▪ The dictionary meaning of risk is the possibility of loss

or injury ; the degree or probability of such loss

▪ In the terms of investment, the risk is the chance that
the actual outcome of an investment will differ from
the expected outcome ( here outcome mean return)
▪ Risk is defined as the volatility of returns.
▪ Each investor has a unique risk profile that determines
their willingness and ability to withstand risk. In
general, as investment risks rise, investors expect
higher returns to compensate for taking those risks.
▪ Risk can be reduced using diversification and hedging
strategies.
 There is distinction between risk & uncertainty
✓ Risk refers to a situation where the decision
maker knows the possible consequence of a
decision & related likelihoods. It can be
quantified
✓ Uncertainty involves a situation about the
likelihood of possible outcome is not known.
Uncertainty cannot be quantified
❖ Wrong method of investment
❖ Wrong timing of investment
❖ Wrong quantity of investment
❖ Natural calamities
❖ Maturity period or length of investment
❖ National & international factors
1. Systematic Risk
✓ Market Risk
✓ Interest rate Risk
✓ Purchase Power Risk
2. Unsystematic Risk
✓ Business Risk
✓ Financial Risk
1. Systematic Risk :
• It affects the entire market.
• The economic conditions, political situations &
sociological changes effect the security market.
• Systematic risk, also known as “undiversifiable risk,”
“volatility” or “market risk,” affects the overall market,
not just a particular stock or industry.
• This risk is largely unpredictable and generally viewed
as being difficult to avoid.
• Investors can somewhat mitigate the impact of
systematic risk by building a diversified portfolio.
❖ Jack Francis has defined market risk as that portion of
the total variability of returns that is caused by the
alternating forces of bull and bear markets.
❖ When the stock market moves upwards, it is known as
bull market. On the other hand, when the stock market
moves downwards, then it is known as bear market.
❖ The two forces that affect the market are:
✓ Tangible events: Earthquake, war, political uncertainty and
decrease in the value of money are some of the examples of
tangible events.
✓ Intangible events: It is related to market psychology. Political
unrest or fall of government affects the market sentiments.
✓
❖ It is the risk caused by the variations in the market
interest rates.
❖ Investment value will change due to changes in interest
rates i.e. Prices of debentures, bonds, etc. are affected by
the interest rate risk.
❖ It is not desirable to invest in securities during an inflationary
period
❖ The causes of interest rate risk are as follows:
✓ Changes in the government’s monetary policy
✓ Changes in the interest rate of treasury bills
✓ Changes in the interest rate of government bonds
❖ Variations in returns are caused by the loss of
purchasing power of currency. With the rise in
the inflation there is reduction of purchasing
power
❖ There are mainly two types of inflation:
❖ Demand-pull inflation: The demand for goods and
services remains higher than the supply.
❖ Cost-push inflation: There is a rise in price due to
the increase in the cost of production.
❖Unsystematic risk is due to the influence of internal
factors prevailing within an organization. Such factors
are normally controllable from an organization's point of
view.
❖It is a micro in nature as it affects only a particular
organization. It can be planned, so that necessary actions
can be taken by the organization to mitigate (reduce the
effect of) the risk.
❖The types of unsystematic risk are depicted and listed
below.
✓ Business risk
✓ Financial Risk
 A) Business Risk : arises from inability of a firm to
maintain its competitive edge & growth or stability
of the earning. Business risk is divided into two
parts.
1. Internal Business Risk :
✓ Fluctuations in sales

✓ R&D
✓ Fixed cost

✓ Personnel management

✓ Single Product

2. External Risk : which are beyond companies'

control
✓ Social & Regulatory factors

✓ Political Risk
✓ Business Cycle
B) Financial Risk : the risk that the company will
not have sufficient funds to meet its financial
needs is termed as financial risk. The risk arises
when companies use debt securities for raising
finance. The companies, which issue more debt
securities, will have higher financial risk.
Can we measure Risk and Return?
❑ Historical Return and Risk
▪ Measuring Return
✓ Statistical Tools
▪ Measuring Risk
✓ Statistical tools
❑ Expected Return and Risk
▪ Measuring Expected Return
▪ Measuring expected Risk
 The return from the stock includes both current
income & capital gain caused by the
appreciation of the price

Ri = Dt + (Pt+1 - Pt )
Pt
= Cash divided + Purchase Change
Purchase Price
 Smithline Health Cares’ share price on Feb 202
was Rs 401 & Price on July 2021, was Rs 480.
Dividend received was Rs 35. What is the rate
of return?
 The two most popular summery statistics are
 Arithmetic Mean
 Geometric Mean
Arithmetic Mean
R=
R i

N
where
Ri = i th value of the total return ( i = 1, 2, ....n)
N = No. of total returns
Geometric Mean
▪ Investor may hold their investment in shares for
longer period than one year. Then he gets compound
rate of return.
▪ Geometric Mean return is the compounded rate of
return on a investment.
▪ It is defined as the nth root of the product resulting
from multiplying a series of returns together .

GM = (1 + R1 ) (1 + R2 )......(1 + Rn ) n − 1
1

where
Ri = total return for period i ( i = 1, 2, ....n)
n = number of time periods
 The most commonly used measures of
Variability or Risk in finance are
 Standard Deviation

 ( R − R) i
2

= i =1
N −1
 or

 Variance 2
Expected Return
 Develop the probability distribution.
 It is the probability weighted average of all the possible
returns.

n
E ( R ) =  Ri Pi
i =1

where
Ri = return from security under state i
Pi = probabilit y that the state i
n = no. of possible states of the world
▪ E(R)=R1 X P1 + R2 X P2 +…….. Rn X Pn
Probability Return On Return On
Stock A Stock B
.20 5% 50%
.30 10% 30%
.30 15% 10%
.20 20% -10%
Expected Risk
 It is the variance or standard deviation of the
probability distribution of possible returns.
n
E ( ) =  Pi Ri − E ( R )
2

i =1

where
Ri = return from security under state i
Pi = probability that the state i
E ( R ) = Expected Return on security i
n = no. of possible states of the world
 Company A Company B

Ri Pi Ri Pi

6 .10 4 .10

7 .25 6 .20

8 .30 8 .40

9 .25 10 .2

10 .10 12 .10

Calculate Expected Return & Expected Risk

 Security A Security B

Ri Pi RiPi Ri Pi

6 0.1 4 0.1
0.6
7 0.25 6 0.2
1.75
8 0.3 8 0.4
2.4
9 0.25 10 0.2
2.25
10 0.1 12 0.1
1

8 8
 Security A
Security B

Pi[R-
Pi[R-
Ri Pi RiPi R-E(R) [R-E(R)] Ri Pi RiPi R-E(R) R-E(R) E(R)]
E(R)] )

6 0.1 0.6 -2 4 0.4 4 0.1 0.4 -4 16 1.6

7 0.25 1.75 -1 1 0.25 6 0.2 1.2 -2 4 0.8
8 0.3 2.4 0 0 0 8 0.4 3.2 0 0 0
9 0.25 2.25 1 1 0.25 10 0.2 2 2 4 0.8
10 0.1 1 2 4 0.4 12 0.1 1.2 4 16 1.6

E(R)=8 1.3 8 4.8

1.14 2.19
 A stock costing Rs 120 pays no dividends. The
possible prices that the stock might sell for at
the end of the yr with the respective
probabilities as follows:
Price ( Rs) Probability
115 .1
120 .1
125 .2
130 .3
135 .2
140 .1

1. Calculate the expected return

2. Calculate Expected Risk
 The Market 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 market risk
and vice versa.
 It is measured by a statistical measure called Beta
 Statistical Tools
 Correlation Method
 Regression Method
▪ The beta (β) of an investment security (i.e. a
stock) is a measurement of its volatility of
returns relative to the entire market.
▪ It is used as a measure of risk. A company with
a higher beta has greater risk and also greater
expected returns.
▪ The beta coefficient can be interpreted as
follows:
✓ β =1 exactly as volatile as the market
✓ β >1 more volatile than the market
✓ β =0 uncorrelated to the market
✓ β <0 negatively correlated to the market
▪ Beta Value Equal to 1.0
If a stock has a beta of 1.0, it indicates that its price activity is
strongly correlated with the market. A stock with a beta of
1.0 has systematic risk. However, the beta calculation can’t
detect any unsystematic risk.
▪ Beta Value Less Than One
A beta value that is less than 1.0 means that the security is
theoretically less volatile than the market. Including this
stock in a portfolio makes it less risky than the same
portfolio without the stock.
▪ Beta Value Greater Than One
A beta that is greater than 1.0 indicates that the security's
price is theoretically more volatile than the market.
▪ Negative Beta Value
Some stocks have negative betas. A beta of -1.0 means that
the stock is inversely correlated to the market benchmark.
This stock could be thought of as an opposite, mirror image
of the benchmark’s trends. Put options are designed to have
negative betas.
Correlation Method

rim i m
i =
 m2

Where
Rim = correlation coefficient between the returns of stock i and
the returns of the market index
δi = S.D of returns of stock i
δm = S.D of returns of the market index
 m2 = variance of market returns
Regression Method
 The regression model postulates a linear relationship
between a dependent variable (security’s return) and an
independent variable (market return)

Y =  + X
Where
Y = dependent variable
X = independent variable
α and β are constants

 β : measures the change in the dependent variable in

response to unit change in the independent variable.
 α : measures the value of the dependent variable even when
the independent variable has zero value.
The formula used for the calculation of α and β are:
Where
 =Y − X
nXY − (X )(Y )
 =
nX 2 − (X ) 2

n = number of items
Y = mean value of the dependent variable scores
X = mean value of independent variable scores
Y = dependent variable scores
X = independent variable scores
 Monthly return data (%) are presented below
for ITC stock & BSE National Index for a month
period.
MONTH ITC BSE National Index
1 9.43 7.41
2 0 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20 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 the Beta of ITC stock
MONT ITC(Y) BSE X2 XY
H National
Index(X)
1 9.43 7.41 7.41*7.41=54 7.41*9.43
.90 =69.87
2 0 -5.33 =28.40 0
3 -4.31 -7.35 54.02 31.68
4 -18.92 -14.64 214.32 276.98
5 -6.67 1.58 2.92 -10.53 Y’=111.69/12 9.31
6 26.57 15.19 230.74 403.59 X’=49.82/12 4.15

7 20 5.11 26.11 100.22

8 2.93 0.76 .58 2.22
9 5.25 -0.97 .94 -5.09
10 21.45 10.44 108.99 223.93
11 23.13 17.47 305.20 404.08
12 32.83 20.15 406.02 661.52
∑Y=111.69 ∑X=49.82 ∑X2 ∑XY=
=1433.14 2158.47
MONT ITC(Y) BSE X2 XY
H National
Index(X)
1 9.43 7.41 7.41*7.41=54.9 9.43*7.4
1=69.87
2 0 -5.33 28.4 0
3 -4.31 -7.35 54.02 31.67
4 -18.92 -14.64 214.32 276.98
5 -6.67 1.58 2.50 -10.38 Y’=111.69/12 9.31
6 26.57 15.19 230.74 403.59 X’=49.82/12 4.15

7 20 5.11 26.11 102.20

8 2.93 0.76 .58 2.23
9 5.25 -0.97 .94 -5.09
10 21.45 10.44 108.99 223.38
11 23.13 17.47 305.20 404.08
12 32.83 20.15 406.02 661.52
∑Y=111.69 ∑X=49.82 ∑X2 ∑XY=
=1433.14 2158.47
 =Y − X
nXY − (X )(Y )
=
nX − (X )
2 2

Beta=(12*2158.47 ) – (49.82*111.69) = 25901.64 – 5564.39 = 20337.25

(12*1433.14 ) - (49.82)^2 17197.68 - 2482.03 14715.65

= 1.38

Alpha= 9.31- 1.38*4.15 =3.58

▪ A portfolio is a bundle or a combination of individual assets or
securities.
▪ Portfolio theory provides a normative approach to investors to
make decisions to invest their wealth in assets or securities under
risk
▪ The return of a portfolio is equal to the weighted average of the
returns of individual assets (or securities)
Formula is
Expected return(p) = (w1 * r1) + (w2 * r2)

w1 = weight of 1st investment in the portfolio

w2 = weight of 2nd investment in the portfolio
r1 = rate of return of 1st investment in the portfolio
r2 = rate of return of 2nd investment in the portfolio
The standard deviation of a two-asset portfolio is
calculated as:
σP = √(wA2 * σA2 + wB2 * σB2 + 2 * wA * wB * σA *
σB * ρAB)
Where:
σP = portfolio standard deviation
wA = weight of asset A in the portfolio
wB = weight of asset B in the portfolio
σA = standard deviation of asset A
σB = standard deviation of asset B; and
ρAB = correlation of asset A and B asset
An Investor holds two equity shares x and y in
equal proportion with the following risk and
return :
E(Rx)= 24%, E(Ry)= 19%, σx=28%, σy=23%,
δxy=0.6
You are required to calculate portfolio return and
risk.
Further , if investor want to reduce the portfolio
risk to 15%, how much should the correlation
coefficient be to bring the portfolio risk to the
desired level?
A) ERp = (w1 * r1) + (w2 * r2)
= .5 *24+ .5 *19=12.0+9.5=21.5

σP = √(wA2 * σA2 + wB2 * σB2 + 2 * wA * wB * σA *

σB * ρAB)
= √ (.5)^2 (28)^2+ (.5)^2 (23)^2+ 2*.5*.5*28*23*0.6
=15.17
B) σP = √(wA2 * σA2 + wB2 * σB2 + 2 * wA * wB * σA *
σB * ρAB)
15=
 A stock costing Rs 120 pays no dividends. The
possible prices that the stock might sell for at
the end of the yr with the respective
probabilities as follows:
Price ( Rs) Probability
115 .1
120 .1
125 .2
130 .3
135 .2
140 .1

1. Calculate the expected return

2. Calculate the standard deviation of return
Returns of security

Beta

Alpha Beta
Beta

Returns of market