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Risk and Return

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RISK
Risk in holding securities is generally associated with possibility that
realized returns will be less than the expected returns.
OR
Risk can be defined as the probability that the expected return from the
security will not materialize.
Every investment involves uncertainties that make future investment
returns risk-prone. Risk could be categorized depending on whether it
affects the market as whole, or just a particular industry.
Types of Investment Risk

Systematic Risk

Unsystematic Risk
Risk is the potential for variability in returns. Total variability in returns of
a security represents the total risk of that security.
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk
Systematic risk refers to that portion of total variability in return caused
by factors affecting the prices of all securities. Economic, political, and
social changes are sources of systematic risk.
Nearly all stocks listed on the National Stock Exchange (NSE) move in
the same direction as the NSE Index. On an average, 50 percent of the
variation in a stocks price can be explained by variation in the market
index. In other words, about half of the total risk on an average common
stock is systematic risk.
Systematic Risk is further subdivided into:
Market Risk, (variation in returns caused by the volatility of stock market)
Interest Rate Risk (Variation in bond prices due to change in interest rate)
Purchasing Power Risk (Inflation results in lowering of the purchasing power of money)
(Demand pull inflation and cost push inflation)

Unsystematic Risk
Unsystematic risk is the portion of total risks that is unique to a firm or
industry. Factors such as management capability, consumer preferences,
raw material scarcity and labour strikes cause unsystematic variability of
returns in a firm. Unsystematic factors are largely independent of factors
affecting securities markets in general.
Unsystematic Risk is further subdivided into:
(Operating Environment, and Financing Pattern)

Business Risk (Variability in Operation Income caused by Operating Conditions)


Financial Risk (Variability in EPS due to the presence of debt in Capital
Structure)

Remember the difference: Systematic (market) risk is attributable


to broad macro factors affecting all securities. Non-systematic (nonmarket) risk is attributable to factors unique to a security.

Risk and Expected Return


The risk involved in investment depends on various factors such as:
i.

The credit-worthiness of the issuer of securities - the ability of the


borrower to make periodical interest payments and pay back the
principal amount will impart safety to the investment and this reduces
risk.

ii)

The nature of the instrument or security also determines the risk.


Generally, government securities and fixed deposits with banks tend to
be riskless or least risky; corporate debt instruments like debentures
tend to be riskier than government bonds and ownership instruments
like equity shares tend to be the riskiest. The relative ranking of
instruments by risk is once again connected to the safety of the
investment.

iii

Equity shares are considered to be the most risky investment on


account of the variability of the rates of returns and also because the
residual risk of bankruptcy has to be borne by the equity holders.

iv)

The liquidity of an investment also determines the risk involved in that


investment. Liquidity of an asset refers to its quick salability without a
loss or with a minimum of loss.

v)

In addition to the aforesaid factors, there are also various others such
as the economic, industry and firm specific factors that affect the risk
an investment.

Another major factor determining the investment decision is the rate of


return expected by the investor. The rate of return expected by the
investor consists of the yield and capital appreciation.

Risk-Return Relationship

Return

Low risk

Average risk

High risk

Slope indicates required


Return per unit of risk
Risk-free return R(f)
Risk and Return Relationship
Cont.

C1

AMITY GLOBAL
BUSINESS SCHOOL

Chandig
arh

Copyright 2008, Sudhindra Bhat

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SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat

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