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- 2. Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected. Risk means deviation from the expected. Risks can be classified as Systematic risks and Unsystematic risks. Systematic risks: These are risks associated with the economic, political, sociological and other macro-level changes. It is the risk of the system. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio. Unsystematic risks: These are risks that are unique to a company or industry. Factors such as management capability, consumer preferences etc. contribute to unsystematic risks. Unsystematic risks are controllable and can be considerably reduced by sufficiently diversifying one's portfolio.
- 3. Total Risk = Systematic + Unsystematic Risk Systematic Risk is also called Non diversifiable Risk or Market Risk. This risk is quantified through beta. Systematic risk is the only risk for which an investor should be getting a return. Unsystematic Risk is also called Diversifiable Risk or Unique Risk. It represents that portion of the total risk which stems from company specific factors.
- 5. Is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is the responsiveness of the stock vis-à-vis market. Is used in capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. *Volatility Volatiliity means risk.
- 6. It is a model which describes the relationship between risk and expected (required) return. In this model a security expected (Required) return is equal to risk free rate and risk premium based on the systematic risk of the security. CAPM Defined
- 7. A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. It says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk.
- 8. Ri = Rf + ß(Rm – Rf) Where: Ri = Required (expected) rate of return of security j Rf = Risk free rate of short term govt bond ß = It is the systematic risk of security “i” which can not be diversified. Rm = Required rate of return of market (Rm – Rf) = Risk premium because of bearing risk “ß” (beta) Mathematically CAPM is written as
- 9. •Covariance A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together.A negative covariance means returns move inversely. •Variance Variance measures the variability (volatility) from an average. Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security.
- 10. A company of Beta: 1 will rise by 10% if the market rises by 10% 2 will rise by 20% if the market rises by 10% -2 will fall by 20% if the market rises by 10% 0.20 will rise by 20% if the market rises by 100%
- 11. Less risky companies will have less beta. ß > 1 are called as aggressive betas. ß < 1 are called as conservative betas. Beta tells how sensitive is your stock to the market
- 12. Approaches for Beta Calculation Historical Market Betas Fundamental Betas Accounting Betas
- 13. Expected Return depends on 3 things The time value of money (risk-free rate, Rf). The reward for bearing systematic risk (market risk premium={E(Rm) - Rf} The amount of systematic risk (Beta)