Risk and Return Analysis of the Capital Market - Free Essay Example

A financial market is a market in which the financial assets are created or transferred. A real transaction involves an exchange of money for real goods or services, whereas a financial transaction involves creation or transfer of financial asset. Financial assets or financial transactions represent the claim to a payment of a sum of money in future or periodic payment in the form of interest or dividend. Indian financial sector can be divided into two major segments: Organized and un-organized. Organized sector includes banks, financial institutions, insurance companies and non-banking FI such as unit trusts, mutual funds etc. Unorganized sector consists of indigenous banks, money lenders, chit funds etc. Various financial markets are as follows: Money Market wholesale debt market for low-risk investment Credit Market banks and other financial institutions giving short, medium and long term loans to corporations Forex Market deals with multi-currency requirements Capital Market long-term finance instrument to corporations and government Capital market has two broad segments: primary and secondary market. Primary market helps in raising funds by issuing securities, government and corporations can both participate. Secondary market is where the previously issued securities and financial instruments are transacted by traders. Risk Risk is defined as probability that the return from a security will not match the expectations. Every investment has inherent uncertainties. Uncertainties can be due to economic, social, political or industrial factors. These uncertainties result in making the future returns in this investment risk prone. Total Risk = Market Risk + Issuer Risk The risk in any investment will be either of the following: Systematic risk (Market Risk) Unsystematic risk (Issuer Risk) Systematic risk is a risk which is present to the whole market. It is the change in the security or its variability in terms of overall return which is directly associated with the overall movements in the market. In practical scenario all the securities will have systematic risk in it irrespective of the level of diversification of funds. In contrast, unsystematic risk is specific to an industry or a company. It is the change in the security in term of overall return which is not present on the moveme nts in the existing market. As is apparent, this risk is generally associated to a unique security or a set of similar securities. There are various types of systematic and unsystematic risks to which any security is exposed to, some of them are listed below: Market Risk Interest Rate Risk Purchasing Power Risk Regulation Risk Business Risk Re-investment Risk Bull bear market Risk Management Risk International Risk Default Risk Exchange Rate Risk Country Risk Liquidity Risk Political Risk Industry Risk Measurement of Risk Since, risk will always be present in the securities, quantifying these risks becomes an important issue. In order to quantify first some factors must be standardised on which these risks will be analyses. The most widely accepted factors are as follows: Volatility Risk basically is the deviation of a stock from its anticipated or expected value. The deviation can be in both positive as well as negative direction. Generally, it is being used to focus in the direction of the potential harm. This range of fluctuation from the expected level of return is termed as volatility. The more a security moves up and down in in price, the more volatile will be the security. As it is apparent, more the volatility higher will be the uncertainty in a stock. Hence, increased volatility leads to increased risks. Standard Deviation It is a widely used instrument to measure the risk present in a stock or portfolio. It is similar to volatility, and is used to measure the absolute variation of a stock from its expected price or value. Beta It is the systematic risk inherent in a stock which cannot be cannot be avoided by diversifying. Beta is a relative indicator of the risk of an individual security as against the market portfolio of the securities. It is important to observe that the measure of fluctuation of beta is from the set benchmarks (portfolio of stocks). Beta is a useful instrument to perform comparative analysis of risks prevalent in various set of stocks. This instrument is a direct measure of the riskiness. Most of the times the stocks are ranked in the market based on their beta values. High beta values result in high risk securities. Expected Return Any investment decision is hinged on two important criterions: risk and expected return. Another important factor is the rate of return (ROR). ROR depends upon the capital appreciation and the yield. The key determinants of ROR from the investor perspective are as follows: Expected Rate of Inflation Risk associated with investment unique to the investment Time preference risk free real estate Therefore, ROR = Risk free real estate + Inflation Premium + Risk Premium The rate of return can be calculated as: EQUATION Risk and Return Relationship The fundamental principle of this seminar paper is that there is trade-off between risk and return. The connection between the risk and return demands that as the returns increase there is an increase in risk. Low levels of risk are associated with low potential returns and vice-versa. The risk and return relationship is the desire to be exposed to minimum possible risk and highest possible returns. The following figure represents the risk-return relationship: DIAGRAM The slope in the above figure is the measure of return per unit of risk. High risk prone investments will have steeper line. Generally, higher yield compared to the rest of the market indicates an above average risk. The following figure illustrates that: DIAGRAM Risk-Return Relationship of Different Stocks In most of the practical scenarios, various lines of securities in the market exist. An investor would like to choose options which are consistent with his/her risk preferences. It might be a low risk or a high risk option. There is an important myth that higher risk leads to better returns. The trade- off tells us that higher risk leads to possibility of better returns. Thus, it can also result in potential losses. The risk tolerance differs from person to person. It depends on the income, goals, standard of living, and variety of other issues. On the lower scale of risk-free ROR is treasury bills provided by the government. These bills are virtually risk free as they are backed up by the Indian government. Portfolio Security Returns A portfolio is a collection of securities. Investors rarely put their entire funds of an individual or an institution in a single stock. Thus, It becomes essential to view a security in portfolio context. Expected return from a portfolio will depend on the expected return of each security in the portfolio. Return of portfolio (Two assets) The expected return from a portfolio of two securities is equivalent to the weighted average of the expected returns from them. DIAGRAM Risk of Portfolio (Two assets) The risk will be measured in terms of the various measurement parameters as discussed in the previously in the paper. The risk will not simply be the weighted average risk of the variance of the returns of securities from expected value. These securities will be inter-linked as they belong to the same portfolio. In this case, the portfolio risk also needs to be taken into account. It will consider the co-variance (it is a measure of co-movement) of the two securities and will provide the degree to which these securities vary together. The standard deviation in such a scenario will be calculated by: EQUATION The co-variance of security A and security B can be expressed as: EQUATION The unsystematic risk diversification of the two securities portfolio will depend on the degree of co-relation which exists between the return of these securities. Co-relation varies from -1 to +1. The different values will imply following: Co-relation co-efficient (r) = -+1; No unsys tematic risk can be diversified Co-relation co-efficient (r) = -1; All unsystematic risk can be diversified Co-relation co-efficient (r) = 0; No co-relation It is important to note that ideally, as an investor, assets with low or negative correlations should exist in the portfolio. When one or more of the holdings depreciate in value, the other holdings should pick up the slack. Risk and Return of Portfolio (Three assets) The risk of the portfolio consisting of three securities can be calculated as follows: EQUATION Optimal Portfolio (Two assets) The objective of an investor is minimizing the risk of the portfolio. The tools which are used to achieve this are: risk avoidance and risk minimisation. These tools are integral part part of portfolio management. A portfolio will contain various securities; by combining the weights of these securities expected return can be calculated. An optimal portfolio will minimize the risk to the greatest extend. The minimum risk portfolio of two assets is calculated as follows: EQUATION Portfolio diversification and Risk The fundamental principle of portfolio diversification is not-to hold-all-eggs-in-one-basket. Co-relation is the underlying principle of any diversified portfolio. Ideally in order to diversify project risk and thereby reducing the firms overall risk; the projects which should be added in the portfolio are those which are negatively co-related with the existing projects. By adding such stocks the overall variability of the returns/risks can be reduced to an extent. The following figure shows reducing risks through diversification: DIAGRAM As is clearly visible from the above diagram that project A and B are negatively co-related. The securities have same expected return E under similar market situation. The combination of the two projects also has return E but with less risk and variability. Such, a risk is known as the alpha or diversifiable risk. The combination of two perfectly positively correlated stocks does not reduce the risk of the overall project below the lea st risk level. In contrast, two stocks with perfectly negative co-relation will reduce the risk component of the overall project below the risk of either stocks or in certain situation in can touch 0 also. Modern Portfolio Theory Modern portfolio theory (MPT) is an investment theory which attempts to maximize the portfolios expected return for a given amount of portfolio risk, or to minimize the risk for a level of expected return, by selecting the amounts of various assets. One of the most important models of modern portfolio theory is listed below. Markowitz Model of Risk-Return Optimization Harry Markowitz proposed the portfolio theory. The model proposed in 1952, tries to optimize the trade-off between the risk and expected return of a portfolio. The underlying assumption of the theory is that individual assets do not matter to the investor but its the contribution in the total risk of the portfolio is critical. Utility function and Risk Taking Common investors will have three possible attitudes to undertake risky course of action: An Aversion to risk A Desire to take risk An Indifference to Risk This behaviour can best be understood with the help of an example. There are two stock options A and B with expected return of 100 each in normal economy. In a booming economy the return will be 110 and 200 units for stocks A and B respectively. The risk seeker or the person, who desires to take risk, will in such a scenario prefer the riskier stock option B. A risk indifferent (risk neutral) will be unresponsive to both the options A and B as they have same expected returns. Utility in economic terms is defined as the indicator of relative satisfaction. Generally, money is considered as a desirable commodity and large sum of money has a greater utility than smaller sum. The utility function is expressed in the following figure: DIAGRAM The figure clearly implies that the risk preferring decision maker maximi ses the expected utility by increasing the expected monetary value to maximum.