RISK

Every investment is characterised by return and risk. The concept of

risk is intuitively understood by investors. In general, it refers to the
possibility of incurring a loss in a financial transaction. But risk
involves much more than that. The word ‘risk’ has a definite financial
meaning.
MEANING OF RISK
A person making an investment expects to get some return from the
investment in the future. But, as future is uncertain, so is the future
expected return. It is this uncertainty associated with the returns from
an investment that introduces risk into an investment.
We can distinguish between the expected return and the realised
return from an investment. The expected return is the uncertain
future return that an investor expects to get from his investment. The
realised return, on the contrary, is the certain return that an investor
has actually obtained from his investment at the end of the holding
period. The investor makes the investment decision based on the
expected return from the investment. The actual return realised from
the investment may not correspond to the expected return. This
possibility of variation of the actual return from the expected return is
termed risk. Where realisations correspond to expectations exactly,
there would be no risk. Risk arises where there is a possibility of
variation between expectations and realisations with regard to an
investment.
Thus, risk can be defined in terms of variability of returns. “Risk is
the potential for variability in returns.”1 An investment whose returns
are fairly stable is considered to be a low-risk investment, whereas
an investment whose returns fluctuate significantly is considered to
be a high-risk investment. Equity shares whose returns are likely to
fluctuate widely are considered risky investments. Government
securities whose returns are fairly stable are considered to possess
low risk.
ELEMENTS OF RISK
The essence of risk in an investment is the variation in its returns.
This variation in returns is caused by a number of factors. These
factors which produce variations in the returns from an investment
constitute the elements of risk.
Let us consider the risk in holding securities, such as shares,
debentures, etc. The elements of risk may be broadly classified into
two groups. The first group comprises factors that are external to a
company and affect a large number of securities simultaneously.
These are mostly uncontrollable in nature. The second group
includes those factors which are internal to companies and affect
only those particular companies. These are controllable to a great
extent. The risk produced by the first group of factors is known as
systematic risk, and that produced by the second group is known as
unsystematic risk.
The total variability in returns of a security represents the total risk of
that security. Systematic risk and unsystematic risk are the two
components of total risk. Thus,
Total risk = Systematic risk + Unsystematic risk

Systematic Risk
As the society is dynamic, changes occur in the economic, political
and social systems constantly. These changes have an influence on
the performance of companies and thereby on their stock prices. But
these changes affect all companies and all securities in varying
degrees. For example, economic and political instability adversely
affects all industries and companies. When an economy moves into
recession, corporate profits will shift downwards and stock prices of
most companies may decline. Thus, the impact of economic, political
and social changes is system-wide and that portion of total variability
in security returns caused by such system-wide factors is referred to
as systematic risk. Systematic risk is further subdivided into interest
rate risk, market risk, and purchasing power risk.
Interest Rate Risk
Interest rate risk is a type of systematic risk that particularly affects
debt securities like bonds and debentures. A bond or debenture
normally has a fixed coupon rate of interest. The issuing company
pays interest to the bond holder at this coupon rate. A bond is
normally issued with a coupon rate which is equal to the interest rate
prevailing in the market at the time of issue. Subsequent to the
issue, the market interest rate may change but the coupon rate
remains constant till the maturity of the instrument. The change in
market interest rate relative to the coupon rate of a bond causes
changes in its market price.
A bond having a face value of ` 100 issued with a coupon rate of ten
per cent when the market interest rate is also ten per cent will have a
market price of ` 100. If, subsequent to the issue, the market interest
rate moves up to 12.5 per cent, no investor will buy the bond with ten
per cent coupon interest rate unless the holder of the bond reduces
the price to ` 80. When the price is reduced to ` 80, the purchaser of
the bond gets interest of ` ten on an investment of ` 80 which is
equivalent to a return of 12.5 per cent which is the same as the
prevailing market interest rate.
Thus, we see that as the market interest rate moves up in relation to
the coupon interest rate, the market price of the bond declines.
Similarly, the market price of the bond would move up when there is
a drop in market interest rate compared to the coupon rate. In other
words, the market price of bonds and debentures is inversely related
to the market interest rates. As a result, the market price of debt
securities fluctuates in response to variations in the market interest
rates. This variation in bond prices caused due to the variations in
interest rates is known as interest rate risk.
The interest rate variations have an indirect impact on stock prices
also. Speculators often resort to margin trading, i.e. purchasing stock
on margin using borrowed funds. As interest rates increase, margin
trading becomes less attractive. The lower demand by speculators
may push down stock prices. The opposite happens when interest
rates fall.
Many companies use borrowed funds to finance their operation.
When interest rates move up, companies using borrowed funds have
to make higher interest payments. This leads to lower earnings,
dividends and share prices. On the contrary, lower interest rates may
push up earnings and prices. Thus, we see that variations in interest
rates may indirectly influence stock prices. Interest rate risk is a
systematic risk which affects bonds directly and shares indirectly.
Market Risk
Market risk is a type of systematic risk that affects shares. Market
prices of shares move up or down consistently for some time
periods. A general rise in share prices is referred to as a bullish
trend, whereas a general fall in share prices is referred to as a
bearish trend. In other words, the share market alternates between
the bullish phase and the bearish phase. The alternating movements
can be easily seen in the movement of share price indices such as
the BSE Sensitive Index, BSE National Index, NSE Index, etc.
Business cycles are considered to be a major determinant of the
timing and extent of the bull and bear phases of the market. This
would suggest that the ups and downs in share markets would follow
the expansion and recession phase of the economy. This may be
true in the long run, but it does not sufficiently explain the short-term
movements in the market.
The short-term volatility in the stock market is caused by sweeping
changes in investor expectations which are the result of investor
reactions to certain tangible as well as intangible events. The basis
of the reaction may be a set of real tangible events, political,
economic or social, such as the fall of a government, drastic change
in monetary policy, etc. The change in investor expectations is
usually initiated by the reaction to real events. But the reaction is
often aggravated by the intangible factor of emotional instability of
investors. They tend to act collectively and irrationally, leading to an
overreaction.
The stock market is seen to be volatile. This volatility leads to
variations in the returns of investors in shares. The variation in
returns caused by the volatility of the stock market is referred to as
the market risk.
Purchasing Power Risk
Another type of systematic risk is the purchasing power risk. It refers
to the variation in investor returns caused by inflation.
Inflation results in lowering of the purchasing power of money. When
an investor purchases a security, he foregoes the opportunity to buy
some goods or services. In other words, he is postponing his
consumption. Meanwhile, if there is inflation in the economy, the
prices of goods and services would increase and thereby the
investor actually experiences a decline in the purchasing power of
his investments and the return from the investment. Let us consider
a simple example. Suppose a person lends ` 100 today at ten per
cent interest. He would get back ` 110 after one year. If during the
year, the prices have increased by eight per cent, ` 110 received at
the end of the year will have a purchasing power of only ` 101.20, i.e.
92 per cent of ` 110. Thus, inflation causes a variation in the
purchasing power of the returns from an investment. This is known
as purchasing power risk and its impact is uniformly felt on all
securities in the market and as such, is a systematic risk.
The two important sources of inflation are rising costs of production
and excess demand for goods and services in relation to their
supply. They are known as cost-push and demand-pull inflation
respectively. When demand is increasing but supply cannot be
increased, price of the goods increases thereby forcing out some of
the excess demand and bringing the demand and supply into
equilibrium. This phenomenon is known as demand pull inflation.
Cost push inflation occurs when the cost of production increases
and this increase in cost is passed on to the consumers by the
producers through higher prices of goods.
In an inflationary economy, rational investors would include an
allowance for the purchasing power risk in their estimate of the
expected rate of return from an investment. In other words, the
expected rate of return would be adjusted upwards by the estimated
annual rate of inflation.
Unsystematic Risk
The returns from a security may sometimes vary because of certain
factors affecting only the company issuing such security. Examples
are raw material scarcity, labour strike, management inefficiency.
When variability of returns occurs because of such firm—specific
factors, it is known as unsystematic risk. This risk is unique or
peculiar to a company or industry and affects it in addition to the
systematic risk affecting all securities.
The unsystematic or unique risk affecting specific securities arises
from two sources: (a) the operating environment of the company,
and (b) the financing pattern adopted by the company. These two
types of unsystematic risk are referred to as business risk and
financial risk respectively.
Business Risk
Every company operates within a particular operating environment.
This operating environment comprises both internal environment
within the firm and external environment outside the firm. The impact
of these operating conditions is reflected in the operating costs of the
company. The operating costs can be segregated into fixed costs
and variable costs. A larger proportion of fixed costs is
disadvantageous to a company. If the total revenue of such a
company declines due to some reason or the other, there would be a
more than proportionate decline in its operaing profits because it
would be unable to reduce its fixed costs. Such a firm is said to face
a larger business risk.
Business risk is thus a function of the operating conditions faced by
a company and is the variability in operating income caused by the
operating conditions of the company.
Financial Risk
Financial risk is a function of financial leverage which is the use of
debt in the capital structure. The presence of debt in the capital
structure creates fixed payments in the form of interest which is a
compulsory payment to be made whether the company makes profit
or loss. This fixed interest payment creates more variability in the
earnings per share (EPS) available to equity share holders. For
example, if the rate of return or operating profit ratio is higher than
the interest rate payable on the debt, EPS would increase. On the
contrary, if the operating profit ratio is lower than the interest rate,
EPS would be depressed. The increase or decrease in EPS in
response to changes in operating profit would be much wider in the
case of a levered firm (a company having debt in its capital structure)
than in the case of an unlevered firm.
This variability in EPS due to the presence of debt in the capital
structure of a company is referred to as financial risk. This is specific
to each company and forms part of its unsystematic risk. Financial
risk is an avoidable risk in so far as a company is free to finance its
activities without resorting to debt.
MEASUREMENT OF RISK
An intelligent investor would attempt to anticipate the kind of risk that
he is likely to face. He would also attempt to estimate the extent of
risk associated with different investment proposals. In other words,
he tries to measure or quantify the risk of each investment that he
considers before making the final selection. The quantification of risk
is thus necessary for investment analysis.
Risk in investment is associated with return. The risk of an
investment cannot be measured without reference to return. The
return, in turn, depends on the cash inflows to be received from the
investment. Let us consider the purchase of a share. While
purchasing an equity share, an investor expects to receive future
dividends declared by the company. In addition, he expects to
receive the selling price when the share is finally sold.
Suppose a share is currently selling at ` 120. An investor who is
interested in the share anticipates that the company will pay a
dividend of ` 5 in the next year. Moreover, he expects to sell the
share at ` 175 after one year. The expected return from this
investment can be calculated as follows:

In this case the investor expects to get a return of 50 per cent in the
future. But the future is uncertain. The dividend declared by the
company may turn out to be either more or less than the figure
anticipated by the investor. Similarly, the selling price of the stock
may be less than the price anticipated by the investor at the time of
investment. It may sometimes be even more. Thus, there is a
possibility that the future return may be more than 50 per cent or less
than 50 per cent. Since the future is uncertain the investor has to
consider the probability of several other possible returns. The
expected returns may be 30 per cent, 40 per cent, 50 per cent, 60
per cent or 70 per cent. The investor now has to assign the
probability of occurrence of these possible alternative returns. An
example is given below:
Possible returns (in per cent) Probability of occurrence

Xi p(Xi)

30 0.10

40 0.30

50 0.40

60 0.10

70 0.10

This table gives the probability distribution of possible returns from

an investment in shares. Such a distribution can be developed by the
investor by studying the past data and modifying it appropriately for
the changes he expects to occur in the future.
The information contained in the probability distribution has to be
reduced to two simple statistical measures in order to aid investment
decision-making. These measures are summary statistics. One
measure would indicate the expected return from the investment and
the other measure would indicate the risk of the investment.
Expected Return
The expected return of the investment is the probability weighted
average of all the possible returns. If the possible returns are
denoted by Xi and the related probabilities are p(Xi), th expected
return may be represented as and can be calculated as:

It is the sum of the products of possible returns with their respective

probabilities.
The expected return of the share in the example given above can be
calculated as follows:
Risk
Expected returns are insufficient for decision-making. The risk
aspect should also be considered. The most popular measure of risk
is the variance or standard deviation of the probability distribution of
possible returns.
Variance is usually denoted by σ2 and is calculated by the following
formula:

Variance = 116 per cent

Standard deviation is the square root of the variance and is
represented as σ. The standard deviation in our example is =
10.77 per cent.
The variance and standard deviation measure the extent of
variability of possible returns from the expected return. Several other
measures such as range, semi-variance and mean absolute
deviation have been used to measure risk, but standard deviation
has been the most popularly accepted measure.
In the method described above, the probability distribution of
possible returns from an investment proposal is used to estimate the
expected return from the investment and its variability. The mean
gives the expected value and the variance or standard deviation
gives the variability. This widely used procedure for assessing risk is
known as the mean-variance approach.
The standard deviation or variance, however, provides a measure of
the total risk associated with a security. Total risk comprises of two
components, namely systematic risk and unsystematic risk.
Unsystematic risk is risk which is specific or unique to a company.
Unsystematic risk associated with the security of a particular
company can be reduced by combining it with another security
having opposite characteristics. This process is known as
diversification of investment. As a result of diversification, the
investment is spread over a group of securities with different
characteristics. This group of securities is called a portfolio.
As far as an investor is concerned, the unsystematic risk is not very
important as it can be reduced or eliminated through diversification.
It is an irrelevant risk. The risk that is relevant in investment decision-
making is the systematic risk because it is undiversifiable. Hence,
the investor seeks to measure the systematic risk of a security.

Measurement of Systematic Risk

Systematic risk is the variability in security returns caused by
changes in the economy or the market. All securities are affected by
such changes to some extent, but some securities exhibit greater
variability in response to market changes. Such securities are said to
have higher systematic risk. The average effect of a change in the
economy can be represented by the change in the stock market
index. The systematic risk of a security can be measured by relating
that security’s variability with the variability in the stock market index.
A higher variability would indicate higher systematic risk and vice
versa.
The systematic risk of a security is measured by a statistical
measure called Beta. The input data required for the calculation of
beta are the historical data of returns of the individual security as
well as the returns of a representative stock market index. Two
statistical methods may be used for the calculation of Beta, namely
the correlation method or the regression method.
Using the correlation method, beta can be calculated from the
historical data of returns by the following formula:

The second method of calculating beta is by using the regression

method. The regression model postulates a linear relationship
between a dependent variable and an independent variable. The
model helps to calculate the values of two constants, namely α and
β. β measures the change in the dependent variable in response to
unit change in the independent variable, while α measures the value
of the dependent variable even when the independent variable has
zero value. The form of the regression equation is as follows:
For the calculation of beta, the return of the individual security is
taken as the dependent variable, and the return of the market index
is taken as the independent variable. The regression equation is
represented as follows:
Ri = α + βRm
where
Ri = Return of the individual security.
Rm = Return of the market index.
α = Estimated return of the security when the market is stationary.
βi = Change in the return of the individual security in response to unit
change in the return of the market index. It is, thus, the measure
of systematic risk of a security.
A security can have betas that are positive, negative or zero.
“The beta of an asset, βi, is a measure of the variability of that asset
relative to the variability of the market as a whole. Beta is an index of
the systematic risk of an asset.”2
As beta measures the volatility of a security’s returns relative to the
market, the larger the beta, the more volatile the security. A beta of
1.0 indicates a security of average risk. A stock with beta greater
than 1.0 has above average risk. Its returns would be more volatile
than the market returns. For example, when market returns move up
by five per cent, a stock with beta of 1.5 would find its returns moving
up by 7.5 per cent (i.e. 5 × 1.5). Similarly, decline in market returns
by five per cent would produce a decline of 7.5 per cent in the return
of the individual security.
A stock with beta less than 1.0 would have below average risk.
Variability in its returns would be comparatively lesser than the
market variability. Beta can also be negative, implying that the stock
returns move in a direction opposite to that of the market returns.
Beta is calculated from historical data of returns to measure the
systematic risk of a security. It is a historical measure of systematic
risk. In using this beta for investment decision-making, the investor is
assuming that the relationship between the security variability and
market variability will continue to remain the same in future also.
To conclude, risk is the possibility of variation in returns from an
investment. Many factors contribute to this variability in returns.
Some of these factors are system-wide and affect all securities, while
some are unique and affect only specific securities. Total variability
or risk of a security can be measured by calculating the standard
deviation or variance of the security’s returns. Beta measures the
systematic risk of a security.
VALUE AT RISK (VaR) ANALYSIS
Value-at-Risk (VaR) is a novel concept of measuring risk associated
with investment. Risk is related to the variability of returns from an
investment. Risk or the possibility of incurring a loss arises when
there is an adverse movement in the asset value. Standard deviation
which is the most popular measure of variability does not consider
the direction of movement; it measures the total variability in returns,
which could be both favourable and unfavourable. VaR is a measure
which specifically focuses on the downside risk in investment.

Origin
VaR has emerged as a risk assessment tool at banks and other
financial services firms since the early 1990s. The term value-at-risk
and the usage of the VaR measure can be traced back to the
RiskMetrics service offered by J.P. Morgan, a globally diversified
commercial bank, in 1995. RiskMetrics service provided public
access to data on the variances of and covariances across various
security and asset classes that the bank had been using internally
for risk management. The data enabled the users to calculate the
risk assessment measure called VaR. J.P. Morgan released the first
detailed description of value-at-risk titled RiskMetrics Technical
Document as part of its free RiskMetrics service. Value-at-risk was
rapidly embraced as the tool of choice for quantifying investment
risk.

Concept
Risk has two components: (i) exposure to loss or decline in value
and (ii) uncertainty regarding the future value. Risk metrics or
measures used to quantify risk may be of three types: (i) those that
quantify exposure, (ii) those that quantify uncertainty, (iii) those that
quantify exposure and uncertainty in some combined form. VaR is a
risk metrics that quantifies both exposure and uncertainty.
An Investor often asks the question: “what is the most I can lose on
this investment?” He is interested in knowing the worst-case
scenario. As the future is uncertain, he would also like to know the
probability of the worst-case scenario. VaR is a measure that is
designed to answer these questions.
VaR is a measure of the worst possible outcome, expressed with the
probability of its occurrence. VaR measures the potential loss in the
value of a risky asset or portfolio over a specified period expressed
with a confidence level. A typical VaR metrics has three parameters:
1. The amount of potential loss (loss amount or loss percentage).
2. The probability of the loss occurring (confidence level).
3. The time frame (or horizon).
Example
An example can be used to explain the concept of VaR. An
investment portfolio held by an investment fund has calculated its 1
day VaR as ` 50 lakhs with 95 per cent confidence level. It implies
that the maximum loss that the portfolio will suffer on a single day
will be limited to (or will be less than) ` 50 lakhs in 95 out of 100
trading days. The loss is likely to exceed ` 50 lakhs only in 5 out of
100 trading days. That is to say that there is 95 per cent confidence
that the value of the portfolio will decrease only by less than ` 50
lakhs on a single trading day. However, there is 5 per cent probability
that the value of the portfolio may decline by more than ` 50 lakhs on
a single trading day.
Thus, VaR calculates the maximum loss expected (or the worst-case
scenario) on an investment over a given time period with a specified
degree of confidence. It is defined as: “the expected loss from an
adverse market movement with a specified probability over a period
of time”.

Methods
Three methods are generally used for calculating VaR. These
methods are:
1. Historical method (Historical simulation)
2. Variance-covariance method (Parametric method)
3. Monte Carlo simulation method
It is necessary to understand the assumptions and methodology of
each method.
Historical method
This method assumes that history will repeat itself. The data set
used for calculation of VaR in this method is the historical returns
(daily or monthly) of the investment for a fairly long time period, say
5 to 10 years. These historical returns are rearranged in ascending
order from the worst to the best. VaR focuses on the worst returns. A
histogram of the rearranged data can be used to identify the worst 5
per cent or 1 per cent of returns from the left tail of the histogram.
Mathematically, the 5th percentile or 1st percentile of the historical
returns can be calculated to find the VaR metrics. The 5th percentile
indicates the VaR metrics of 95 per cent confidence level; whereas
the 1st percentile indicates the VaR metrics of 99 per cent
confidence level. The worst-case scenario of the historical data is
assumed to repeat in the future time period also.
Parametric method
This method assumes that the investment returns are normally
distributed. For a given set of daily or monthly return data, two
statistical measures are estimated: the expected return (mean
return) and the variability of returns (standard deviation of returns).
VaR metrics are calculated for different confidence levels using the
standard deviation of returns (SD) and the critical values (z values)
from the Standard Normal Distribution curve (or table).
The z values for different confidence levels are as follows:
90 per cent confidence level = 1.28
95 per cent confidence level = 1.645
99 per cent confidence level = 2.326
VaR metrics for different confidence levels are calculated by
multiplying the corresponding Critical value and the Standard
Deviation of returns.
VaR (95 per cent confidence level) = 1.645 × SD
VaR (99 per cent confidence level) = 2.326 × SD
The return data may be calculated for different time periods such as
daily, weekly, monthly, yearly, etc. Hence, VaR metrics can also be
calculated for different time periods. But, VaR metrics calculated for
one time period can be easily converted into VaR metrics for another
period. For example, daily VaR metrics can be converted into
monthly VaR metrics. This conversion is done using the square root
rule which says that the T-period volatility is equal to the one period
volatility (Standard deviation) multiplied by the square root of T.
For example, daily volatility or standard deviation of returns of 1.5
per cent is equivalent to annual volatility of 23.72 per cent, assuming
that there are 250 trading days (1.5 × = 23.72).
For converting daily VaR into annual VaR, the daily SD has to be first
converted into annual SD and then multiplied with the required z
value.
Example
A mutual fund holds an investment portfolio having a market value of
` 30 lakhs. The standard deviation of daily returns of the investment
portfolio is 0.64 per cent. Trading days in a month are 20. You are
required to calculate the monthly VaR with 99 per cent confidence
level.
Daily SD = 0.64 per cent
Monthly SD = Daily SD × = 0.64 × = 2.86 per cent
Monthly VaR (99 per cent confidence level) = 2.326 × SD = 2.326 ×
2.86 = 6.65 per cent
This is the VaR metrics in percentage terms.
VaR metrics in amount or currency units can be calculated by
multiplying the value of the investment with the VaR percentage.
Thus, VaR (amount) = ` 30,00,000 × 6.65 per cent = ` 1,99,500
Monte Carlo simulation method
The method is based on the historical data of investment returns.
The Monte Carlo simulation procedure is used to develop a model
for future investment returns by running multiple hypothetical trials or
simulations with the historical data. The worst 5 per cent or 1 per
cent outcome from the model gives the respective VaR metrics.
The three methods are likely to give different results. The Parametric
method is the easiest of the three methods, while Monte Carlo
simulation is the most complex method. The Historical method
requires manipulation of large historical data.

Evaluation
VaR analysis is called the “new science of risk management”. The
concept of Value-at-Risk is simple to understand and has an intuitive
appeal. However, as a meaningful measure of investment risk, it has
certain limitations. VaR has a narrow focus with a narrow definition of
risk. It is exclusively focused on downside risk, and even within that
downside risk, only at a very small slice of it. There is no single
precise method for measuring VaR; hence, there can be no unique
value for the VaR metrics. All methods of calculation use historical
data in some form; but historical data may not serve as a good
predictor of future outcomes.
SOLVED EXAMPLES
Example 1 A share is ` currently selling at 50. It is expected that a
dividend of ` 2 per share would be paid during the year and the
share could be sold at ` 54 at the end of the year. Calculate the
expected return from the share.

Example 2 Calculate the expected return and the standard deviation

of returns for a stock having the following probability distribution of
returns.
Possible returns (in per cent) Probability of occurrence

−25 0.05

−10 0.10

0 0.10

15 0.15

20 0.25

30 0.20

35 0.15
Example 3 A stock costing ` 120 pays no dividends. The possible
prices that the stock might sell for at the end of the year with the
respective probabilities as follows:

Price (` ) Probability
 115 0.1

120 0.1

125 0.2

130 0.3

135 0.2

140 0.1

1. Calculate the expected return.

2. Calculate the standard deviation of returns.
Solution Here, the probable returns have to be calculated using the
formula

Calculation of Probable Returns

Possible prices (P1) P1 − P0 [(P1 − P0)/P0] × 100

` ` Return (per cent)

115 −5 −4.17

120 0 0.00

125 5 4.17

130 10 8.33

135 15 12.50

140 20 16.67

Calculation of Expected Return

Calculation of Standard Deviation of Returns

Example 4 An investor has analysed a share for a one-year holding

period. The share is currently selling for ` 43 but pays no dividends
and there is a fifty-fifty chance that the share will sell for either ` 55 or
` 60 by the year end. What is the expected return and risk if 250
shares are acquired with 80 per cent borrowed funds? Assume the
cost of borrowed funds to be 12 per cent. (Ignore commissions and
taxes).
Example 5 Monthly return data (in per cent) are presented below for
ITC stock and BSE National Index for a 12 month period.
Month ITC BSE National Index

1 9.43 7.41

2 0.00 −5.33

3 −4.31 −7.35

4 −18.92 −14.64

5 −6.67 1.58

6 26.57 15.19

7 20.00 5.11

8 2.93 0.76

9 5.25 −0.97

10 21.45 10.44

11 23.13 17.47

12 32.83 20.15

Calculate beta of ITC stock.

Calculation of Correlation Coefficient

Example 6 With the data given in example 5, calculate beta of ITC
stock, using the regression model.
Solution
Dependent variable Y = Ri
Independent variable X = Rm
From the table prepared for solving the problem in example 5, we
have the following values:
Example 7 Monthly return data (in per cent) for ONGC stock and the
NSE index for a 12 month period are presented below:
Month ONGC NSE Index

1 −0.75 −0.35

2 5.45 −0.49

3 −3.05 −1.03

4 3.41 1.64

5 9.13 6.67

6 2.36 1.13

7 −0.42 0.72

8 5.51 0.84

9 6.80 4.05

10 2.60 1.21
 11 −3.81 0.29

12 −1.91 −1.96

1. Calculate alpha and beta for the ONGC stock.

2. Suppose NSE index is expected to move up by 15 per cent next
month. How much return would you expect from ONGC?
Solution Since alpha and beta of the stock are to be calculated, the
regression model may be used.
The expected return from ONGC stock when NSE index moves up
by 15 per cent can be calculated from the regression equation which
is
Ri = 0.67 + 1.359 Rm
Substituting the value of Rm as 15 in the equation, we get
Ri = 0.67 + 1.359 (15) = 0.67 + 20.385 = 21.055
EXERCISES
1. Calculate the expected return and the standard deviation of
returns for a stock having the following probability distribution:
Probable returns (per cent) Probability of Occurrence

− 24 0.05

− 10 0.15

0 0.15

12 0.20

18 0.20

22 0.15

30 0.10

2. A stock costing ` 250 pays no dividends. The possible prices

that the stock might sell for at the end of the year and the
probability of each are:
Possible prices (`) Probability

200 0.10

230 0.25

250 0.35

280 0.20

310 0.10

(a) What is the expected return?

(b) What is the standard deviation of the returns?
3. An investor has analysed a stock for a one-year holding period.
There is a fifty-fifty chance that the stock, currently selling at ` 60,
will sell for ` 55 or ` 70 by the year end. The investor can borrow on
40 per cent margin from his bank at 10 per cent per annum.
(a) What are the investor’s expected holding period yield and
 risk if he buys 100 shares and does not borrow?
(b) What would be his expected yield and risk if he buys 200
shares paying 60 per cent of the cost with borrowed funds?
4. Monthly return data (in per cent) for IPCL stock and the NSE
index for a 12 month period are presented as follows:
Month IPCL NSE Index

1 10.27 11.00

2 9.31 3.69

3 6.73 4.20

4 −5.68 −4.93

5 2.60 3.05

6 2.86 5.88

7 2.78 3.74

8 3.84 2.63

9 −6.51 −2.10

10 −23.42 −21.35

11 0.00 −4.55

12 6.64 2.80

Calculate beta of IPCL stock.

REVIEW QUESTIONS
1. What is the meaning of risk?
2. Explain the concept of systematic risk. Why is it called
systematic risk?
3. Write notes on:
(a) Interest rate risk
(b) Market risk
(c) Purchasing power risk
4. “The market price of bonds is inversely related to the market
interest rates.” Explain.
5. What is unsystematic risk? Explain the different types of
unsystematic risk.
6. “Financial risk is a function of financial leverage.” Explain.
7. Explain the mean-variance approach to estimation of return and
risk of a security.
8. What is Beta? How is it interpreted?
REFERENCES
1. Rao, Ramesh K.S. 1989, Fundamentals of Financial
Management, p. 389, Macmillan, New York.
2. Ibid., p. 416.