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![Measuring Risk
• In real life its not possible to estimate future returns or the range of return.
• Nor can we assign accurate probabilities.
• Investors only have a single series of past observations, from which both
actual and expected returns have to be extracted. [Estimation]
• Investors tend to expect on the basis of historical data, it is common to
represent expected returns by an average return.](https://image.slidesharecdn.com/risk-230927040706-5d659a39/75/RISK-pptx-20-2048.jpg)
RISK.pptx
- 1. INVESTMENT RISK Dr. AnkitSrivastava
- 2. RISK • Exposure toa danger or hazard • The possibility that what is actually earned as return could be different from what is expected to be earned. • The deviation between actual and expected returns is the risk in investment. • If the return from an investment remains unchanged over time, there would be no risk.
- 3. Common Types ofRISK • Inflation Risk • Default Risk • Liquidity Risk • Re-investment risk • Business Risk • Exchange Rate Risk • Interest Rate Risk • Market Risk • Systematic • Unsystematic Risk
- 4. Inflation Risk • Therisk that the money received on an investment may be worth less when adjusted for inflation. • Also known as purchasing power risk. • It is a risk that arises from the decline in value of security’s cash flows due to the falling purchasing power of money.
- 5. Default Risk orCredit Risk • The probability that borrowers will not be able to meet their commitment on paying interest and/or principal on time. • Debt instruments are subject to default risk as they have pre- committed pay outs. • The ability of the issuer of the debt instrument to service the debt may change over time and this creates default risk for the investor.
- 6. Liquidity or MarketabilityRisk • The ease with which an investment can be bought or sold in the market. • Liquidity risk refers to an absence of liquidity in an investment. • It implies that the investor may not be able to sell his investment when desired, or it has to be sold below its intrinsic value, or there are high costs to carrying out transactions. • All of this affects the realizable value of the investment.
- 7. Re-investment Risk • Ifthe income flows received from an investment are not able to earn the same interest as the original interest rate. • The risk is that intermediate cash flows may be reinvested at a lower return as compared to the original investment. • The rate at which the re-investment of these periodic cash flows is made will affect the total returns from the investment. • The reinvestment rates can be high or low, depending on the levels of interest rate at the time when the coupon income is received. • If Interest rate rises , reinvestment risk reduces or is eliminated • If Interest rate falls, reinvestment risk increases
- 8. Business Risk • Therisk inherent in the operations of a company. • Also known as operating risk, because it is caused by factors that affect the operations of the company. • Common sources include cost of raw materials, employee costs, introduction and position of competing products, marketing and distribution costs.
- 9. Exchange Rate Risk •Incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. • When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment is subject to exchange rate risk. • If domestic currency depreciates against foreign currency, the value of foreign asset goes up in terms of domestic currency and the value of domestic assets in terms of foreign currency goes down. • If domestic currency appreciates against foreign currency, the value of foreign asset goes down in terms of domestic currency and the value of the domestic assets in terms of foreign currency goes up.
- 10. Exchange Rate Risk •An NRI based in the US invests $1000 in a bank deposit in India @10% for 1 year when the exchange rate is Rs. 60/US$. After one year, the rupee depreciates, and the exchange rate is Rs. 67/US$. What is the risk to his investment if he decides to repatriate the money back? • Initial Invested amount = US$1000 = Rs.60000 • Interest earned = 10% x 60,000 = Rs. 6000 • Investment value after one year = 60000+6000 = Rs. 66000 • Investment value in dollar terms = 66000/67 = $985 • Loss in investment value = $1,000 - $985 = $15
- 11. Interest Rate Risk •The risk that bond prices will fall in response to rising interest rates and rise in response to declining interest rates. • Bond prices and interest rates have an inverse relationship. • 5-year bond, issued at Rs. 100 face value, annual interest rate of 8%. • After one year, the Reserve Bank of India cuts policy interest rates.
- 12. Interest Rate Risk •As a result, all rates in the market start declining. • New 5-year bonds are issued at a lower rate of 7.5%. • Investors in the old bonds have an advantage of additional 0.5% . • Demand for old bonds will rise and price of the old bond will go up. • The price will rise up to a level at which the IRR of the cash flows from the old bond reaches about 7.5%. • This will take place for all bonds until their yields are aligned with the prevailing market rate.
- 13. Interest Rate Risk •The relationship between rates and bond prices can be summed up as: • If interest rates fall, or are expected to fall, bond prices go up. • If interest rates rise, or are expected to rise, bond prices decline.
- 14. Market Risk • Itrefers to the risk of the loss of value in an investment because of adverse price movements in an asset in the market. • The price of an asset responds to information that impacts the intrinsic value of an investment.
- 15. Systematic and UnsystematicRisk • Total risk consists of two parts. • Part of risk that affects the entire system is known as systematic risk. • Part that can be diversified away is known as unsystematic risk.
- 16. Systematic Risk • Systematicrisk or market risk refers to those risks that are applicable to the entire financial market or a wide range of investments. • Also known as undiversifiable risks. • Cannot be eliminated through diversification. • Caused due to factors that may affect the economy/market. • Changes in government policy, external factors, wars or natural calamities.
- 17. Systematic Risk • Inflationrisk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks. • The 2008 financial crisis affected economic growth and led to depressed equity prices across all stocks. • The RBIs move to increase interest rates in order to control inflation. This led to a fall in the prices of all bond during that period. • The depreciation of the rupee in 2013 increased the costs of imports into the country. It affected the profitability of all companies whose inputs involved imported commodities.
- 18. Unsystematic Risk • Unsystematicrisk is the risk specific to individual securities or a small class of investments. • It can be diversified away by including other assets in the portfolio. • Also known as diversifiable risk. • Credit risk, business risk, and liquidity risks are unsystematic risks.
- 19. Measuring Risk • Riskis defined as deviation of actual returns from expected return. • Measurement of risk needs data for actual and expected returns. • Thus, while evaluating the risk of an investment two types of information are needed: • 1. The future values of return • 2. The likelihood of occurrence, or probability estimate for each return value
- 20. Measuring Risk • Inreal life its not possible to estimate future returns or the range of return. • Nor can we assign accurate probabilities. • Investors only have a single series of past observations, from which both actual and expected returns have to be extracted. [Estimation] • Investors tend to expect on the basis of historical data, it is common to represent expected returns by an average return.
- 21. Measuring Risk: StandardDeviation & Variance • The most common measure of risk is standard deviation (σ). • The SD is the average deviation of observed returns from the average return over a time period.
- 22. Computation of SD 1.Calculate average return (X ̄ ) of the series for which SD is to be computed 2. Calculate deviations (𝑑) of each actual return value from the average return. 3. Square this deviation (𝑑2) 4. Add up all the squared deviations ( 𝑑2) 5. Square root of the ( 𝑑2 ) 6. σ = ( 𝑑2) 𝑁
- 26. Return expectations fora given σ • The mean and standard deviation can be used to estimate the range within which the returns will fall for an investment whose returns follow a normal distribution. • The mean and standard deviation are connected by the 68-95-99.7 rule. • 68% of the returns are distributed within ±1 standard deviation of the mean. • 95% of the returns are distributed within ±2 standard deviation of the mean • 99% of the returns are distributed within ±3 standard deviation of the mean. • Since the mean represents average return, and standard deviation represents risk, the normal distribution allows us to estimate risk in terms of mean and standard deviation.
- 27. Return expectations fora given σ • Neeraj is considering two investment options: • Option A X ̄ returns = 12%, σ = 2.5%. • Option B X ̄ returns = 12%, σ = 4.5%. • As his investment adviser how would you explain the risk in the investments using this data? • Since it is assumed that the investment returns follow a normal distribution pattern, the range of returns that the investment can take can be estimated using the 68-95-99.7 rule.
- 28. Option A • Themaximum return that the investment can take 99% of the times is Mean+3 times • Standard Deviation = 12% + 3 (2.5%) = 12% + 7.5% = 19.5% • The minimum return that the investment can take 99% of the times is Mean – 3 times • Standard Deviation = 12% - 3(2.5%) = 12%-7.5% = 4.5% The returns will range between 19.5% and 4.5%. • Option B • The maximum return that the investment can take 99% of the times is Mean+3 times • Standard Deviation = 12% + 3(4.5%) = 12% + 13.5%= 25.5% • The minimum return that the investment can take 99% of the times is Mean – 3 times • Standard Deviation = 12% - 3(4.5%) = 12%-13.5% = - 1.5% The returns will range between 25.5% and - 1.5% Since the range that the returns from Option B can take is wider (25.5% to -1.5%) the volatility is higher and therefore the investment is riskier. Higher the standard deviation of the returns from an investment, greater is the range the returns can fall in and therefore greater in the volatility and risk in the investment.