S AmmeuY- Uol Din

MBA 3ro Semester

CobitalMar Kels A investme

Risk

of risk.
Every invesiment is characterised by return and risk. The concept
is intuitively understood by investors. In general, it refers to the possibility
of incurring a loss in a financial transaction. But risk involves much more
than that. The word 'risk has a definite financial meaning.

MEANING OF RISK
to get some rehurn fron the
A person making an investment expects
investment in the future. But, as future is uncertain, so is the future expected
return It is this uncertainty associated with the returns from an investment
that introduces risk into an investment.
We can distinguish between the expected retun and the realised return
froin an investment. The expected return is the uncertain future return that
an investor expects to get from his investment. The realised return, on the
contrary, is the certain return that an investor has achually obtained from
his investment at the end of the holding period. The investor makes the
investment decision based on the exped return from the in nt.
The actual return realised from the investment may not correspond to the
expected return. This possibility of variation of the actual returrn from the
expected return is termed risk. Wher realisations correspond to expectations
exactly, there would be no isk. Risk arises where there is a possibility. of.
variation between expectations and reaisations with regard to an investment.
Thus, risk can be definéd in terms of variability of returns. "Risk is the
potential for variability in returns." An investment whose returns are
fairly stable is considered to be a low-risk investment, whereas an investment
whose returns fluctuate significantly is considered to. be a high-risk
investment. Equity shares whose returriS are likely to fluctuate widely are
considered risky imvestmernts. Govermment securities, whose refuns are
fairly stable are considered to possess low risk.
19
 20 POATFOLKO MANAGEMENT

ELEMENTS OF RISK
r e t u r n s . This
variation in its
is the
investment factors which
of risk in an factors. These
The essence
number of
variation in retums is caused byfrom a n i n v e s t m e n t constitute the elements
a

in the returns
variations
produce
debentures,
of risk. such as shares,
the risk in holding securities, The
Let us consider into two groups.
The elements of risk may be broadly classified and affect a
etc.
are external to
a company
factors that
first group comprises
are mostly uncontrollable
number of securities simultaneously. These to
large which a r e internal
nature. The second group includes those factors
in
cormpanies. These are controllable
companies and affect only those particular
is known
to a greàt extent. The risk produced by
the first group of factors
is known a s
as and that produced by the second group
systematic risk,
unsystematic risk.
the total risk of
The total variability in returns of a security represents
that security. Systematic risk and unsystematic risk are
the two components
of total risk. Thus,
risk Unsystemaic risk
Total risk =
Systematic +

Systematic Risk
As the society is dynamic, changes occur in the economic, political and
social.systems constantly. These char have an influence on the
performance of companies and thereby 1 their stock prices. But these
changes affect all companie_ and all semauities in varying degrees. For
example, economic and political in1stability adversely affects all industries
and companies. When an economy moves into recession, corporate profits
will shift downwards and stock prices of most companies may decline.
Thus, the impact of economic, political and social changes is system-wide
and that portion of total variability in security returns çaused by such
system-wide factorS -is referred to as systematic risk. Systematic risk is
further subdivided into interest rate risk, market risk, and purchasing
power risk.
Interest Rate Risk
Interest rate risk is a type of systematic risk that particularly affects debt
securities like bonds and debentures. A bond or debenture normally has
a fixed coupon rate of interest. The issuing company pays interest to the
bond holder at this coupon rate. A bond is normaly issued with a coupon
. rate which is equal to the interest rate prevailing in the market at the time
of issue. Subsequent to the issue, the market interest rate may change but
the coupon rate remains constant ill the maturity of th instrument. The
 RISK 21

change in market interest rate relative to the coupon rate of a bond caises
changes in its market price.
A bond having a face value of Rs. 100
issued with a coupon rate of ten
is also ten per cent will have
a
market interest rate
per cent when the rate
of Rs. 100. If, subsequert to the issue, the market interest
market price cent
to 12.5 cent; no. inivëstor will buy the bond with ten per
moves up per to
of the bond reduces the price
coupon interest rate untess the holder, of the bond gets
Rs. 80, the purchaser
Rs. 80. Whénthe price is reduced to to a return
80 which is equivalent
interest of Rs. ten on a n investnent of Rs. rate.
the prevailing market interest
of 12.5 per cent which is the s a m e as relation to
rate m o v e s up in
Thus, we that as the market interest
see
Similarly,
rate, the market price of the bond declines.
the coupon interest is a drop.in
move up when there
the market price of the bond would other words, the
market interest rate compared to
the coupon rate. In
to the market
debentures is inversely related
market price of bonds and fluctuates in
of debt securities
market price
interest rates. As. a result, the
This variation in bond
to variations in the market interest rates.
response known as interest
due to the variations in interest rates is
prices caused
rate risk. on stock prices
The interest rate variations have
an indirect impact
ie. purchasing stock on
Speculators often resort to margin trading,
also.
As interest rates increase, margin trading
margin using borrowed funds. push down
becomes less attractive. The lower demand by speculators may
when interest rates fall.
stock prices. The opposite happens finance their operatión. When
companies use borrowed funds to
Many borTOwed funds have to make
interest rates move up, companies using
to lower earnings, dividends and share
higher interest payments. This leads
interest rates nay push up earnrings andd
prices. On the contrary, lower
in interest rates may indirectly influence
prices. Thus, we see that variations
risk which affects bonds
stock prices. Interest rate risk is a systematic
directly and shares indirectly.
Market Risk
Market risk is a type of systematic risk that affects shares. Market prices
of shares move up or down consistently for some time periods. A general
rise in share prices is referred to as a bullish trend, whereas a genieral fal
in share prices is referred to as a bearish trend. In other words, the sháre
market altenates between the biullish phase and the bearish phase. The
alternating movemernts can be easily seen in the movement of share price
indices such as the B^E Sensitive Index, BSE National Index, NSE ndex
etc.
.Business cycles are considered to be a major determinant of the timing
and extent of the bull and bear phases of the market. This would suggest
that the ups and downs in share markets would follow the expansion and
 2PORTFOLUO MANAGEMENT
true in the long
r u n , but it
This may be
r e c e s s i o n phase
of the economy. m o v e m e n t s in
the m a r k e t .
short-term
does not sufficiently
explain the market is caused by sweeping
in the stock reactionns
The short-term volatility the result of investor
expectations which
are reaction
changes in investor of the
as intangible events. The basis
to certain tangible as well such a s
events, political, economic or social,
may be a set of real tangible in monetary policy, etc. The change
the fall of a government, drastic change events.
is usually initiated by the reaction to real
in investor expectations emotiornal
the intangible factor of
But the reaction is often aggravated by
and irrationady, leading
instability of investors. They tend to act collectively
to an overreaction.
leads to variatiorns
The stock market is seen to be volatile. This volatility
in the returns of investors in shares. The variation in returns
caused by the
volatilityy of the stock market is eferred to as the markef risk.
Purchasing Power Risk
Another type of systematic risk is the purchasing power risk. It refers tao
the variation in investor returns caused by inflation.
When
nflationresults in lowering of the purchasing power of
an investor purchases a
money.
security, he foregoes the opportunity to buy sorme
goods or services. In other words, he is postponing his consumption.
Meanwhile, if there is infiation in the economy, the prices of goods arLd
services would increase and thereby the investor acttualy experiences a
decline in the purchasing power of his invesiments and the return fron
the investment. Let us consider a
simple exnple. Suppose a person lends
Rs. 100 today at ten per cent interest. e winili
get back Rs. 110 after one
year. If during the year, the prices have mcreased by eight per
Rs. 110 received at the end cent
of the year wi hav a purchasing power of
only Rs. 101.20, ie. 92 per cent of Rs. 110. Xtns, inflation causes a variation
in the purchasing
power of the returns from an nvestment. This is known
as
purchasing power risk and its impact is wniformly felt on all securities
in the market and as such, is a
The two important sources of
systematic risk.
inflation are rising costs of
and excess demarnd
for goods and production
are known as cost-push and
services in relation to their
supply. They
demand-pull inflation
supply cannot be increased,respectively.
demand is increasing but When
increases thereby forcing out some of the excess demandprice of the goodss
and bringing the
demand and supply into
equilibrium. This phenomenonis known as demand
pull inflation. Cost push inflation occurs
increases and this încrease in cost is passedwhen the cost of production
on to the consumers
producers
n an,
through higher prices öf goods.
by the
inflationary economy, rational, investors would include arn
allowance for the purchasing
a e of power risk in their estimate of the
retum from an investunent. In
refurn would be
expected
other words, the expected rate of
adjusted upwards by the estimated annual rate of
inflation
 FISK 223

Unsystematic Risk
factors
The retyurns from a security may sometimes vary because ofarecertain
raw material
affecting only the company issuing such security. Examples
labour strike, management inefficiency. When variability of returns
scarcity, it is known as unsystematic
occurs because of such firm-specific factors,
industry and affects
risk. This risk is unique or.peculiar to a company or
all securities.
it in addition to the systematic risk affecting from
The unsystematic or urnique risk affecting
specific securitjes arises the
(6)
two sources: (a) the operating
ènvironment of the company, and
unsystematic
company. These two types of
financing pattern adopted by the isk respectively.
risk and financial
risk are referred to as business

Business Risk
environment. This
within a particular operating
Every company operates internal environment within
the
environment comprises. both of thesé
operating
firm arnd external environment
outside the firm. The impact
costs of the company.
conditions is refected in the operating
operating fixed costs and variable costs.
costs can be segregated into. the
The operating disadvantageous toa company. If
costs is
A larger proportion of fixed to s o m e reason or
the other,
of such a company declines due
total decline in its operaing profits
r e v e n u e

would be.a m o r e than proportionate is said to

there
unable to reduce its fixed costs. Such a firm
because it would be
face a larger business risk. the operating conditions.faced by
a
thus function of
Business risk is a
caused by the operating
and is the variability in operating income
company
conditions of the cornpany.

Financial Risk the use of debt

of financial levetage which is
Financial risk is a function creates
presence of
debt in the capital structure
in the capital structure. The which is. a compulsory payment
to
fixed paymentsin the form
of interest interest
nakes profit or loss. This fixed
be made whether the company availabile
creates m o r e variability
in the earnings per share (EPS)
payment
example, 'if the rate of return or operating
toequity share holders. For EPS wouldA
than the interest rate payable on the debt,
profit ratio is higher ratio is lower than the
increase. On the contrary,
if the operating profit EPS in
The increase or decrease in
interest rate, EPS would be depressed. be much wider in the
case
profit would
response. to changes in operating debt in its capital structure) than in.
firm (a company having
of a levered
the case of àn unleverèd firn.
of debt in the capital structure
This variability in EPS due to the presence
risk. This is specific to each company
.

of a company is referred to as financial avoidable risk

of unsystermatic risk. Financial risk is an
and forms part its activities without resorting
to
is free to finance its
in so far as comparny
a

debt.
. ,
4 PORTFOLIO MANAGEMENT

MEASUREMENT OF RISK
that he
to anticipate the kind of risk
An intelligent investor would
attempt
to estimate the
extent of risk
He would also attempt
i_ likely to face. proposals. In other words, he tries
to
associated with different investment before
risk of each investment that he considers
quantiky the
is thus necessary for
measure o r

the finaB selection. The quantification of risk

making
investment analysis.
investment is associated with reurn
The risk of an invest1rent
Risk in
return. The return, in turn, depends
cannot be measured without reference to the
cash inflows to be received from the investment. Let us consider
onthe share, an investor expects
purchase of a share. While purchasing an equity In addition, he expects
to receive future dividends declared by the company.
sold.
to receive thé selling price when the share is finally
120. An investor who-is
Suppose a share is currently selling at Rs. a dividend of
interested in the share anticipates that the company will pay
at Rs. 175 after
Rs. 5 in the next year. Moreover, he expects to sell the share
one year. The expected return from this investment can be calculated as
follows:.

R=
RForecasted dividend +Forecasted end of the period stock price
Initial investrient

175
RR= Rs. Rs. Rs.
5+
120 1 = 0.5 or 50er KNT

In this case the investor expects s get a retum of 50 per cent in the
future. But the future is uncertain. The diridend declared by the company
may turn out to be either more or less thar1 the figuie anticipated by the
investor. Similarly, the selling price of the stock may be less than the price
anticipated by the investor at the time of investment. It may sometimes be
even more. Thus, there is a possibility that the future return may be mor
than 50 per cent or less than 50 per cent. Since the future is uncertain the
investorhas to consider the probability of several other possible returns.
The expected returns may be 30 per cent, 40 per cent, 50 per cent, 60 per cent
or 70 per cent. The investor now has to assign the probabílity of occurrence
of. these poss+bBe alternative returns. An example is given below:

Possible
.
returns (in per cent) Probability of occurrence
PRAD
30 0.10
40 :0.30
50 040
60 0.10
0.10
 RISK 25

This table gives the probabiïlity distribution of possible returns from an

investment în shares. Such a distribution can be developed by the investor
by studying the past data and modifying it appropriately for the changes
he expects to occur in the futiure.
The information contained in the probability distribution has to be
reduced to two simple statistical measures in order to aid investment
decisionmaking. These measures are summary statistics. Onemea_ure would
meásure
indicate the' expected return fromn the investment and the other
would indicate the risk of the investnent.

Expected Returr
The expected return of the investmernt is the probability weighted.average
are denoted by X, and the
of all the possible returns. If the possible returns
be represented as
related probabilities are p(X), the expected return may
a n d can be calculated as:

It is the sum of he products of possible retums with their respective

probabilities above can be
The expected returm of the share in the example given
calculated as shown below:
Calculation of Expected Return

Poss+ble returns Proibabilily

pX)
30 0.10 3.0
0.30 12.0
40
0.4 20.0
50
0.10 6.0
60
0.10 7.0
70

Xp(X) = 48.0

Here, the expected return is 48 per cent.,

Risk
The risk aspect should
*w***i*r***********

Epected returns are insufficient for decision-making.

m e a s u r e of risk is the varíance or
also be cansidered. The most popular of possible returns.
standard deviation of the probability distribution
26 PORTPOLIO MANAGEMENT
following
calculated by the
o2 and is
denoted by
Variance is u_ually
formula:

example.
calculations in the c a s e of our
the required
The table below provides
Product
Deviatiom
Probability
Deviation ( Kp(X)
Possible (X-X squared
retura p(X (X-
X 32.4
-18 324
0.10 19.2
30 64
0.30 8 1.6
40
50 0.40 14.4
12 144
60 0.10 48.4
484
70 0.10 22
= 116.0

Variance 1166 per cent as

of the variance and is represented
=

root
Standard deviation is the square 10.77 per cent.
example is.116
=
in our
a. The standard deviatiorn
the extent of variability
variance and standard deviation measure
The other measures such
returns from the expected returrn Several
of possíble used to
semi-variance and m e a n
absulte deviation have been
as range, most popularly accepted
measure
standard deviatiox1. Faa benn the
risk, but
measure. distribution of possible
In the method described above. he robability
propOsal is t
investment expected return
to stimate the
returns from a n valuee
i}em e a n gives the expected
from the investnent and its variability.
deviaticn gives the variability. This widely
and the variance or standard
risk is known as the mean-variance approach
used procedure for assessing
a m e a s u r e of
The standard deviation or variance, however, provides
Total risk comnprises of two
the total risk associated with a security.
components, namely systematic risk and uunsystematic risk. Unsystematic risk
risk is risk which unique to a company. Unsystemnatic
is specific or
can bé reduced by
associated with the security of a particuBar company
characteristics. This
combining it with another security having opposite As a result of
process is known as diversification of investment. with
diversification, the învestment is spread over a group of securities
different characteristics. This group of securities is called a' portfolio:
AS far as an investor is concerned, the unsystematic risk is not very
be reduced or eliminated through diversification. It is
important as it can
 AUSK 27

an irrelevant risk. The risk that is relevant in investment

decision-making
is the systemmatic risk because it is undiversifiable. Hence, the investor
seeks to measure the systematic risk of a security.

Measurement of Systematic Risk

Systematic risk is the variability in security returns caused by ch¡nges in
the economy or the market. All securities are affected by such changes to
someextent, but some securities exhibit greater variability in response to
market changes. Such secuirities áre said to have higher systematic risk.
The average effect of a change in the economy can be represented by the
change in the stock market index: The systematic 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 systematic
risk and vice versa.
The systematic risk of a security is measured by a statistical measure
called Beta. The input data required for the calculation of beta are the
historical data of returns of the individual security as well as the returns
of a representative stock market index. Two statistical methods may be
used for the calculation of Beta, namely the correlation method or thhe
regression method.
Using the correlation method, beta can be calculated from the historical
of returns by the following formula:
data
= Tim a

where
Correlation coefficient betweern the retiarns of stock i and the
T
returns of the market index. .
Standard deviation of returns of stock i.
o Standard deviation of returns of the market index.
o=Variance of the market returns.
The second method of calculating beta is by using the regression method.
The regression model postulates a linear relationship betweena dependent
variable and an independent variable. The model helps to calculate the
vauès of two constants, namely a and B. B measures the change in the
dependent variable in response to unit change in the independent variable
while a measures the value of the dependent variable even when the
independent variable has zero' value. The form of the regression equation
is asfollows:
Y= a+ BX
28 PORTFOLIO MANAGEMENT

where Dependent
variable.
Y =

X Independent variable.
constants. below.
a and ß are
of a and B a r e given
calculation
used for the
The formula
'a Y-BX
A nXY-(EXYE)
nEX-(EX

where
n Number of items. variable scores.
= Mean value of the dependent
Y variable scores.
X = Mean value of independent
Dependent variable
scores.
Y=
scores.
X Independent variable
security is
=

individual
the return of the
For the calculation of beta, the market
index iS
variable, and the return of
taken as the dependent variable. The regression equation is represented
taken as the independent
as follows:
R;= a +BR»
where
individual secuzity.
R=Return of the
market index.
R Return of the market is stationary.
of the secuiity nhen the
return
a =Estimated in response to unit
in the return of the indivicdiiai security
B Change the measure
of the narkei index. It is, thus,
change in the return
of systematic risk of a security.
or zero.
A security can have betas that are positive, negative
of that asset
The beta of asset, B, is a measure of the variability
an
index of the
relative to the variabiity of
the market as a whole. Beta is an
asset."2
systematic risk of an the
As beta m e a s u r e s the volatility
of a security's returns relative to
1.0
volatile the security. A beta öf
market, the larger the beta, the more 1.0 has
risk. A stock with beta greater than
indicates a seçurity of average market
would be more volatile than the
above average risk. Its returns
For example, when market
returns. returns move up by five per cent, a
stock with beta of 1.5 would find its returns moving up by 7.5 per cent (i.e.
five per cent would produce
5 x1.5). Similarly, decline in market returns by
decline of 7.5 per cent in the return of the
individual security.
a
below average risk. Variability
have
A stock with beta less than 1.0 would lesser
than the market variability.
in its returns would be comparatively
move in a directiorn
Beta can also be negative, implying that the stock returns
opposite to that of the market returns.
 RISK29

Beta is calculated fron historical data

of returns to m e a s u r e the
risk.
of secarity. It is a historical measure of systematic
systematic risk a
the investor is assuming
In using this beta for investment decision-making,
the relationship between the security
variability and nmarket variability
that also...
will continue to remain the same in future variation in returns from an
of
To' conclúde, risk is the possibility in returns. Sonme of
factors contribute to this variability
investment. Many a r e unique
and affect all securities, while some
system-wide
variability or risk of security can
these factors a r e
a
and affect only specific
securities. Total the
standard deviation or variance of
be measured by calculating the of a security.
returrns. Beta m e a s u r e s
the systematic.risk
security's that a
selling at Rs. 50. It is expected
is currently
Example 1 A share would be paid during the year and the shar
dividend of Rs. 2 per share return
Calculate the expected
end of the year.
could be sold at Rs. 54 at the
from the sha'e.

Solution

Forecasted dividend + Forcasted end of the period stock price

R Initial inv stment

254 12 per cent

0.12 or
R=
Alternatively,
R-
where
D Dividend.

P1 End of period stock price.

Po Initial strick price.

R 54-50 =0.12 or 12 per cent.

R + =0.04 +0.08
standard deviation of
Example 2 Calculate the expected return and the
stock having the following probability
di_tribution of returns.
returns for a
Passible returns (in per cent) Probability of occurnence

25 0.05
0.10
-10
0.10
15 0.15.
0.25
20
30 0:20
35. 0.15

i':.***i, *****
 PORTFOLJO MANÃGEMENT
30

Solutio
Calculation of Expected Return
Product
Possible returns Probability Kpp (Xi)
-1.25
-25
0.05
-1.00
0.10
0.00
0.10
225
15 0.15
5.00
20 0.25
6.00
30 020
5.25
35 0.15
16.25

-XP(X;) = 16.25 per cent

Calculation of Standard Deviation of Return

Deviation Deviatiom Product
Posgible returns Probability
squared
PX (XK)

0.05 1701.56 85.08

-25.
-10 0.10 **
689.06 68.91
I.5 264.06 26.41
0.10
0.15 1.56 0.23
15
20 0.25 14.06 3.52
0.20 2375 189.06 37.81
30
35 0.15 18.75 351.56 52.73
o 274.69

Variance, o =
2[(X - Xp{X)] = 274.69 per cent
Standard deviation, o =
N274.69 =1657 per cent"

Example3 A stock costing Rs. 120 pays no dividends. The possible prices
that the stock might sell for at the end of the year with the respective
probabilities are
 AISK 31

Price (Rs) Probability

0.1
115
0.1
120
0.2
125
0.3
130
135
0.2
140
0.1

1. Calculate the expected return. of returns.

the standard deviation
2. Calculate
the formula
returns have to be calculated using
Solution Here, the probable

Po
Returns
Calculation of Probable
CP- PoUPod x 100
Possible prices (P) P-Po Return per cent)
Rs. Rs.
4.17
115
0.00
120
5 4.17
125
10
8.33
130
12.50
15
135 16.67
140 20
Return
Calculation of Excpected
Product
Probable return Probability
p(X) Xp(X
-0.417
4.17 0.1
0.1 0.000
0.00
4.17 02 0.834
0.3 2.499
8.33
2500
12.50. 02
0.1 1.667
16.67
**
X 7.o83

Expected retun, = 7.08 per cent

*
32PORTFOLJO MANAGEMENT
Deviation of Returns
Calculation of Standard
Deviation Product
Probable return Probability Deviation
squared
(X- KPp(X)
p(X
12656 12.66
-4.17 0.1 -11.25
-7.08 50.13 5.01
0.00 0.1
8.47 1.69
4.17 0:2 -2.91
1.25 1.56 0.47
833 0.3
12.50 0.2 5.42 29:38 5.88
. 16.67 959 91.97 9.20

o= 34.91

Variance, o = 34.91 per cernt

Standard deviation, d= 34.91 =

5.91 per cent

Example 4 An investor has analysed a share for a one-year holding period.

The share is curtenty selling for Rs. 43 but pays no dividends and there
is a fiftyifty chance that the share will seil for either Rs. 55 or Rs. 60 by
the year'end. What is the expected rehurn and risk if 250 shares are acquired
with 80 per cent borrowed funds? Assume the cost of borrowed funds to
be 12 per cent. (1gnore-commissiors and iaxes).
Solution

Calculation of ?zobatie Reluns

ww.erem

Year-end prices (P) .{Fg Return (per cent)

(Rs.) (Rs.) fCP PoPol x
- 100

55 12 27.91
60 17 39-53

Calculation of Expected Return

Probable return Probability Product
(per cent) (Xi) pX Xp(X
27.91 0.50 13.955
39-53 0.50 19.765
X=33.720
 RISK 3 3

Calculation of Standard Deviation

Deviation squard Product
Probable return Probability Deviation . (X-X (X-p(X)
PX)
33.76 16.883
27.91 0.5 5.81 16.88
5.81 33.76
0.5
39.53 33.76

Variance, o 33.76
=

Standard aeviation, o= 5.81

Return and risk of buying 250 shares
250 x Rs. 43
Investment in 250 shares
= Rs. 10,750
Rs. 8,600
(80 per cent)
=
Borrowed funds

Expected return fron 250 shares:

Gross return =
10,750 x 33.72 - 3,624.90
-100

funds
cent on borrowed
Less: Interest at the rate of 12 per
8600x 12 =
1,032.00
100100
Net returns 2,592.90

Risk in investing in 250 shares:

10,750 x 5.81Rs. 624.58
100
ITC
cent) a r e presented belowfor
Example 5 Monthly retun data (in per
for a 12 month period.
stock and BSE National Index
BSE National Index
ITC
Month
9.43 7.41
0.00 -5.33
-4.31 -7.35
-14.64
-18.92
-6.67 358
26.57 15.19
20.00 5.11
0.76
293
5.25 0.97
1044
21.45
10
17.47
11 23.13
20.15
32.83
1233
Calculate beta of ITC stock.

' ** .*
34 POATFOLIO' MANAGEMENT

formula:
Solution Correlation coefficient is calculated with the following

nEXY (ExX) (E)

.
ynEx-(Ex)2. nEY2-(En?
'

where
X = Ore datà series (R).
Y = Other data series (R).
= Number of iterns.
Calculation of Correlation Coefficiern
FTC reiurns BSE Index return
Y2 XY
Y (R X (R
54.91 69.88
9.43 7A1 88.92 00.00
0.00 -5.33 O0.00 28.41
-4.31 -7.35 18.58 54.02 31.68
- 18.92 -14.64 357.97 214.33 276.99
-6.67 1.58 44.49 2.50 -10.54
26.57 15.19 705.96 230.74 403.60
20.00 5.11 400.00 26.11 102.20
2.93 0.76 8 58 0.58 2.23
5.25 0.97 27.55 0.94 -5.09
2145 10.44 $.19 108.99 223.94
23.13 1747 535.00 305.20 404.08
32.83 20.15 406.02 661.52
111.69 4982 323. 1432-75 2160.49

(12 x 2160.49) - (A9.32 x 111.69)

1 2 x1432.75) -(49.82) ya2 x 3724.97) - (a11.69)2

25,925.88-5564.40
17193-2482.0344,699.64 12, 474.66
20,361.448 20,36148
14,710.97 x 32,224.98 21,772.94
r =0.935
Standard deviation,.and varianice can be calculated by using the following
formula

Variance, o=.2 NEX-(EX

NZ

**
 AUSK 35

NEX(EXY
Standard deviation, o = N
where
X-Original data.
N Nwnber of items.
Standard deviation of FTC returns From the above table, the following
data are available:
N = 12
ER =111.69 ER? = 3724.97

44,699.64- 12,474.66
(12 x3724.97-(111.69)2 144
12x 12
=223.78 = 14.96

From the above

standard deviation of BSE Index returns
Variance and
table, the following data are available:
N 12
2R=49:82 LR =1432.75

2 (12x 1432.75)-(49.82)2
12 x 12

17.193-2482.0314,710.97 102.16
144 144
o = 102.16 = 10.11

Beta

Om
(0.935)(14.96 x 10.11) 141.41
102.16 102.16
B-1.384

Example 6 With the data given in example 5, calculate beta of ITC stock,
using the'regression model.

Solution
Dependent variable Y = R;
Independent variable X = R

the table prepared for solving the problem in example 5,

we.
From
have the following values:
 PORTFOLIO MANAGEMENT
36
EY = 111.69
49.82
ZXY = 2160.49 EX=
E x = 1432.75 n= 12

2 111.6=931
12

" 4.15

anEXY-(2X)2)
P nEX2 - (EX

(12x 2160.49)-(49.82 x111.69).

. (12x1432.75)-(49.82
25,925.88 - 5564.40

17,193-2482.03
20,361.48
14,710.97
B 1.384

Y BX = 931 -(1.384x 4.15)

a -

= 9.31 - 5.74 3 . 5 7
ONGC stock and the
7 Monthly return data (n per cerat) for
Example ure sesented below:
12 month perkxd
.

NSE index for a

NSE Indez
Month
-0.35
.7
-0.49
5.45
-1.03
-3.05
1.64
3.41
6.67
9.13
5 1.13
2.36
6 0.72
-0.42
0.84
5.51
4.05
6.80
1.21
2.60
10 0.29
-3.81
11 -1.96
1.91
12
ONGC stock."
Calculate and beta for the
alpha cent next
to move up by 15 per
NSE index is expected from ONGC?
2 Suppose would you expect
month. How much return
 RISK 37
Solution Since alpha and beta of the stock are to be calculated, the
regression model nay be u_ed.
Calculation of a and ß of ctock

ONGC returns NSE Index retura X XY

Y (R X (R)
0.12 0.26
-0.75 -0.35
5.45 -0.49 0.24 -2.67
1.03 1.06 3.14
-3.05
2.69 5.59
1.64
3.41 60.90
9.13 6.67 44.49
1.28 2.67
2.36 1.13
0.52 -0.30
-0.42 0.72
0.71 4.63
5.51 0.84
16.40 27.54
6.80 4.05
1.46 3.15
2.60 1.21
0.08 -1.10
-3.81 0.29
3.84 3.74
-1.96
-1.91
72.89 107.55
12.72
25.32

nXY- (2XEY)
B nEX-(EX2

25.32)
(12x107.55)- (12.72
x

(12x 72.89)
-

(12.72)

= 1290.60-322.07 968.53
874.68-161.80 712.88

B 1.359

a= -BR

-(1:359) 2
(1.359) (1.06) 2.11- 1.44 =0.67a d
= 2.11
NSE inderm
The expected relum fron ONGC .pajadxa s,J0}sAAUI
stock when YISeJE
io]saAuI
uy

15 per cent can be calculated from the saeys

regressiongeyIon 0 0

aIeu
R=0.67 +1.359PR ( 9

uoy
paSAjEue
pue sey

Saop su

req
3ou

"***
*
38 POATFOLIO MANAGEMENT
we get
R as 15 in the equation,
Substituting
the value of 21.055
0.67 + 20.385
=

1.359 (15)
=
0.67 +
Ri
EXERCISES

deviation of retuns
atandard
return and thé
Caleulate the expected distribution:
3. stock having the
following probability
for a

Probability of
Probable Occurrence
returns (per cent)
0.05
-24 0.15
- 10
0.15

0.20
12
0.20
18
0.15
22
0.10
30 4**wraN********

the.
possible prices that
.

n o diviclevc~s.
The
2 . A stock costing Rs. 250 pays of he ycar and the probability of éach
the end
stock might sell for at
are:
Possible prises (Rs.)
Probability
0.10
200
.25
230
0.35
250
0.20
280
0.10
310

cted return?
returns?
deviation of the
There
k for a one-year holding period.
will sell
currently selling at Rs. 60,
on
A. The investor c a n borrow '

er cent per annum.

risk
8 period. yield and
e buys 200 shares
nds?
 RISK 39

4Monthly return data (in per cent) for IPCL stock and the NSE index for
a 12 month period are presented below:
Month IPCL NSE Tndex
10.27 11.00
9.31 3.69
6.73 4.20
-5.68 4.93

2.60 3.05
2.86 5.88
7 3.74
2.78
8 3.84 2.63
-2.10
9 -6.51 -21.35
10 -23.42
11 0.00 -4.55
2.80
12 6.64

Calculate beta of IPCL stock.

5. What is the meaning of risk?
6. Explain the concept of systemnatic risk. Why is it called systematic
risk?
7. Write notes on:
(a). Interest.rate risk
(b) Market risk
Purchasing powe'f risk
8. The marketprice bonds is inversely related to the mnarket interest
rates." Explaint
. What is unsytematic risk? Explain the diff rent types of unsystenatic
risk.
I0. "Financ al risk is a function of financial leverage." Explain
of return and risk
ain the mean-variance approach to estimation
Of
a security.
W h a t is Beta? How.is it interpreted? .

REFERENCESS
389,
1.. Ramesh K.S. Rao, Fundamentals of Financial Managemen, p.
Macmillan, New York, 1989.
2. Tbid., p: 416.