Financial Management I

S S S Kumar
Indian Institute of Management Kozhikode
Calicut 673 570
A story of two stocks contd..

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A story of two stocks contd..

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Which one will you invest in???

A difficult one
Lets move on.

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Now what is your decision?

Stock M Stock N

30% 26%

28% 13%

34% 48%

32% 11%

31% 57%

31% 31%

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Why risk and return are linked..

Investment A is the A
obvious choice A but add
risk, is the
choice still
obvious?
B
B

B would die
out through
lack of takers!

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Stocks M and N contd

The greater the risk, the higher the expected return

What is return?
What is the nature of the risk?
How is it measured?
How does it determine the return expected by shareholders
from their investment?

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Return

A bond 1 month holding

period
buy for Rs.968, sell for
Rs.952
1 month R

952 - 948
= .0168 = 1.68%
948

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 annualized R:

(1.0168)12 - 1 = .2213 = 22.13%

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example 2

100 shares ABC, 9 months

buy for Rs. 82, sell for Rs. 100
8 dividends
9 month R:

100 - 82 + 8
= .3171 =31.71%
82

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 annualized R:

(1.317)12/9 - 1 = .4437 = 44.37%

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Expected Return

measuring likely future return

based on probability distribution
random variable

E(R) = SUM(Ri x Prob(Ri))

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example 1

R Prob(R)
10% .2
5% .4
-5% .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%

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example 2

R Prob(R)
1% .3
2% .4
3% .3

E(R) = (.3)1% + (.4)2% + (.3)(3%)

= 2%

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Risk

measure likely fluctuation in return

how much will R vary from E(R)
how likely is actual R to vary from E(R)

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Measuring risk

Range
MAD
Variance
Standard deviation

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Measuring risk

Microsoft Office
Excel Worksheet

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Diversification

A major implication is that the risk of a single stock can

be divided into two components
Unsystematic or diversifiable risk

Can be eliminated through portfolio diversification

Systematic or non-diversifiable risk

Cannot be eliminated through portfolio

diversification

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General expression for return

n
RP wi Ri
i 1

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General expression for risk

n n n
w i wi w j ij i j
2 2
i
2

i 1 j 1 i 1
i j

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Diversification and no. of stocks

Microsoft Office
Excel Worksheet

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Risk reduction through diversification

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Examples of Unsystematic risk

1. Company workers declare a strike

2. An accident occurs in the production facility
3. A formidable competitor enters the market
4. Loses a big contract
5. Makes a break-through in new
product/delivery/services
6. Key personnel leaves the organization
7. Customs duty increases/decreases

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Examples of Systematic risk

1. interest rate changes

2. Corporate taxes change
3. Government resorts to massive deficit financing
4. RBI changes to a restrictive credit policy
5. Full convertibility
6. Withdraws/imposes dividend tax
7. Increases/decreases capital gain taxes

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The Final Take Away

Financial markets will not reward unsystematic risk

Because it can be eliminated through diversification at
practically no cost
Thus, the only risk that matters in determining the required
return on a financial asset is the assets systematic risk
In other words, the required rate of return on a financial
asset depends only on its systematic risk

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measuring relative risk

if some risk is diversifiable,

then is not the best measure of risk
is an absolute measure of risk
need a metric that measures just the systematic
component

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Systematic Risk Measurement

A firms systematic risk is usually measured relative

to the market portfolio
Portfolio that contains all the assets in the world
Systematic risk of a stock is estimated by
Measuring the sensitivity of its returns to changes in a broad
stock market index
Such as the S&P CNX 500 index
This sensitivity is called the stocks beta coefficient

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Beta,

variation in asset/portfolio return relative to return of market

portfolio
mkt. portfolio = mkt. index
Nifty index or BSE 100 index

% change in stock returns

% change in index returns

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interpreting

if
stock is risk free
if
stock return = market return
if
stock is riskier than market index
if
stock is less risky than market index

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Characteristic Line

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Using Regression

Micros oft Office

Excel Works heet

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Betas of Nifty Stocks

Microsoft Office
Excel Worksheet

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PF of a Risk free asset and a risky asset A

Micros oft Office

Excel Works heet

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PF of a Risk free asset and a risky asset A

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PF of a Risk free asset and a risky asset B

Micros oft Office

Excel Works heet

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PF of a Risk free asset and a risky asset B

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Putting together

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Fundamental Relationship between risk and ret

Returns

E ( Ri ) R f

E(RC) i
E(RB)
E(RA)

A B C Beta

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 E ( R ) R f [ E ( Rm ) R f ]

where
is the portfolio risk

E( R m ) R f is the market risk premium

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implication

expected return is a function of

Amount of systematic risk (Beta)
Reward for postponing consumption (risk free return)
Reward for bearing systematic risk (risk premium)

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 CAPM tells us size of risk/return tradeoff
CAPM tells use the price of risk

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