Foreign Bonds-

Infosys Tec.
(Foreign Co.)

US Dollar denominated
Bonds

Foreign Bonds

US Market
(Investors)

A bond that is issued in a domestic market by a foreign


entity, in the domestic market's currency. Foreign bonds are
regulated by the domestic market authorities. Since
investors in foreign bonds are usually the residents of the
domestic country, investors find them attractive because
they can add foreign content to their portfolios without the
added exchange rate exposure.

2. Euro BondsInfosys Tec.


(Foreign Co.)
Yen denominated
Bonds

Euro Bonds

US Market
(Investors)

A bond issued in a currency other than the currency of the


country or market in which it is issued. Usually, a euro bond is
issued by an international syndicate and categorized
according to the currency in which it is denominated. A euro
dollar bond that is denominated in U.S. dollars and issued in
Japan by an Australian company would be an example of a
euro bond. The Australian company in this example could
issue the euro dollar bond in any country other than the U.S.

American Depository Receipt


If a foreign firm plans to issue its common equity shares in
US market, it can issue through ADR in US capital
market. The foreign firm will issue its share to some
international bank which will in turn convert the equity
shares into certain number of depositories. And that
depositories will be sold the U.S. investors
For example XYZ Inc. plans to issue one lakh shares in US market. Bank
convert these shares into depository where one depository will represents
certain number of shares for example one depository equal to 1000 shares.
It means banks will be able to issue 100 depositories in the US market.

American Depository Receipt


Infosysis Co.
(Foreign Co.)
Equity Shares

Dividends in Re.

US Market

International
Bank

NYSE

Re/$
Dividends in US Dollar

Depositories

US Investors

Europe Depository Receipt


If a foreign firm plans to issue its common equity shares in
Europe, it can issue through EDR in European capital
market. The foreign firm will issue its share to some
international bank which will in turn convert the equity
shares into certain number of depositories. And that
depositories will be sold to the European investors.
For example XYZ Inc. plans to issue one lakh shares in Europe market. Bank
convert these shares into depository where one depository will represents
certain number of shares for example one depository equal to 1000 shares.
It means banks will be able to issue 100 depositories in the European
market.

European Depository Receipt


Infosysis Co.
(Foreign Co.)
Equity Shares

Dividends in Re.

London Market

London St.
Mkt

International
Bank
Re/
Dividends in pounds

Depositories

U.K. Investors

Global Depository Receipt


If a foreign firm plans to issue its common equity shares in
global market , it can issue through GDR in global capital
market. The foreign firm will issue its share to some
international bank which will in turn convert the equity
shares into certain number of depositories. And that
depositories will be sold to the investors across the
world.
For example XYZ Inc. plans to issue one lakh shares in global market.
Bank convert these shares into depository where one depository will
represents certain number of shares for example one depository
equal to 1000 shares. It means banks will be able to issue 100
depositories in the global market.