Investment -CHAPTER TWO

ANALYSIS OF RISK IN INVESTMENT

Risk and Return

Savings are invested in various investment opportunities for earning better returns. The returns of the
investment depend up on the risk of such investment. All investments involve some risk. The objective
of any investor is to minimize the risk and maximize return. The value of financial assets depends on
their return and risk pattern.

Although there is a difference in the specific definition of risk & uncertainty, for our purposes and in
most financial literature, the two terms are used interchangeably. For most investors, risk means, the
uncertainty of future outcome.

 Risk:- the uncertainty that an investment will earn its expected rate of return.
 Risk:-“the chance of future loss that can be foreseen.”
 Risk can be defined as “the chance factor in trading in which expected or perspective advantage,
gain, profit, or return may not materialize.”

The actual outcome of investment may be less than the expected outcome. The greater is the
availability in the possible outcome, the greater is the risk. Generally, the variance and standard
deviation of return are used as the alternative statistical measures of the risk of the financial asset.
Similarly, co-variance measures the risk of the risk of the asset, relative to other assets in a portfolio.

Risk free investment means only the certainty of the return of an investment and not free from all risks.
Risk comprises all elements which cause for the variability in the return. Some risks can be controlled by
the investors. Others cannot be controlled, and they are to be borne compulsory by the investor. Risk
may be caused by the factors, such as, “wrong decision of investment”, “wrong timing of investment”,
“kinds of instruments”, “maturity period of investments”, “amount of investment”, “method of
investment”, “nature of industry”, and, “national and international economical factors.”

Number of factors will influence the risk and depending upon the cause the risk can be classified into the
following major types:

1. Default Risk
2. Financial Risk
3. Business Risk
4. Liquidity Risk
5. Maturity risk
6. Call Risk
7. Interest rate Risk
8. Inflation Risk
9. Currency Risk/Exchange rate Risk

1. Default Risk:-means the failure of the borrower to pay the interest & principal amount within
the stipulated period of time. The default risk has the capital risk and income risk as its
components. It means not only failure to pay but also delay in payment.

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2. Financial Risk:-Financial risk refers to the risk on account of pattern of capital structure. It is
usually measured by debt equity mix of the firm. The higher the proportion of debt in the capital
structure, greater is the variability of return and financial risk. Financial risk is an avoidable risk
to the extent that managements have freedom.

A firm with debt financing has no financial risk. Financial risk is related to the debt and equity
mix of financing in the firm. The reliance on debt financing is also called financial leverage. It has
an important effect on shareholders return. Debit financing increases the variability of their
returns.
3. Business Risk:-Business risk arises due to the uncertainty of return which depends upon the
nature of the business. It will influence for the firm’s operating income. It relates to the
variability of the business, sales, income, expenses, and profits. It depends upon the market
conditions for the product mix, input supplies, strength of the competitor etc. The business risk
may be classified into two kinds viz., internal risk and external risk. Internal risk is related to the
operating efficiency of the firm. This is manageable within or by the firm. Internal business risk
leads to fall, in revenues and profit of the companies. External risk refers to the policies of the
government or strategies of competitor or unforeseen situation in the market. This risk may not
be controlled and corrected by the firm.
4. Liquidity Risk:- Liquidity risk refers to a situation wherein it may not possible to sell the asset.
Liquidity risk refers to inability to meet the liabilities of creditors when they want to withdraw
their money. Assets are disposed off at great inconvenience and cost in terms of money and
time. Any asset that can be bought and sold quickly is said to be liquid. Failure of disposable of
assets is called liquidity risk. Liquidity risk has a different meaning from the point of view of
banks and financial institutions.
5. Maturity Risk:-Maturity risk will arise when the money was not received at time of maturity of
the security. It is on long-term bases, that it will happen when the term of maturity period of the
security is longer. The longer the term of maturity, the greater is the risk, because forecasting
the environment, for assessing conditions and situation becomes more and more difficult.
6. Call Risk:- It is associated with corporate bonds . The bonds are issued with call back provisions
and the issues will have the right of redeeming the bonds. The reinvesting the proceeds at lower
interest rate may arise and incurring the cost and inconvenience of investment.
7. Interest Rate Risk:- It is the difference between the expected interest rates and the current
market interest rate . The market will have different interest rate fluctuations, according to
market situations, supply and demand position of cash or credit. The degree of interest rate risk
is related to the length of time to maturity of the security. If the maturity period is long, the
market value of the security may fluctuate widely.
8. Inflation Risk:- Inflation risk is also called as purchasing power risk. It is closely related to
interest rate risk since interest rates generally rise when inflation occurs. Inflation risk is more
relevant in case of fixed income. Securities, shares are regarded as hedge against inflation. It is
the risk that the real rate of return on security may be less than the nominal return.
There is always a chance that the purchasing power of invested money will decline or that the
real return will decline due to inflation.
9. Currency Risk/Exchange rate Risk:- Exchange rate risk is also called as currency risk. It is
associated with the exchange rate fluctuation of foreign exchange on international transactions.
The risk is faced by the limited organizations which are which are involved in export or input
business. This risk will arise due to changes in currency exchange rates, may have an
unfavorable impact on costs or revenues.

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There is no exchange rate risk under the fixed exchange rate system. It refers to cash flow variability
experienced by companies in international exchanges on account of uncertainty in exchange rates.

The following table shows components of risk:

Table 2.1 Components of risk

Risk

A) Systematic Risk B) Unsystematic Risk C) Other Risks

1. Market Risk 1. Business Risk 1. Political Risk

2. Interest Rate Risk 2. Financial Risk 2.Exchange rate Risk

3. Purchasing Power Risk 3. Default Risk 3. Management Risk

4.Currency/Convertibility Risk

5.Natural Calamities Risk

6. Social Risk

7. Solvency Risk

A) Systematic Risk: - is also called non-diversified risk. It is unavoidable. It may also be called as
market risk. The variability in securities total return is directly associated with the overall
movements in the general market or economy is called systematic risk. This risk is inseparable
from the investment. No matter how the well the portfolio is diversified. It is caused by a wide
range of factors exogenous to securities themselves viz., recession, war, and structural changes
in the economy.
B) Unsystematic Risk:-Unsystematic risk is also called “Diversifiable risk” or “Non-market risk”.
Unsystematic risk can be minimized or eliminated through diversification of security holding.
The variability in scrip’s total return that is not related to the overall market variability is called
unsystematic risk. It represents the portion of an investment risk that can be eliminated by
holding diversified stocks. This risk is due to management changes in the company, labor
problems, strikes, etc.
C) Total Risk (Other Risks):- It is the total variability in the return the assets or the portfolio,
whatever may be the source of the variability. It is the uncertainty or volatility in return due to
both security –specific and economic factors. We can say that total risks the combination of
systematic and unsystematic risks.

Total Risk=Systematic Risk +Unsystematic Risk

Beta is a measure of relative risk of a security or its sensitivity to the movements in the market. It is
a measure of volatility or the systematic risk faced by the assets or portfolio or project.

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Return
Return is a reward and motivating force behind every investment. Return is always hunted by
investment. Return is the amount or rate of gain, profit which accrues to an investment. Return is the
amount or rate of benefits derived by a business firm from its operations. The rate of return required by
a firm to a great extent depends upon the risk involved, higher the risk, greater is the return expected by
the firm. Return on investment has two components:
a. Regular income in the form of interest or dividend , and
b. Capital appreciation.

The total return on investment can be defined as ‘income plus (minus) price appreciation
(depreciation).”

Types of return

The following are the various kinds of return:

A. Internal rate of return

B. Coupon rate
C. Expected return
D. Holding period return
E. Basic yield
F. Current yield
G. Yield to maturity
H. Dividend yield
I. Earning yield
J. Real and Nominal return
K. Gross and Net yield
L. Required rate of return

A. Internal rate of return:- This also known as yield rate . It is the rate at which discounts the cash
flows to zero. Internal rate of return is that rate at which the sum of discounted cash inflows
equals the sum of discounted cash outflows. The marginal IRR is the rate of discount which
makes the present value of the marginal revenue from the additional investment equal to
equity.
B. Bond Rate/Coupon Rate:- Coupon rate means , the interest rate received on the face value or
the par value of the bond. If a company or government issues a 10-year bond with birr 100as
face value and 14 % rate of interest , it would be described as 14%bond or debenture and may
be said to have , a coupon rate of 14%.
C. Expected rate of return/Realized return:-Return is not guaranteed. It is mostly expected and it
may or may not be realized. Therefore the expected return is an anticipated or predicted,
desired return by the investor which is subject to uncertainty. Realized return means actually
earned and received.
D. Holding Period Yield/Return:-Holding period yield (HPY)measures the total return from an
investment during a given or designated time period in which the asset is held by the investor.
It is to be noted that HPY does not mean that the security is actually sold and the gain or loss is

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 actually realized by the investor. The concept of HPY is applicable whether one is measuring the
realized return or estimating the future (expected) return. It can be calculated as follows:

HPY= Any cash payments received +price change over the holding period

Price at which the asset is purchased(beginning) price.

E. Basic Yield:-is associated with high grade bonds. It is the lowest yield actually attained the
market. Basic yield can be understood by noting the concept of pure rate of interest, which is
unique and absolutely riskless; It implies absolute safety and certainty of principal and income
and also freedom from losses through changes in commodity prices, interest rates and taxes.
The basic yield, however, does not imply either riskless or uniqueness.
F. Current Yield:- Current yield is also known as the market yield /income yield/ running yield.
Bonds are offered to the public with coupon rate. Current yield is the ratio of the interest per
year to the current market price of the bond. It does not take into account the return earned by
the investor because of appreciation in the value of bond.
G. Yield to Maturity:- It is also known as redemption yield. It is the promised rate of return an
investor will receive from a bond purchased at the current market price and held till maturity.

YTM= Annual interest + (appreciation/ Depreciation of the asset)

Redemption value of face value

H. Dividend Yield: Dividend yield is the ratio of per share expected dividends, gross of tax to the
current market price of the share.
I. Earnings Yield:- It is the ratio of expected EPS of the firm to the current market price of the
share. There is no difference between dividend yield and earnings yield., if the firms dividend
payout ratio is 100%.
J. Nominal and Real Return:-Nominal return is the return in nominal dollars or birr, the real return
is equal to the nominal return adjusted for inflation.
K. Gross an Net Yield:- The yield realized by the investor before paying taxes, is called as gross
yield. The net yield is gross yield less income tax paid.

Net Yield= Gross yield [1-Tax rate]

L. Required Rate of Return:-Required rate of return is an important factor to be considered for

buying securities. The RRR is defined as the minimum expected rate of return needed to an
investor to purchase the security, given its risk. The RRR has two components viz.

A. The risk free rate of return or the time value of money ; and
B. The risk premium

It is the return that an investor must get for facing the risk by investing his money in all those risk
generating investments.

RRR = The time value of money +inflation premium +risk premium

Or

RRR= Risk free rate of return+ risk premium

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Return the results in different exhibits generally confirm the expected relationship between annual rates
of return and the total risk (standard deviations) of these securities. The riskier assets -those that had
higher standard deviations – expected higher returns. For example, the US stock indexes had relatively
high return (10 to 15%) and large standard deviations (13 to 21%). It is not surprise, that the highest –
risk asset class (without commodities)was emerging market stock with a standard deviations of 29.72
% ,whereas risk- free US cash equivalents (30 days T. Bills)had low returns (6.70%) and the smallest
standard deviations (2.90).

2.2 Measure of Historical Rates of Return:- The aim of this part is to help us understand how to choose
among alternative investment assets. process requires that estimate & evaluate the expected risk return
trade –offs for the alternative investors available. Therefore, we must understand how to measure the
rate of return and the risk involved in an investment accurately.

1. The first measure is the historical rate of return on an individual investment over the time period the
investment is held (that is the holding period).

2. Next we consider how to measure the average historical rate of return for an individual investment
over a number of time periods.

3. The third subsection considers the average rate of return for a portfolio of investments.

When we are evaluating alternative investments for inclusion in our portfolio we will often be
computing investment with widely different prices or lives. As an example we might want to compare a
$ 10 stock that pays no dividends to a stock selling for $ 150 that pays dividends of $ 5 a year. To
properly evaluate these two investments, we must accurately compare their historical rates of returns.

When we invest, we differ current consumption in order to add to our wealth, so that we can consume
more in the future. Therefore, when we talk about a return on an investment, we are concerned with
the change in wealth resulting from this investment. This change in wealth can be either due to cash
inflows, such as interest or dividends or caused by a change in the price of the asset (positive or
negative).

If we commit $ 200 to an investment at the beginning of the year and get back $ 220 at the end of the
year, what is our return for the period? The period during which we own an investment is called its
holding period, and the return for the period is the holding period return (HPR). In this example, the HPR
is 1.10 calculated as follows:

1.1 HPR = Ending value of investment

Beginning value of investment
$220 =1.10
$200

T he value will always be zero or greater –that is, it can never be a negative value. A value greater than
1.0 reflects an increase in our wealth, which means that we received a positive rate of return during the
period. An HPR of zero indicates that we lost all our money.

Although, HPR helps us express the change in value of an investment, investors generally evaluate
returns in percentage terms on an annual basis. This conversion to annual makes it easier to directly
compare alternative investments that have markedly different characteristics.

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The first step in converting an HPR to an annual percentage rate is to derive a percentage return, return
referred to as the holding period yield (HPY). The HPY is equal to the HPR minus 1.
!.2 HPY=HPR-1
In our example, HPY=1.10-1= 0.10
= 10%

To derive an annual HPY, we compute an annual HPR and subtract 1.

Annual HPR is found by:
Annual HPR-HPR 1/n
Where; n = number of years the investment is held, consider an investment that cost $ 250 and is worth
$350 after being held for two years;
1.2 HPR= Ending value of investment = $ 350 = 1.40
Beginning value of an investment $250
Annual HPR = 1.40 1/n
=1.40 1/n
= 1.1832
Annual HPY= 1.1832-1=0.1832
=18.32%
If you experience a decline in your wealth value, the computation is as follows:
HPR= Ending value = $ 400 = 0.80
Beginning $ 500
HPY= 0.80-1.00= 0.20= -20%
A multiple year loss over two years would be computed as follows:
HPR= Ending value = $ 750 = 0.75
Beginning value $ 1000
Annual HPR= (0.75) 1/n = 0.75 1/n
0.866
Annual HPY = 0.866-1.00= - 0.143= 13.4%
In contrast, consider an investment of $ 100 held for only six months that earned a return of $ 12:
HPR= $112 = 1.12 (n=0.5)
$100
HPR= 1.12 1/5
= 1.12 1/5
=1.2544
Annual HPY= 1.2544-1= 0.2544
= 25.44%
The purpose of this part is to help us understand how to choose among alternative investment assets.
This selection process requires that we estimate & evaluate the expected risk return trade-offs for the
alternatives investment available.
Therefore, we must understand how to measure the rate of return and the risk involved in an
investment accurately. To meet this need we examine ways to quantify return & risk.

We consider historical measures of return and expected rates of return and risk because many
publications provide numerous examples historical average rates of return & risk measures for various
assets, and understanding them is very important. In addition this historical result is often used by
investors when attempting to estimate the expected rates of return and risk for an asset class.

Measuring Expected Risk and return

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Risk premium and portfolio Theory
An alternative view of risk has been derived from existence work in portfolio theory and capital market
theory by Markowitz (1952-1959) and Sharpe (1964) . Those theories indicated that investors should use
an external market measure of risk. Under a specified set of assumptions, all rational, profit- maximizing
investors want to hold a completely diversified market portfolio of risky assets, and they borrow or lend
to arrive at a risk level that is consistent with their risk preferences. Under this condition, the relevant
risk measure for an individual asset is its comovement with the market portfolio. This comovement,
which is measured by an asset’s covariance with the market portfolio, is referred t o as an asset
systematic risk, the portion of an individual assets total variance attributable to the variability of the
total market portfolio ( the assets nonmarket variance) that is the assets unique features. This market
nonmarket variance is called unsystematic risk , and it is generally considered unimportant because it is
eliminated in a large diversified portfolio. Therefore, under this assumption, the risk premium for an
individual earning asset is a function of the asset systematic risk with the aggregate market portfolio of
risky assets. The measure of an asset’s systematic risk is referred to as its beta.
Fundamental Risk versus Systematic Risk
A number of studies have examined the relationship between the market measure of risk and
accounting variables used to measure the fundamental risk factors, such as business risk , financial risk
and liquidity risk. Therefore, the two measures of risk can be complementary. This consistency seems
reasonable, because, in a properly functioning capital market, the market measure of the risk should
reflect the fundamental risk characteristics of asset.
An example, we would expect a firm that has high business risk and financial risk to have an above
average beta. At the same time it is possible that a firm that has a high level of fundamental risk and a
large standard deviations of return on stock can have a lower level of systematic risk, because its
variability of earnings and stock price is not related to the aggregate economy of the aggregate market.
Therefore, one can specify the risk premium for an asset as:

Risk premium= f (Business risk, Financial risk, liquidity risk, Exchange rate risk, Country risk)

Or

Risk Premium = f (Systematic Market Risk)

Measures and Sources of Risk

The measures of risk for an investment are:

 Variance of rates of return

 Standard deviations of rate s of return
 Coefficient of variation of rates of return ( standard deviations/means)
 Covariance of returns with the market portfolio (beta)

Relationship between Risk and Return

We have seen how to measure the risk and rates of return for alternative investments and what
determines the rate of return that investors require.
The following graph shows the expected relationship between risk and return. It shows that investors
increase the required rate of return as perceived risk (uncertainty) increases. The line that reflects the
combination of risk and return available on alternative investments is referred to as the security market
line /SML/. The SML reflects the risk return combinations available for all risky assets in the capital
market at a given time.

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Investors would select investments that are considered with their risk preferences, some would consider
only low –risk investments, whereas others welcome high risk investments.

Beginning with an initial SML three changes can occur.

1. Individual investment can change positions on the SML. Because of changes in the perceived risk
of the investments.
2. The slope of the SML can change because of a change in the attitudes of investors toward risk;
at is investors can change the returns they require par unit of risk, and
3. The SML can experience a parallel shift due to a change in the RRFR/real risk -free rate /or the
expected rate of inflation that is a change in the NRFR.

Relationship between Risk and Return

Expected return Security Market Line

( SML)

Law Risk Average Risk High Risk

The slope indicates the

Required return per unit of risk

NRFR

Risk

(Business Risk, etc or systematic risk –beta)

NRFR=Nominal risk free rate

RRFR= Real risk- free rate

Movements along the SML

Investors place Risk alternative investments somewhere along the SML based on their perceptions of
the risk of the investment. Obliviously, if an investments risk changes due to a change in one of its risk
services (business risk, and such), it will move along the SML. For example, if a firm increases its financial
risk by selling a large bond issue that increases its financial leverage, investors will perceive its common
stock as a riskier and the stock will move up the SML, to a higher risk positions. Investors will then
require a higher rate of return. As the common stock becomes riskier, it changes its positions on the
SML. Any change in asset that affects its fundamental risk factors or its market risk /that is the beta/ will
cause the asset to move along the SML as shown in the next graph.

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Changes in the Required Rate of Return due to Movement along the SML.

Expected return

SML

Movements along with the

Curve that reflect changes in the risk of the asset

NRFR Risk

Summary of Changes in the Required Rate of Return

The relationship between risk and the required rate of return for an investment can change in three
ways:

1. A movement along the SML –demonstrates a change in the risk characteristics of a specific
investment, such as a change in its business, its financial risk, or its systematic risk /its beta/.
This change only affects the individual investment.
2. A change in the slope of the SML occurs in response to a change in the attitudes of investors
toward risk. Such a change demonstrates that investors want either higher or lower rates of
return for the same risk. This is also described as a change in the market risk premium (Rm-
NRFR). A change in the market risk premium will affect all risky investments.
3. A shift in the SML reflects a change in expected real growth, a change in market conditions (such
as ease or tightness of money), or a change in the expected rate of inflation. Again, such a
change will affect all investments.

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