Methods of Measuring Risks of Individual

Securities as well as Portfolio

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Portfolio Management.

Methods of Measuring Risks of Individual

Securities as well as Portfolio
Introduction
Risk is one of the most important concepts in finance and investment management. Every investment
decision involves uncertainty regarding future returns. Investors expect returns from securities, but actual
returns may differ from expected returns because of changing market and economic conditions. This
uncertainty regarding return is known as investment risk.

In financial management, risk and return are closely related. Generally, investments with higher expected
returns involve greater risk, while safer investments provide relatively lower returns. Therefore, investors
must evaluate both return and risk before making investment decisions.

Risk measurement techniques help investors analyze the variability of returns and make rational
investment decisions. These techniques are useful for evaluating both individual securities and portfolios.
Some methods measure total variability in returns, while others measure systematic market-related risk.

This assignment discusses the major methods used to measure risks of individual securities and portfolios,
including variance, standard deviation, coefficient of variation, covariance, correlation coefficient, coefficient
of determination, and beta coefficient. It also discusses diversification, portfolio risk, and modern
approaches to investment risk analysis.

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Concept of Investment Risk
Investment risk refers to the possibility that actual returns may differ from expected returns. Risk exists
because future events cannot be predicted with certainty. Economic conditions, inflation, interest rates,
political instability, market fluctuations, and business conditions all influence investment returns.

In finance, risk is usually associated with variability in returns. If the returns of an investment fluctuate
significantly over time, the investment is considered risky. On the other hand, investments with relatively
stable returns are considered less risky.

The objective of investors is not to eliminate risk completely, because risk is unavoidable in investment
activities. Instead, investors attempt to manage risk efficiently in order to maximize return for a given level
of risk.

Types of Investment Risk

Investment risk is generally divided into two major categories:

1. Systematic Risk
2. Unsystematic Risk

Systematic Risk
Systematic risk refers to market-wide risk that affects all securities in the financial market. It arises from
external economic and political factors and cannot be eliminated through diversification.

Systematic risk is also known as market risk or non-diversifiable risk.

Components of Systematic Risk

Market Risk

Market risk arises because of changes in stock market conditions, investor expectations, and economic
activities.

Interest Rate Risk

Interest rate changes affect bond prices and other fixed-income securities.

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Inflation Risk

Inflation reduces purchasing power and decreases the real value of returns.

Exchange Rate Risk

International investments are affected by fluctuations in currency exchange rates.

Political Risk

Political instability, government regulations, and policy changes influence investment returns.

Unsystematic Risk
Unsystematic risk refers to company-specific or industry-specific risk. It arises from internal business factors
and can be reduced through diversification.

It is also called diversifiable risk.

Components of Unsystematic Risk

Business Risk

Business risk arises from operational inefficiency, competition, and changes in consumer demand.

Financial Risk

Financial risk results from the use of debt financing and fixed financial obligations.

Industry Risk

Industry-specific developments may influence profitability and investment performance.

Measures of Risk
Risk measurement methods are broadly classified into:

1. Absolute Measures of Risk

2. Relative Measures of Risk

The major statistical measures of investment risk include:

• Variance

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 • Standard Deviation
• Coefficient of Variation
• Covariance
• Correlation Coefficient
• Coefficient of Determination
• Beta Coefficient

Variance
Variance measures the dispersion of returns around the expected return. It indicates how much actual
returns deviate from average returns.

A larger variance indicates higher variability and therefore greater investment risk.

Formula of Variance
σ² = [Σ(rᵢ − r̄ )²] / (N − 1)

Where:

• σ² = variance
• rᵢ = return in each period
• r̄ = average return
• N = number of observations

Importance of Variance
1. Measures total variability of returns.
2. Helps compare risky securities.
3. Important in portfolio analysis.
4. Useful in Modern Portfolio Theory.

Limitations of Variance
1. Difficult to interpret because values are squared.
2. Sensitive to extreme values.
3. Treats positive and negative deviations equally.

Standard Deviation
Standard deviation is the square root of variance and is one of the most widely used measures of risk.

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It measures the degree of variability of returns from the average return.

Formula
σ = √σ²

Importance of Standard Deviation

1. Measures total risk of securities.
2. Easy to interpret.
3. Useful for comparing investment alternatives.
4. Important in portfolio management.

Advantages
1. Simple and widely accepted.
2. Measures actual volatility.
3. Applicable to historical and expected returns.

Limitations
1. Assumes normal distribution.
2. Influenced by extreme observations.
3. Does not separate systematic and unsystematic risk.

Coefficient of Variation
Coefficient of variation is a relative measure of risk. It measures the amount of risk per unit of expected
return.

Formula
CV = σ / E(r)

Where:

• CV = coefficient of variation
• σ = standard deviation
• E(r) = expected return

Importance
1. Helps compare securities with different returns.

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 2. Indicates efficiency of investment.
3. Useful in investment selection.

A lower coefficient of variation indicates a better risk-return relationship.

Covariance
Covariance measures the degree to which two securities move together.

Formula
CovAB = Σ[(rA − r̄ A)(rB − r̄ B)] / (N − 1)

Interpretation
• Positive covariance indicates movement in the same direction.
• Negative covariance indicates movement in opposite directions.
• Zero covariance indicates no relationship.

Importance of Covariance
1. Important in portfolio construction.
2. Helps measure portfolio risk.
3. Supports diversification decisions.

Correlation Coefficient
Correlation coefficient is a standardized measure of covariance. It measures the strength and direction of
relationship between two securities.

Formula
rAB = CovAB / (σA × σB)

Range of Correlation
• +1 = perfect positive correlation
• −1 = perfect negative correlation
• 0 = no correlation

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Importance
1. Helps reduce portfolio risk.
2. Important for diversification.
3. Measures relationship among securities.

Lower correlation among securities provides greater diversification benefits.

Coefficient of Determination
Coefficient of determination is the square of the correlation coefficient.

Formula
R² = (rAB)²

It measures the proportion of variation in one security explained by another security or market movement.

A higher R² indicates stronger explanatory power.

Beta Coefficient
Beta coefficient measures systematic or market risk. It indicates the sensitivity of a security’s return to
changes in market return.

Formula
β = Covim / σ²m

Or,

β = rim (σi / σm)

Where:

• β = beta coefficient
• Covim = covariance between market and security
• σ²m = variance of market return
• rim = correlation between market and security

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Interpretation of Beta

Beta Value Meaning

β>1 More risky than market

β=1 Same risk as market

β<1 Less risky than market

β<0 Moves opposite to market

Importance of Beta
1. Measures systematic risk.
2. Useful in CAPM.
3. Helps investors evaluate market sensitivity.
4. Important in portfolio management.

Risk Measurement of Individual Securities

The risk of individual securities can be measured using:

1. Variance
2. Standard deviation
3. Coefficient of variation
4. Beta coefficient

Total risk consists of:

Total Risk = Systematic Risk + Unsystematic Risk

Standard deviation measures total risk, while beta measures systematic risk.

Portfolio Risk
A portfolio is a combination of different securities held by an investor.

Portfolio risk depends on:

1. Risk of individual securities

2. Covariance among securities
3. Correlation among securities

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 4. Asset weights in the portfolio

Diversification reduces unsystematic risk, but systematic risk remains unavoidable.

Portfolio Diversification
Diversification means investing in different securities in order to reduce risk.

The main objective of diversification is to minimize unsystematic risk.

Benefits of diversification include:

1. Reduction of portfolio volatility.

2. Stabilization of returns.
3. Protection against company-specific losses.
4. Improvement in long-term portfolio performance.

Portfolio Return and Portfolio Variance

Portfolio Return
Rp = Σ WiRi

Where:

• Wi = proportion invested
• Ri = expected return

Portfolio Variance
σ²p = W²Aσ²A + W²Bσ²B + 2WAWBCovAB

This formula shows that portfolio risk depends on covariance among securities.

Portfolio Beta
Portfolio beta measures the systematic risk of an entire portfolio.

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Formula
βp = Σ Wiβi

Where:

• βp = portfolio beta
• Wi = weight of each security
• βi = beta of each security

A portfolio beta greater than one indicates an aggressive portfolio, while a beta below one indicates a
defensive portfolio.

Modern Portfolio Theory

Modern Portfolio Theory was developed by Harry Markowitz.

According to this theory:

1. Investors are risk-averse.

2. Diversification reduces unsystematic risk.
3. Efficient portfolios maximize return for a given level of risk.
4. Portfolio selection depends on risk-return tradeoff.

The theory emphasizes that securities should be analyzed within the context of a portfolio rather than
individually.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model explains the relationship between expected return and systematic risk.

CAPM Formula
E(Ri) = Rf + βi [E(Rm) − Rf]

Where:

• E(Ri) = expected return of security

• Rf = risk-free rate
• βi = beta coefficient
• E(Rm) = expected market return

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CAPM suggests that investors are rewarded only for systematic risk because unsystematic risk can be
diversified away.

Importance of Risk Measurement

Risk measurement techniques are important because they:

1. Help compare investment alternatives.

2. Improve portfolio management.
3. Assist in diversification.
4. Reduce probability of loss.
5. Help investors make scientific investment decisions.

Risk analysis is essential for investors, banks, insurance companies, mutual funds, and financial institutions.

Limitations of Risk Measurement Techniques

1. Most methods rely on historical data.
2. Future market conditions may differ.
3. Statistical assumptions may not always hold.
4. Market behavior may become unpredictable during crises.

Therefore, investors should combine statistical analysis with practical judgment.

Conclusion
Risk measurement is a fundamental part of security analysis and portfolio management. Since investment
returns are uncertain, investors must evaluate both risk and return before making financial decisions.

Variance and standard deviation measure total variability of returns, while covariance and correlation
coefficient analyze relationships among securities. The coefficient of variation measures risk relative to
return, and beta coefficient measures systematic market risk.

Portfolio diversification plays an important role in reducing unsystematic risk and improving investment
efficiency. Modern Portfolio Theory and CAPM further explain how investors can construct efficient
portfolios and achieve an appropriate balance between risk and return.

Therefore, understanding different methods of measuring risks of individual securities and portfolios is
essential for effective investment management and long-term financial success.

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References
1. Security Analysis and Portfolio Management course materials.
2. Markowitz, Harry. Portfolio Theory.
3. Sharpe, William F. Capital Asset Pricing Model.
4. Reilly, Frank K. Investment Analysis and Portfolio Management.
5. Bodie, Kane, and Marcus. Investments.

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