Name: Nidhi N.

Shah
Roll no.: 28

Q1 What do you understand by risk and measurement of risk? Explain the factors that
affect risk.
Answer: By the term risk we mean a situation in which the possible future outcome of a
present decision is plural and in which the probabilities and dimensions of their outcomes are
known in the form of a frequency distribution. Risk refers to variability. It is measured in
financial analysis generally by standard deviation or by beta coefficient. Technically risk can
be defined as a situation where the possible consequences of the decision that is to be taken
are known.
Risk is composed of the demands that bring in variations in return of income. The main
forces contributing to risk are price and interest. Risk is also influenced by external and
internal considerations. External risks are uncontrollable and broadly affect the investments.
These external risks are called systematic risk. Risk due to internal environment of a firm or
those affecting a particular industry are referred to as unsystematic risk. Unsystematic risk is
unique to a firm or industry. It does not affect the investor. Unsystematic risk is caused by
factors like labour strike, irregular disorganised management policies and consumer
preferences.
Measurements of Risk:
1. Standard deviation. The investment industry’s primary measure of risk is standard
deviation. Standard deviation really tells you how much an investment will fluctuate
from the average return. For example, if Bell Charts (by Morningstar) says that a fund
has a standard deviation of 3.0, this means that the monthly return will be 3% lower
than the average monthly return and 3% higher than the monthly return. If the average
monthly return is 2%, then the range at a 3.0% deviation is -1% to 5% (statistically,
this happens with a 68% likelihood).

2. Chance of loss. Chance of loss measures how often a fund loses money versus makes
money. Ultra-conservative investments make money 100% of the time and never lose.
At the other extreme, some Far East funds lose money as much as 60% of the time and
make money only 40% of the time. The more often a fund loses money, the greater the
patience required by the investor.

3. The magnitude of loss. When an investment loses money, how much could a fund
lose in any given year? Measuring this will tell us the tolerance we have for loss.
Suppose a fund loses as much as 40% in any given year. That means a $100,000
investment becomes $60,000. More conservative funds might only drop 10%, a level
much more tolerable to many, especially nervous, investors. Bell Charts (by
 Morningstar) uses a figure called worst 1-year return to measure the magnitude of
loss.

4. Draw down. According to Levi Folk of Fundlibrary.com, “A draw down is the loss

incurred in a fund from any high point in the fund’s value until the fund recovers that
value.” Drawdowns are typically expressed as a percentage from a previous high. For
example, the maximum draw down for the AIC Advantage Fund was -37% and
occurred March of 2003. Fundlibrary.com has an incredible tool that helps investors
understand drawdowns of various mutual funds.

5. Beta ratios. Beta ratios are used to measure the risk of an investment relative to the
risk of a comparable market benchmark. If we look at the Canadian Equity Funds, the
Mackenzie Ivy Canadian Fund has one of the lowest Betas at 0.36. On the other end of
the spectrum, the Mavrix Growth fund has the highest beta at 2.00. What do these
numbers mean? If a fund has a beta of 1.0, it is said to have the same risk as the
market. Thus, the Mavrix Growth Fund with a beta of 2.0 is said to have twice the risk
of the market. The Mackenzie Ivy Canadian, with a beta of 0.36 is said to have one-
third the risk of the market. Betas are often used in the industry as a relative
benchmark for risk analysis.

Factors that affect Risk

Business risk: As a security holder you get dividends, interest or principal (on maturity in
case of securities like bonds) from the firm. But there is a possibility that the firm may not
be able to pay you due to poor financial performance. This possibility is termed as
business risk. The poor financial performance could be due to economic slowdown, poor
demand for the firm‟s goods and services and large operating expenses.

Inflation risk: It is the possibility that the money you invested will have less purchasing
power when your financial goal is met. This means, the rupee you get when you sell your
asset buys lesser than the rupee you originally invested in the asset.

Interest rate risk: The variability in a security’s return resulting from changes in the level
of interest rates is referred to as interest rate risk. For example, the value of a bond may
reduce due to rising interest rates. When the interest rate rises, the market price of existing
fixed income securities fall, and vice versa. This happens because the buyer of a fixed
income security would not buy it at its par value or face value if its fixed interest rate is
lower than the prevailing interest rate on a similar security.

Market risk: Market risk is the changes in returns from a security resulting from ups and
downs in the aggregate market (like stock market). This type of risk arises when unit price
or value of investment decreases due to market decline. The market tends have a cyclic
pattern
Q2 Write about emerging markets. Explain the risk involved in international investing.
Answer: Emerging Markets:
Investing in emerging markets offers high returns but with equally high risk. These are
capital markets in developing countries, typically with low per capita GDP. While
developing countries make up over 80% of the world’s population, they make up less than
10% of the stock market capitalization. There is low correlation between emerging market
returns and returns elsewhere in the world and this aids diversification. However, as
impediments to capital market mobility fall, correlations will increase.

The following are the common features of an emerging market; however these
characteristics differ from country to country:

 Economic growth is high

 Exchange rate risk is high
 Political risk is high
 Weak legal systems and lack of effective regulation
 Minority shareholders are not protected enough
 A single majority shareholder or a group of connected shareholders (e.g. a
family) controlling a large number of companies The
 presence of large conglomerates.

There are risks involved in international investing. Some of the risks are:

1. Changes in currency exchange rates

When the exchange rate between the foreign currency (in which the international
investment is denominated) and the home currency (say, Rupee for an Indian) changes, it
can increase or decrease the investment return. Foreign securities trade and pay dividends
in the currency of their local market. When an investor receives dividends or sells his
international investment, he will need to convert the cash that he receives into his home
currency.

During a period when the foreign currency is strong compared to the home currency, this
strength increases his investment return because his foreign earnings translate into more
units of local currency. Thus, for an Indian who has made investments in the US, if the
dollar appreciates it is good news since the dollar earnings would convert into more Indian
rupees.

By the same token if the US dollar depreciates, it reduces his investment return because his
earnings translate into fewer rupees. In addition to this exchange rate risk, there is the risk
that the country may impose controls that restrict or delay moving money out of the
country.

2. Dramatic changes in market value

There can be dramatic changes in market value in Foreign markets as well like any other
market. By investing for long term and by trying to ride out the short-term downturns in the
market can help reduce the impact of these price changes. When individual investors try to
"time" the market in the domestic markets and sometimes in the foreign markets as well,
they fail in their attempt. Two decisions need to be made when one times the market-–
deciding when to get out before prices fall and when to get back in before prices rise again.

3. Political, economic and social events

Political, economic and social factors that influence foreign markets are difficult to
understand by the investors. Although these factors provide diversification, they also
contribute to the risk of international investing.

4. Lack of liquidity
Foreign markets may have lower trading volumes, fewer listed companies and may be
open only for a few hours in a day. In some countries there are restrictions on the amount
or type of stocks that foreign investors may purchase. To buy a foreign security an investor
may have to pay premium prices and may also have difficulty finding a buyer when he
wants to sell the security.

5. Less information
In many cases investors don’t get the same type of information in the case of foreign
companies as in the case of domestic companies. The investors may not be able to find up-
to- date information and the investor may not be able to understand the language used by
the company.

6. Reliance on foreign legal remedies

The investor may not be able to sue the company in his own country’s courts and even if
he is able to sue successful in a domestic court, he may not be able to collect on a home
country judgment against a foreign company. The investor will have to rely on legal
remedies are available in the company's country.

7. Different market operations

The operations in the domestic country’s trading markets will be different from that of
foreign markets. For example, there may be different periods for clearance and settlement
of security transactions. Home markets may report stock trades much faster than foreign
markets. Rules providing for the safekeeping of shares held by custodian banks or
depositories may not be as well-developed in some foreign markets, with the risk that the
investors shares may not be protected if the custodian has credit problems or fails.