This document provides a lesson plan on investment analysis covering risk and return. It defines risk as the possibility of the actual outcome differing from the expected outcome. It discusses different types of risk including systematic and unsystematic risk. It also covers topics like measurement of risk and return, risk-return tradeoff, capital asset pricing model, and security market line. The document aims to educate readers on key concepts in investment analysis and risk management.

1. Investment Analysis
Dr. Mohammed Arif Pasha
Principal
Brindavan College
Bangalore - 560063

2. RISK AND RETURN
Lesson Plan
 Concept of Risk
 Sources of Risk
 Types of Risks
 Systematic and unsystematic Risk
 Measurement of Risk
 Standard Deviation
 Coefficient of variation
 Beta as a measure of Risk
 Concept of Return
 Measurement of Return
 Relative Return
 Expected value and measuring Return over multiple periods.

3. RISK MANAGEMENT
Risk is
 the possibility of the actual outcome being
 different from the expected outcome.
It includes both
 upside and downside potential.
Upside potential is the possibility of the actual results
being better than the expected results while
Downside potential is the possibility of the actual
results being adverse compared to the expected results.
Greater the risk assumed higher will be the return.

4. Certainty, Uncertainty and Risk
 There is a clear distinction between certainty, uncertainty
and risk.
 Certainty is the situation where it is known what will
happen and the happening or non happening of an event
carries 100% probability.
 Uncertainty refers to a situation about which the
likelihood of possible outcome is not known. It reflects a
total lack of knowledge of what may happen.
 Risk is the situation where there is a possibility that the
actual outcome will differ from its expected outcome.

5. Causes of risk
 A number of factors which can cause risk in the investment arena
are given below:
 Wrong method of investment.
 Wrong timings of investment
 Wrong quantity of investment
 Interest rate risk
 Nature of investment instruments
 Nature of industry in which the company is operating
 Creditworthiness of the issuer
 Terms of lending
 Maturity period
 National and international factors
 Natural calamities.

6. Risk defined
 Risk refers to the possibility that the actual outcome of an
investment will differ from its expected outcome.
 In other words, risk is the possibility of loss or the
probable outcome of all the possible events.
 Most investors are concerned about the actual outcome
being less than the expected outcome.
 The degree of risk depends upon the features of assets,
investment instruments, mode of investment etc.
 The wider the range of possible outcomes, the greater the
risk.

7.  Risk consists of two components, the systematic
risk and unsystematic risk.
 The systematic risk is caused by factors external
which are uncontrollable and affects the market as
a whole.
 The unsystematic risk is due to reasons which are
specific, unique and particular to industry or
company.

8. Sources of risk
 Risk emanates from several sources.
 Business risk caused by a variety of factors like competition,
emergence of new technologies, change in consumer preferences,
short supply of inputs, changes in government policies.
 Interest rate risk is the variation in the single period rates of return
caused by the fluctuation in the market interest rate which may be
caused by changes in the government monetary policy and changes
that occur in the interest rates of government bonds and treasury
bills.
 Market risk is that portion of total variability of return caused by
the alternate forces of bull and bear markets which will affect the
market and the prices of scrips.

9. Degree of Risk
 The degree of risk in a particular situation is not absolute.
 It depends on the level of information available with the
entity facing the risk.
 Even when the complete information is available, the
perception of the entity differs.
 Two different entities may interpret the same information
differently or different expectations for the future which
would lead to two different sets of probability
distribution.
 Hence, the same set of circumstances may translate into
different levels of risk for different people.

10. Types of risk
• The various types of risk are classified are:
SYSTEMATIC UNSYSTEMATIC
RISK
Market
Risk
Interest
rate Risk
Purchasing
power Risk
Business
Risk
Financial
Risk
Credit
Risk

11. SYSTEMATIC RISK
 The systematic risk affects the entire market.
 It indicates the movement of entire market in a
particular direction either upward or downward.
 The security market is affected by conditions like
economic, social, political, cultural etc.
 Systematic risk is beyond the control of corporate and
investor, which cannot be avoided.
 The systematic risk is further classified into market risk,
interest risk and purchasing power risk.

12. Market risk
 Market risk is caused by the alternating forces of bull and bear
markets.
 When the index moves upward, it is called bull market which
moves from a low level to the peak.
 Bear market moves downward from peak to low level.
 The forces that affect the stock market are both tangible and
intangible.
 Tangible events are natural calamities like flood and earthquakes,
political instability, economic conditions, currency decline, wars
etc.
 Intangible events are related to market psychology where
reaction of investors is like a herd behaviour that starts disposing
the stock fearing the loss of their investment.

13. Interest rate risk
 Interest rate risk is the variation in the rates of return
caused by fluctuations in the market interest rate which
affect the prices of stock, bond and debentures.
 They are caused by the changes in the government
monetary policy and the interest rates of treasury bills and
government bonds.
 The government bonds are generally risk free.
 Interest rates affect the security traders and corporate who
carry their business with borrowed funds.
 The cost of borrowing reduces the profit due to payment
of interest.
 This would lead to a reduction in earnings per share and a
consequent fall in the price of share

14. Purchasing power risk
 Variations in returns are caused by the loss of
purchasing power of currency.
 Inflation is the reason behind the loss of
purchasing power.
 Purchasing power risk is the probable loss of the
returns to be received.
 The rise in prices penalizes the returns to the
investor and every potential rise in price is a risk
to the investor.

15. UNSYTEMATIC RISK
 It refers to that portion of risk which is caused
to factors unique to a firm or industry.
 This is a company specific risk and can be
controlled if proper measures are taken.

 It is caused by factors like labour unrest,
management policies, shortage of power,
consumer preferences etc.

16. Business risk
 Business risk can be internal or external.
 Internal risk is caused due to improper product mix, non-
availability of raw materials, incompetence to face
competition, absence of strategic management.
 External risk arises due to change in operating condition
caused by reasons which are beyond control of business
like business cycle, government controls, changes in
business laws, market conditions.

17. Financial risk
 Financial risk is associated with the capital
structure of a company.
 A company with no debt financing has no
financial risk.
 The extent of financial risk depends on the
leverage of the firm’s capital structure, proper
financial planning and other financial adjustments
can be used to correct this risk and it is
controllable.

18. Credit risk
 Credit risk deals with the probability of meeting with a
default.
 It is the probability that a buyer will default.
 The chances the borrower will not pay up can stem from
a variety of factors.
 The borrower’s credit rating has fallen suddenly and he
has become defaulter which may lead to insolvency.
 In such case, the investor may not get any return.
 Proper management of credit risk reduces the chances of
non payment of loan by borrowers.

19. Measurement of risk
• Sensitivity analysis: Sensitivity analysis is a behavioral approach
to assess risk using a number of possible return estimates to obtain
a sense of the variability among outcomes. a possible approach is to
estimate the worst, the expected and the best return associated
with the asset.
Sensitivity Analysis (Amount in Rs. Crores)
Particulars Asset A Asset B
Initial outlay (t=0) 50 50
Annual return 14 8
Pessimistic 16 16
Expected 18 24
Optimistic 18 24
Range (optimistic – pessimistic) 4 8

20. Probability
 The risk associated with an asset can be assessed
more accurately by the use of probability than
sensitivity analysis.
 The probability of an event represents the
likelihood chance of its occurrence.
 If the expectation of a outcome will occur 6 out
of 10 times, it can be to have a 60% chance of
happening, if it is certain to happen.

21. Risk and expected return
 The concept of security analysis is based on risk and
return.
 To earn return on investment, investment has to be
made for some period of time.
 Risk denotes deviation of actual return from the
estimated return.
 The fact that the investors do not hold a single
security is enough to say that they are interested not
only in maximization of return but also minimization
of risk.

22.  The unsystematic risk is eliminated through
holding more diversified securities.
 However, Systematic risk cannot be eliminated
through diversification.
 There is a positive relationship between the
amount of risk and expected return.
 Greater the risk, larger the return and larger the
changes of loss.
 One of the most difficult problems for an
investor is to estimate the highest level of risk he
is able to assume.

23. RETURN
Equity shares
Preference shares
Unsecured loans
Debentures
Mortgage
Loans
RISK
(Risk-Return Relationship of Different Stocks)

24. Managing risk
 Once the different types of risks are identified,
the next step is to identify the alternate tools
available for managing the risk. The various tools
of managing risk are
 avoidance
 loss control
 separation
 combination
 transfer

25. Return
 The Return on an asset or investment for a given period is
the annual income received plus any change in market price.
 Greater the risk assumed higher will be the return.
 Investments which carry low risk such as government
securities will offer a low rate of return.
 Return on investment may be because of income, capital
appreciation or a positive hedge against inflation.
 Income is either interest on bonds or debentures, dividend
on equity or preference shares.

26. RISK-RETURN TRADE OFF
 A machine with higher capacity may give higher expected return
but involves higher risk where as a machine with lower capacity
may have a lower expected return a lower risk of investment.
 A higher debt equity ration may help in increasing the return on
equity but will also enhance the financial risk. a choice between a
debt equity ratio has to be made.
 Again dividend decision involves the quantum of profits to be
distributed.
 The financial manager has to strike a balance between various
sources so that the overall profitability of the firm and its market
value increases.

27. RISK RETURN TRADE OFFAND MARKET VALUE OF THE FIRM
Investment
Decisions
Financing
Decisions
Return
Dividend
Decisions
Market
Value of
the
Firm
Risk

28. CAPITAL ASSET PRICING MODEL (CAPM)
 CAPM refers to the way in which the securities are valued in line with their
anticipated risks and returns.
 A risk averse investor prefers to invest in risk free securities. A small investor
having few securities in his portfolio has greater risk.
 To reduce the unsystematic risk, he must build up a well diversified portfolio of
securities.
 A diversified and balanced portfolio will bring down the investor’s systematic risk
in the stock market. Sharpe asserts that risky portfolio do not pay more than the
safe ones.
 The systematic risks of two portfolios remain the same. To the rational investors,
it makes no difference that stocks in one portfolio are individually riskier than
other stocks because successive stock price changes are identically distributed.
 An individual is assumed to rank alternatives in the order of his preference.
 However, due to constraints he can avail only some of the alternatives.
 An individual acts in a way in which he can maximize the return on his investment
under conditions of risk and uncertainty.
 Thus, CAPM is a linear relationship in which the required rate of return from an
asset is determined by that asset’s systematic risk.

29. Variability of Return
Return
Total Risk
Unsystematic Risk
Systematic Risk
No. of Portfolios
(Risk exposure of portfolio)

30. ASSUMPTIONS OF CAPM
 CAPM is based on the assumptions given belo
w:
 Efficient capital market exists.
 Investors base their portfolio investment decisions on security, its expected return and
standard deviation criteria.
 Investors may borrow and lend without limit at risk free rate of return.
 Investors have identical expectations about the future outcomes over one period time
horizon.
 All investors have the same expectation about the risk and return.
 Market wide influences that affect all assets to some extent, such as the state of the
economy.
 No transaction costs involved.
 Investment goals of investors are rational. Investors desire higher return for any acceptable
level of risk or the lowest risk for any desired level of return.
 Capital markets are in equilibrium.
 There are no market imperfections. Investments are infinitely divisible, information is cost
less, there are no taxes or interest rate changes and there is no inflation.
 Investors are risk averse and maximize expected utility of wealth.
 Capital market is not dominated by any individual investors.
 Securities or capital assets face no bankruptcy or insolvency.

31. SECURITY MARKET LINE (SML)
 The security market line expresses the basic theme of
CAPM i.e., expected return of a security increases linearly
with risk as measured by beta.
 It is an upward sloping straight line with an intercept at the
risk free return securities and passes through the market
portfolio.
 The upward slope line indicates that greater excepted
returns accompany higher levels of beta. In equilibrium,
each security or portfolio lies on the SML.
 An investor will come forward to take risk only if the
return on investment also includes risk premium.
 CAPM provides an intuitive approach of thinking about
the return that an investor should require on an
investment.

32. Expected Security Market Line
Return
E(Rm) Risk Premium
Rf
Risk free return
0 0.5 1.0 1.5 Risk (beta)
SECURITY MARKET LINE
E (R) = Rf + βi ( Rm – Rf )
Where,
E (R) = Expected rate of return on any individual security
or portfolio of securities.
Rf = Risk free rate of return
Rm = Expected rate of return on the market portfolio.
Rm – Rf = Risk premium
βi = Market sensitivity index of individual security or
portfolio of securities.

33. CAPITAL MARKET LINE
• The capital market line defines the relationship between the total risk
and expected return for portfolios consisting of the risk free asset and
the market portfolio.
• If all the investors hold the same risky portfolio, then in equilibrium it
must be the market portfolio.
• CML generates a line on which efficient portfolio can lie.
• Those which are not efficient will however lie below the line.
• It is worth mentioning here the CAPM risk return relationship is separate
and distinct from risk return relationship of individual securities as
represented by CML.
• An individual security’s expected return and systematic risk statistics
should lie on the CAPM but below CML.
• In contrast the risk less end (R) statistics of all portfolios, even the
inefficient ones should plot on the CAPM.
• The CML will never include all points, if efficient portfolios, inefficient
portfolios and individual securities are placed together on one graph.
• The individual assets and the inefficient portfolios should plot as points
below the CML because their total risk includes diversifiable risk.

34. Z
K
Expected
Return
E (rm – R)
R
Defensive Aggressive
Assets Assets
Risk
CAPITAL MARKET LINE