INVESTMENT MANAGEMENT

CHAPTER - 3
Risk and Return

➢ Risk
Introduction
The interplay between risk & return is a foundational concept in finance, dictating investment strategies &
portfolio management. Understanding this relationship is crucial for both individual & Institutional
investors as it guides decision-making in the pursuit of financial goals.
Risk is an unavoidable component of the investment landscape, inherently linked to the potential for return.
Understanding & managing risk through strategies like diversification and appropriate asset allocation
based on one’s risk tolerance and investment horizon are vital for achieving financial objectives.

Meaning of Risk
Risk refers to uncertainty associated with the future outcome of an investment. It embodies the possibility
that an investment’s actual returns will deviate from its expected returns, which can occur in either
directional positive or negative. In the financial context, risk is often perceived negatively, focusing on the
potential for losing part or whole of the investment.

According to John J Hampton, “ Risk is the chance of future loss that can be foreseen.”

Causes of Risk
1. Wrong decision of what to invest in.
2. Wrong timing of investment may cause higher risk & less return.
3. Nature of instruments invested like category of assets like company share, bonds, chit funds are
highly risk, as they are in unorganized sector.
4. Maturity period or length of investment. The larger the period , the more risky is the investment
normally.
5. Method of investment namely, secured by collateral or not.
6. Terms of lending such as periodicity of servicing, redemption periods etc.
7. National & international factors such as change in political structure.
8. Natural calamities such as act of gold, etc.

Measurement of Risk
Quantifying risk is essential for making informed investment decisions. Several metrics and models have
been developed to measure and analyze risk, including:
• Standard Deviation:
A statistical measure of the dispersion of returns for a given security or market index. It quantifies the
variability of an asset's returns around its mean, serving as a proxy for its volatility. Higher standard
deviation indicates higher risk.
• Beta:
A measure of the sensitivity of an asset's returns relative to the overall market returns. A beta greater than
1 indicates that the asset's price is more volatile than the market, while a beta less than 1 suggests less
volatility.
• Value at Risk (VaR):
A technique used to estimate the probability of portfolio losses based on the statistical analysis of
historical price trends and volatilities.

Types of Risk

Types of Risk

systematic Risk Unsystematic Risk

Systematic Risk
It is also known as market risk or un- diversifiable risk. Variability in a security's total returns that is directly
associated with overall movements in the general market or economy is called systematic risk. Virtually all
securities have some systematic risk because systematic risk directly encompasses interest rate, market, and
inflation risks. Systematic risk is attributable to broad macro factors affecting all securities.
In other words, systematic risk is the uncertainty inherent to the entire market or entire market segment.
Also referred to as volatility, systematic risk is the day-to-day fluctuations in a stock's price. Volatility is a
measure of risk because it refers to the behaviour, or "temperament," of your investment rather than the
reason for this behaviour. Because market movement is the reason why people can make money from
stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that
it will experience a dramatic change in either direction.
Interest rates, recession and wars all represent sources of systematic risk because they affect the entire
market and cannot be avoided through diversification. Systematic risk can be mitigated only by being
hedged.

Systematic Risk
- Uncontrollable by an organisation
- Macro in nature

Types of systematic risk

• Market Risk
• Interest Rate Risk
• Purchasing Power/ Inflationary Risk

1. Market Risk
The variability in a security's retums resulting from fluctuation in the aggregate market is known as market
risk. Market risk is sometimes used synonymously with systematic risk. All securities are exposed to market
risk including
• Recession
• Wars
• Structural changes in the economy
• Tax law Changes
• Changes in Consumer Preferences.
The types of market risk are depicted from following diagram:
• Market Riss
• Absolute Risk
• Relative Risk
• Directional Rise
• Non-Directional Risk
• Basis risk
• Volatility risk

Types of Market Price

(a) Absolute Risk: Absolute risk is without any content. For e.g., if a coin is tessent there is fifty percentage
chance of getting a head and vice-versa
(b) Relative Risk: Relative risk is the assessment or evaluation of risk at different levels of business
functions. For e.g. a relative-risk from a foreign exchange fluctuation may be higher if the maximum sales
accounted by an organization are of expert sales
(c) Directional Risks: Directional risks are those risks where the loss arises from an exposure to the
particular assets of a market. For eg. an investor holding some shares experience a loss when the market
price of those shares falls down
(d) Non-Directional Risk: Non-Directional risk arises where the method of trading is not consistently
followed by the trader. For eg the dealer will buy and sell the share simultaneously to mitigate the risk
(e) Basis Risk: Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g.
the risks which are in offsetting positions in two related but non- identical markets.
(f) Volatility Risk: Volatility risk is of a change in the price of securities as a result of changes in the
volatility of a risk-factor. For eg it applies to the portfolios of derivative instruments, where the volatility
of its underlying is a major influence of prices

2. Interest Rate Risk

There are four types of movements in prices of stocks in the market. These may be termed as (2) long term,
(b) cyclical (bull or bear market) (c) intermediate or within the code and (d) short term. The prices of all
securities rise or fall depending on the change interest rates. Therefore the variability in a security's return
resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally
affect securities inversely, that is, other things being equal, security prices move inversely to interest rates.

Types of Interest Rate Risk

• Price Risk
• Reinvestment Rate Risk

(a) Price Risk: Price risk arises due to the possibility that the price of the shares, commodity, investment
etc. may decline or fall in the future.
(b) Reinvestment Rate Risk: Reinvestment rate risk results from the facts that the interest or dividend
earned from an investment can't be reinvested with the same rate of return as it was acquired earlier.

3. Purchasing Power Risk

A factor affecting all securities is purchasing power risk, also known as inflation risk. With uncertain
inflation, the real (inflation- adjusted) return involves risk even if the nominal return is safe. This risk is
related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand
additional inflation premiums to compensate for the loss of purchasing power.
In other words, it is so, since it emanates (originates) from the fact that it affects a purchasing power
adversely. It is not desirable to invest in securities during an inflationary period.

The types of power or inflationary risk

• Demand Inflation Risk
• Cost Inflation Risk

(a) Demand Inflation Risk: Demand inflation risk arises due to increase in price, which result from an
excess of demand over supply. It occurs when supply fails to cope with the demand and hence cannot
expand anymore. In other words, demand inflation occurs when production factors are under maximum
utilization.
(b) Cost Inflation Risk: Cost inflation risk arises due to sustained increase in the prices of goods and
services. It is actually caused by higher production cost. A high cost of production inflates the final price
of finished goods consumed by people.

Non-Systematic Risk
The variability in a security's total returns not related to overall market variability is called the non-
systematic/ Unsystematic (non-market) risk. Non-systematic risk is specific to an industry or the company
individually. This risk is unique to a particular security and is associated with such factors as business and
financial risk as well as liquidity risk.
In other words, Unsystematic risk is due to the influence of internal factors prevailing within an
organization. Such factors are normally controllable from an organization's point of view. It is a micro in
nature as it affects only a particular organization. It can be planned, so that necessary actions can be taken
by the organization to mitigate (reduce the effect of) the risk.
Unsystematic Risk is also known as "specific risk," "diversifiable risk" or "residual risk," this type of
uncertainty comes with the company or industry you invest in and can be reduced through diversification.
For example, news that is specific to a small number of stocks, such as sudden strike by the employees of
a company you have shares in, is considered to be unsystematic risk.

Unsystematic Risk
- Controllable by an organisaiton
- Micro in nature

Types of unsystematic Risk

• [Link] Risk or Liquidity Risk
• [Link] Risk or Credit Risk
• [Link] Risk

1. Business Risk
Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and
purchase of securities affected by business cycles, technological changes, etc. The risk of doing business in
a particular industry or environment is called business risk. For example, as one of the largest steel
producers, US, Steel faces unique problems.

The types of business or liquidity risk

• Assel Liquidity Risk
• Funding Liquidity Risk
(a) Asset Liquidity Risk: Asset liquidity risk is due to losses arising from an inability to sell or pledge
assets at, or near, their carrying value when needed. For e.g. assets sold at a lesser value than their book
value.
(b) Funding Liquidity Risk: Funding liquidity risk exists for not having an access to the sufficient-funds
to make a payment on time. For e.g. when commitments made to customers are not fulfilled.

2. Financial or Credit Risk

Financial risk is also known as credit risk. It arises due to change in the capital structure of the organization.
The capital structure mainly comprises of three ways by which funds are sourced for the projects. These
are as follows:

1. Owned funds. For e.g. share capital.

2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.

In other words, Credit or Default Risk is the risk that a company or individual will be unable to pay the
contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors
who hold bonds in their portfolios. Government bonds, especially those issued by the federal government,
have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest
amount of default risk but also higher interest rates. Bonds with a lower chances of default are considered
to be investment grade, while bonds with higher chances of default are considered to be junk bonds. Bond
rating services, such as Moody's, allows investors to determine which bonds is investment-grade and which
bonds are junk.

The types of financial or credit risk are depicted and listed below.
• Financial Risk/Credit Risk
• Exchange Rate Risk
• Recovery Rate Risk
• Credit Event Risk
• Non-Directional Risk
• Sovereign Risk
• Settlement Risk

(a)Exchange Rate Risk: Exchange rate risk is also called as exposure rate risk. It is a form of financial
risk that arises from a potential change seen in the exchange rate of one country's currency in relation to
another country's currency and vice-versa. For e.g. investors or businesses face it either when they have
assets or operations across national borders, or if they have loans or borrowings in a foreign currency In
other words, all investors who invest internationally in today's increasingly global investment arena face
the prospect of uncertainty in the returns after the convert the foreign gains back to their own currency.
(b) Recovery Rate Risk: Recovery rate risk is an often neglected aspect of a credit-risk analysis. The
recovery rate is normally needed to be evaluated. For e.g. the expected rrecovery rate of the funds tendered
(given) as a loan to the customers by banks, non- banking financial companies (NBFC), etc.
(c) Sovereign Risk: Sovereign risk is associated with the government. Here, a government is unable to
meet its loan obligations, reneging (to break a promise) on loans it guarantees, etc.
(d) Settlement Risk: Settlement risk exists when counterparty does not deliver a security or its value in
cash as per the agreement of trade or business.
 1. Operational Risk
Operational risks are the business process risks arises due to human errors. This risk will change from
industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.

The types of operational risk

• Operational Risk
• Model Risk
• People Risk
• Legal Risk
• Political Risk

(a) Model Risk: Model risk is involved in using various models to value financial securities. It is due to
probability of loss resulting from the weaknesses in the financial-model used in assessing and managing a
risk.
(b) People Risk: People risk arises when people do not follow the organization's procedures, practices
and/or rules. That is, they deviate from their expected behaviour.
(c) Legal Risk: Legal risk arises when parties are not lawfully competent to enter an agreement among
them. Furthermore, this relates to the regulatory-risk, where a transaction could conflict with a government
policy or particular legislation (law) might be amended in the future with retrospective effect.
(d) Political Risk: Political risk also referred to as Country risk, is an important risk for investors today.
With more investors investing internationally, both directly and indirectly, the political and therefore
economic stability and viability of a country's economy need to be considered. Thus, it occurs due to
changes in government policies. Such changes may have an unfavorable impact on an investor. It is
especially prevalent in the third-world countries.

➢ Return
Meaning of Return
Return is the amount or rate of produce, proceeds, profits which accrues to an economic agent from an
undertaking or investment. It is a reward for and a motivating force behind investment, the objective of
which is usually to maximize return.
We often use two terms regarding return from investments, realized return and expected return. Realized
return is after the fact return that was earned (or could have been earned).

Realized return is the net actual return earned by the investor over the holding period. It refers to the actual
return over some past period.
Expected return refers to the anticipated return for some future period. It may be noted that all investment
decisions are made in the light of expected return. The expected return is estimated on the basis of actual
returns in the past periods. The returns in the past periods provide good basis for estimation of prospective
behaviour.
In simple words, expected return is the return from an asset that investors anticipate they will earn over
some future period. It is a predicted return, and it may or may not occur.

Determinants of Return
Three major determinants of the rate of return expected by the investor are:
• The time preference risk-free real rate.
• The expected rate of inflation
 • The risk associated with the investment, which is unique to the investment. Required Return Risk-
free real rate Inflation premium - Risk Premium
Component of Return
The rate of return from an investment consists of the two:

• Yield: The interest or dividend received is called yield.

• Capital Appreciation: The difference between the sale price and the purchased price is the capital
appreciation.

Types of return

1. Internal Rate of Return: The internal rate of return (IRR) is the rate of discount which makes the present
value of all the revenues (cash flows) from the investment equal to the total cost of that investment. This is
also known as the yield or yield rate.

2. Bond Rate: It is the interest rate received on the face value or the par value of the bond. If a company
or the government issues a 10-year bond with 100 as face value and 15 per cent rate of interest, it would be
described as 15 per cent bond.

[Link] and Expected Return: Return is not as simple a concept as it appears to be because it is not
guaranteed, it is mostly expected, and it may or may not be realized. Thus, expected return is an anticipated,
predicted, desired which is subject to uncertainty. Realized return, on the other hand, is actually earned.

4. Holding Period Yield Return: Holding period yield (HPY) measures the total return from an investment
during a given time period in which the asset is held by the investor. It is to be noted that HP does not mean
that the security is actually sold and the gain or loss is actually realized by the investor. The concept of
HPY is applicable whether one is measuring the realized return or estimating the future 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)

5. Redemption Yield or Yield to Maturity (YTM): Redemption yield is the indicated or promised rate of
return an investor will receive from a bond purchased at the current market price and held till maturity.
Annual Interest + Average annual appreciation or depreciation

YTM = Annual Interest + Average annual appreciation or depreciation

Redemption or face value

6. Dividend Yield: Dividend yield is the ratio of per share expected dividends, to the current market price
of the share.

7. Earnings Yield: Earnings yield is the ratio of expected earnings per share of the firm to the current
market price of the share. The dividend yield and earnings yield do not differ if the firm distributes all net
earnings in the form of dividends i.e. if it practices 100 per cent dividend payout ratio.
8. Nominal and Real Return: While the nominal return is the return in nominal rupees, the real return is
equal to the nominal return adjusted for changes in prices Le. rate of inflation.

9. Gross and Net Yield: While gross yield refers to the yield realized by the investor before paying taxes,
the net yield is what remains with him after paying the taxes. The net yield can be calculated as follows:
Net Yield = Gross Yield (1-Tax Rate)

Portfolio Risk and Return

Portfolio risk and return are central concepts in the field of investment management, focusing on how to
maximize returns for a given level of risk through diversification and strategic asset allocation.

Expected Returns of a Portfolio

The expected return of a portfolio is the weighted average of the expected returns. of its individual assets,
where the weights are the proportion of each asset's value relative to the total value of the portfolio. This
metric provides investors with an estimate of the average return that the portfolio is expected to generate
over a future period.

Formula for Expected Portfolio Return

If a portfolio contains n assets, with Ri representing the expected return of asset/ and wi representing the
weight of asset / in the portfolio, the expected return of the portfolio (Rp) can be calculated as:

Rp = w1R1+w2R2+……+wnRn
Rp = ∑i=1n wiRi

where:
Rp = Expected return of the portfolio
Wi = Weight of asset / in the portfolio (the proportion of the portfolio's total value invested in asset/)
Ri = Expected return of asset i
n = Number of assets in the portfolio

Example Calculation
Suppose a portfolio consists of three assets. Asset A has an expected return of 5%, Asset B has an expected
return of 10%, and Asset C has an expected return of 15%. If 50% of the portfolio is invested in Asset A,
30% in Asset B, and 20% in Asset C, the expected return of the portfolio can be calculated as follows:
Solution : Rp (0.50×5%)+(0.30×10%)+(0.20×15%)
Rp=2.5%+3%+3%
Rp=8.5%
Thus, the expected return of the portfolio is 8.5%.

Importance
Calculating the expected return of a portfolio is crucial for investors as it helps in:
•Portfolio Construction: Guiding the allocation of assets to achieve desired return objectives while
managing risk.
• Performance Measurement: Serving as a benchmark to evaluate the actual performance of the portfolio
against its expected performance.
•Risk Management: Assisting in understanding the trade-offs between risk and return, facilitating
adjustments in portfolio composition to align with an investor's risk tolerance.