![Holding Period Return
HPR= C + CG
VV00
CC == ccuurrrreenntt iinnccoommee dduurriinngg ppeerriioodd
CCGG == ccaappiittaall ggaaiinn((lloossss)) dduurriinngg ppeerriioodd
[[EEnnddiinngg iinnvveessttmmeenntt vvaalluuee –– BBeeggiinnnniinngg iinnvveessttmmeenntt vvaalluuee]]
VV00 == bbeeggiinnnniinngg iinnvveessttmmeenntt vvaalluuee](https://image.slidesharecdn.com/lecture4sec-141027001211-conversion-gate01/85/Risk-Analysis-18-320.jpg)
Risk Analysis
- 1. Lecture 4. Security Analysis RISK ANALYSIS of SECURITIES
- 2. 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.
- 3. 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 stock’s 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)
- 4. 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)
- 5. Remember the difference: Systematic (market) risk is attributable to broad macro factors affecting all securities. Non-systematic (non-market) risk is attributable to factors unique to a security.
- 6. Total Risk = Systematic Risk + Unsystematic Risk Factors such as changes in nation’s economy, tax reform by the Congress, or a change in the world situation. RETURN PORTFOLIO UUnnssyysstteemmaattiicc rriisskk TToottaall OF RRiisskk DEV Systematic risk STD NUMBER OF SECURITIES IN THE PORTFOLIO
- 7. Total Risk = Systematic Risk + Unsystematic Risk Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract. RETURN PORTFOLIO UUnnssyysstteemmaattiicc rriisskk TToottaall OF RRiisskk DEV Systematic risk STD NUMBER OF SECURITIES IN THE PORTFOLIO
- 8. The risk involved in investment depends on various factors such as: i) The length of the maturity period - longer maturity periods impart greater risk to investments. ii) 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. iii) 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.
- 9. iv) 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. v) 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. vi) 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.
- 10. Measurement of Risk Unsystematic Risk Volatility may be described as the range of movement (or price fluctuation) from the expected level of return. The variance and standard deviation measure the extent of variability of possible returns from expected return.
- 11. Determining Standard Deviation (Risk Measure) s = S ( ri - r )2 nn--11 n i=1 SSttaannddaarrdd DDeevviiaattiioonn, s, is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution.
- 12. Coefficient of Variation The ratio of the ssttaannddaarrdd ddeevviiaattiioonn of a distribution to the mmeeaann of that distribution. It is a measure of RREELLAATTIIVVEE risk. CV = s / rr
- 13. Risk Attitudes Certainty equivalent > Expected value RRiisskk PPrreeffeerreennccee Certainty equivalent = Expected value RRiisskk IInnddiiffffeerreennccee Certainty equivalent < Expected value RRiisskk AAvveerrssiioonn Most individuals are RRiisskk AAvveerrssee.
- 14. Risk Attitude Example You have the choice between (1) a guaranteed dollar reward or (2) a coin-flip gamble of $100,000 (50% chance) or $0 (50% chance). The expected value of the gamble is $50,000. Mary requires a guaranteed $25,000, or more, to call off the gamble. Raleigh is just as happy to take $50,000 or take the risky gamble. Shannon requires at least $52,000 to call off the gamble.
- 15. Risk Attitude Example What are the Risk Attitude tteennddeenncciieess ooff eeaacchh?? Mary shows ““rriisskk aavveerrssiioonn”” because her “certainty equivalent” < the expected value of the gamble.. Raleigh exhibits ““rriisskk iinnddiiffffeerreennccee”” because her “certainty equivalent” equals the expected value of the gamble.. Shannon reveals a ““rriisskk pprreeffeerreennccee”” because her “certainty equivalent” > the expected value of the gamble..
- 16. Diversification and the Correlation Coefficient SSEECCUURRIITTYY EE SSEECCUURRIITTYY FF CCoommbbiinnaattiioonn correlated reduces risk. INVESTMENT RETURN EE aanndd FF TIME TIME TIME Combining securities that are not perfectly, positively
- 17. Return Determinants Risk premium – a return premium that reflects the issue and issuer characteristics associated with a given investment vehicle Realized return – current income actually received by an investor during a given period Paper return – a return that has been achieved but not yet realized by an investor during a given period Holding Period Return (hpr) – the total return from holding an investment for a specified holding period, usually 1 year or less Yield (internal rate of return) – the compound annual rate of return earned by a long-term investment; the discount rate that produces a present value of the investment’s benefits that just equals its cost
- 18. Holding Period Return HPR= C + CG VV00 CC == ccuurrrreenntt iinnccoommee dduurriinngg ppeerriioodd CCGG == ccaappiittaall ggaaiinn((lloossss)) dduurriinngg ppeerriioodd [[EEnnddiinngg iinnvveessttmmeenntt vvaalluuee –– BBeeggiinnnniinngg iinnvveessttmmeenntt vvaalluuee]] VV00 == bbeeggiinnnniinngg iinnvveessttmmeenntt vvaalluuee