SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

LESSON 5:
RISK MANAGEMENT : CONCEPT, SOURCES & TYPES OF RISK
Risk in a Traditional Sense
Risk in holding securities is genrally associated with possiblity
that realized returns will be less than the returns that were
expected. The source of such disappointment is the failure of
dividends (interest) and/or the securitys price to materialize as
expected.
Forces that contribute to variations in return price or dividend
9interest) constitute elements of risk. Some influences are
external to the firm, cannot be controlled, and affect large
numbers of securites. Other influences are internal to the firm
and are controllable to a large degree. In investments, those
forces that are uncontrollabe, external and borad in their effect
are called sources of systematic risk. Conversely, controllable
internal factors somewhat peculiar toindustries and/or firms are
refereed to as sources of unsystematic risk.
Systematic risk refers to that portion of total variability in return
caused by factors affecting the prices of all securities. Economic,
political, and sociological changes are sources of systematic risk.
Their effect is to cause prices of nearly all individual common
stocks and/or all indivdidual bonds to move together in the
same manner. For example, if the economy is moving toward a
recession and corporate profits shift downward, stock prices
may decline across a broad front. Nearly all stocks listed on the
New York Stock Exchange (NYSE) move in the same direction
as they NYSE Index. On the average, 50 percent of the
variation in a stocks price can be explained by variation in the
market index. In other words, about one-half the total risk in
an average common stock is systematic risk.
Unsystematic risk is the portion of total risk that isunique to a
firm or industry. Factors such as management capability,
consumer preferences, and labor strikes cause systematic
variability of returns in a firm. Unsystematic factors are largely
independent of factors affecting securites markets in general.
Because these factors affect one firm, they must be examined for
each firm.

Systematic Risk
Market Risk
Finding stock prices falling from time to time while a companys
earnings are rising, and vice versa, is not uncommon. The price
of a stock may fluctuate widely within a short span of time
even though earnings remain unchanged. The causes of this
phenomenon are varied, but it is mainly due to a change in
investors attitudes toward equities in general, or toward certain
types or groups of securites in particular. Variability in return on
most common stocks that is due to basic sweeping changes in
investor expectations is referred to as market risk.
Maket risk is caused by investor reaction to tangible as well as
intangible events. Expectaitions of lower corporate profits in
general may cause the larger body of common to fall in price.
Investors are expressing their judgement that too much is being
paid for earnings in the light of anticipated events. The basis for

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the reaction is a set of real, tangible events political, social, or

economic.
Intangible events are related to market psychology. Market risk is
usually touched off by a reaction to real events, but the
emotional instability of investors acting collectively leads to a
snow balling over reaction. The initial decline in the market can
cause the fear of loss to grip invetors, and a kind of her instinct
builds as all investors make for the exit. These reactions to
reactions frequently culiminate in excessive sellings, pushing
prices down far out of live with fundamental value. With a
trigger mechanism such as the assassination of a politican, the
threat of war, or an oil shortage, virtually all stocks are adversly
affected. Likewise, stcks in a particular industry group can be
hard hit when the industry goes out of fashion.
This discussion of market risk has emphasized adverse
reactions. Certainly, buying paincs also occur as reactions to real
events, however, investors are not likely to think of sharp price
advances as risk.
Two other factors, interest rates and inflation, are an integral
part of the real forces behind market risk and are part of the
larger category of systematic or uncontrollable influences. Let us
turn our attention to interest rates. This risk factor has its most
direct effect on bond investments.
Interest-Rate Risk
Interest-rate risk refers to the uncertainty of future market
values and of the size of future income, caused by fluctuations
in the general level of interest rates.
The root cause of interest-rate risklies in the fact that, as the rate
of interest paid on U.S. government securities (USGs) rises or
falls, the rates of return demanded on alternative investment
vehicles such as stocks and bonds issued in the private sector,
rise or fall. In other words, as the cost of money changes for
nearly risk-free securities (USGs), the cost of money to more
risk-prone issuers (Private sector) will also change.
Investors normally regard USGs as coming closest to being riskfree. The interest rates demanded on USGs are thought to
approximate the pure rate of interest, or the cost of hiring
moneyat no risk. Changes in rates of interest demanded on
USGs will permeate the system of avialable securites, from
corporate bonds down to the riskiest common stocks.
Interest rates on USGs shift with changes in the supply and
demand for government securities. For example, a large
operating deficit experienced by the U.S. government will reuqire
financing. Issuance of added amounts of USGs will increase the
available supply. Poetntial buyers of this new supply may be
induced to buy only if interest rates are somewhat higher than
those currently prevailing on outstanding issues. If rates on
USGs advance from, say, 9 percent to 9 percent, investors
holding outstanding issues that yeid 9 per cent will notice a
decline in the price of their securities. Because the 9 percent rate
is fixed by contract on these old USGs, a poetntial buyer
would be able to realize thecomptetive 9 percent rate only if

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11.621.3

therate of increase (inflation) is 3 percent [(1030100)/100]. If

from the second to thethird year, the index changes from 103 to
109, the rate is about 5.8 percent [109-103/103].

Purchasing-Power Risk
Market risk and interest-rate risk can be definded in terms of
uncertainties as to the amount of current dollars to be received
by an investor. Purchasing-power risk is the uncertainityof the
purchasing power of the amounts to be received. In more
everyday terms, purchasing-power risk refers to the impact of
inclation or deflation on an investment.
If we think of investment as thepostponement of consumption, we can see that when a person purchses a stock, he has
foregone the oppportunity to buy some good or service for as
long as he owns the stock. If, during the holding period, good
or services rise, the investor actually loses purchasing power.
Rising prices on goods and services are normally associated with
what is referred to as inflation. Falling prices on goods and
services are termed deflation. Both inflation and deflation are
covered in the all-encompassing term purchasing power risk.
Generally, purchasing-power risk has come to be identified with
inflation (rising prices); the incidence of declining prices in most
countries has been slight.
Rational investors should include in their estimate of expected
return an allowance for purchasing-power risk, in the form of
an expected annual percentage change in prices. If a cost-ofliving index begins the year at 100 and ends at 103, we say that

Business Risk
Business risk is a function of the operating conditions faced by
a firm and the variability these conditions inject into operating
income and expected to increase 10 percent per year over the
foreseeable future, business riskwould behigher if operating
earnings could grow as much as 14 percent or as little as 6
percent than if the range were from a high of 11 percent to a
low of 9 percent. The degree of variation from the expected
trend would measure business risk.
Business risk can bedivided into two broad categories: external
and internal. Internal business risk is largely asociated with the
efficiency with which a firm conducts its operations with in the
broader operating environment imposed upon it. Each firm
has its own set of internal risks, and the degree to which it is
successful in coping with them is reflectedin operating efficienty.
To large extent, external business riskis the result of operating
conditions imposes upon the firm by circumstances beyond its
control. Each frim also faces its own set of external risks,
depending upon the specific operating environmental factors
with which it must deal. The external factors, from cost of
money to defense-budget cuts to higher traffs to a down swing
in the business cycle, are far too numerous to list in detail, but
the most pervasive external risk factor is probably the business

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Just as changes in interest rates have a systematic influence on

the prices of all securities, both bonds and stocks, so too do
anticipated puchasing-power changes manifest themselves. If
annual changes in the consumer price index of other measure
of purchsaing power have been averaging steadily around 3.5
percent and prices will apparently spurt ahead by 4.5 percent
over the next year, required rates of return will adjust upward.
This process will affect government and corporate bonds as well
as common stocks.
Market, purchasing-power and interest-rate risk are the principle
sources of systematic risk in securites; but we should also
consider another important category of security risk a unsystematic risks.

Unsystematic Risk
Unsystematic risk is the portion of total risk that is unique or
peculiar to a firm or an industry, above and beyond that
affecting securites markets in general. Factors such as management capability, consumder preferences, and labor strikes can
cause unsystematic variability of returns for a companys stock.
Because these factors affect one industry and/or one firm, they
mustbeexamined separately for each company.
The uncertainty surroundings the abilityof theissuer to make
payments on securities stems from two sources: (1) the
operating environment of the business, and (2) the financing
of the firm. These risks are referred to as business risk and
financial risk, respectively. They are strictly a function of the
operating conditions of the firm a and they way in which it
chooses to finance its operations. Our intention here will be
directed to the broad aspects and implications of business and
financial risk. In-depth treatment will be the principal goal of
later chapters on analysis of the economy, the industry, and the
firm.

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SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

the current holder market down the price. As the rate on

USGs advances, they become relatively more attractive and other
securities become less attractive. Consequently, bond purchasers
will buy governments instead of corporates. This will cause the
price of corporates to fall and the rate on corporates to rise.
Rising corporate bond rates will evnetually cause preferred- and
common-stock prices to adjust down woard as the chain
reaction is felt through out the system of security yields. (The
exact nature and extent of this mark down process and the
relationships between rates, prices, and maturity will be
exploraed in Chaper 9.)
Thus, a rational, highly interconnected structure of security
yeilds exists. Shifts in the pure cost of money will ripple
through the structure. the direct effect on increases in thelevel of
interest rates is to cause security prices to fall across a wide span
of investment vehicles. similarly, falling interest rates precipitate
prices markups on outstanding securities.
In addition to thedirect, systematic effect on bonds, there are
indirect effects on common stocks. First, lower or higher
interest rates make the purchase of stocks on margin (using
borrowed funds) more or less attractive. Higher interest rates,
for example, may lead to lower prices because of a diminished
demand for equities by speculators who use margin. Ebulient
stock markets are at times propelled to some excesses by margin
buying when interest rates are relatively low.
Second, many firms suchas public utilities finance their operations quite heavily with borrowed funds. Others, suchas
financial institutions, are principally in the business of lending
money. As interest rates advance, firms with heavy doses of
borrowed capital find that more of their income goes toward
paying interest on borrowed money. This may lead to lower
earnings, dividends, and share prices. Advancing interest rates
can bring higher earnings to lending institutions whose
principal revenue sources is interest received on loans. For these
firms, higher earnings could lead to increased dividends and
stock prices.

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

cycle. The sales of some industries (steel, autos) tend to move

in tandem with the business cycle, while the sales of others
move countrycyclically (housing). Demographic considerations
can also influence revenues through changes in the birth rate or
the geographical distribution of the population by age, group,
race, and so on. Political Policies are a part of external business
risk; government policies with regard to monetary and fiscal
matters can affect revenues through the effect on the cost and
availability of funds. If money is more expenseive, consumers
who buy on credit may postpone purchases, and municipal
governments may not sell bonds to finance a water-treatment
plant. The impact upon retail stores, telelvision manufacturers,
of water-purification systems is clear.
Financial Risk
Financial risk is associated with the way in which a company
finaces its activities. We usually gauge finacial risk by looking at
the capital structure of a firm. The presence of borrowed
money of debt in the capital structure creates fixed payment in
the form of interest that must be sustained by the firm. The
presence of these interest commitments fixed interest payments
due to debt of fixed-dividend payments on preferred stock
causes the amount of rasidual earnings available for commonstock dividends to be more variable than if no interest
payments were required. Financial risk is avoidable risk to the
extent that managements have the freedom to decide to borrow
or not to borrow funds. A firm with no debt financing has no
financial risk.
By engaging in debt financing, the firm changes the characteristic
of the earnings stream avaialbel to the common-stock holders.
Speciafically, the reliance on debt financing, called financial
leverage, has at three important effects on common-stock
holders. Debt financing (1) increases the variability of their
returns, (2) affects their expectations concerning their returns,
and (3) increases their risk of being ruined.
Assigning Risk Allowances (Premiums)
One way of quantifying risk and building a required rate of
return (r), would be to express the required rate as comprising
ariskless rate plus compensation for individual risk factors
previously enuciated, or as:
r=i+p+b+f+m+o
Whrere:
i = real interest rate (riskless rate)
p = purchasing-power-risk allowance
b = business-risk allowance
f = financial-risk allowance
m = market-risk allowance
o = allowance for other risks
The first step would to determine a suitable risk less rate of
interest. Unfortunately, no investment is risk-free. The return
on U.S. Treasury bills or an insured savings account, which ever
is relevant to an individual investor, can be used as an approximate risk less rate. Savings accounts possess purchasing-power
risk and are subject to interest-rate risk of income but not
principal. U.S. government bills are subject to interest-risk of
principal. The risk less rate might by 8 percent.

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Using the rate on U.S. government bills and assuming that

interest-rate-and-risk compensation is already included in the
U.S. government bill rate, we see in Figure 3-1 the process of
building required rate of return for alternative investments.
To quantify the separate effects of each type of systematic and
unsystematic risk is difficult because of overlapping effects and
the sheer complexity involved. In the remainder of the chapter,
we will examine some proxies for packaging into a single
measure of risk all those qualitative risk factors taken together
that perhaps cannot be measured separately.

Can we Reduce the Risk Exposure?

Every investor wants to guard himself from the risk. This can
be done by understanding the nature of the risk and careful
planning. Lets see how can we protect ourselves as an investor
from the different types of risks.
Market Risk Protection
a. The investor has to study the price behaviour of the stock.
Usually history repeats itself even though it is not in perfect
form. The stock that shows a growth pattern may continue
to do so for some more period. The Indian stock market
expects the growth pattern to continue for some more time
in information technology stock and depressing conditions
to continue in the textile related stock. Some stocks may be
cyclical stocks. It is better to avoid such type of stocks. The
standard deviation and beta indicate the volatility of the
stock.
b. The standard deviation and beta are available for the stocks
that are included in the indices. The National Stock
Exchange News bulletin provides this information.
Looking at the beta values, the investor can gauge the risk
factor and make wise decision according to his risk
tolerance.c. Further, the investor should be prepared to hold
the stock for a period of time to reap the benefits of the
rising trends in the market. He should be careful in the
timings of the purchase and sale of the stock. He should
purchase it at the lower level and should exit at a higher
level.
Protection Against Interest Rate Risk
a. Often suggested solution for this is to hold the investment
sells it in the middle due to fall in the interest rate, the
capital invested would experience tolerance.
b. The investors can also buy treasury bills and bonds of short
maturity. The portfolio manager can invest in the treasury
bills and the money can be reinvested in the market to suit
the prevailing interest rate.
c.

Another suggested solution is to invest in bonds with

different maturity dates. When the bonds mature in
different dates, reinvestment can be done according to the
changes in the investment climate. Maturity diversification
can yield the best results.

Protection Against Inflation

a. The general opinion is that the bonds or debentures with
fixed return cannot solve the problem. If the bond yield is
13 to 15 % with low risk factor, they would provide hedge
against the inflation .

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11.621.3

c.

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

b. Another way to avoid the risk is to have investment in

short-term securities and to avoid long term
investment.The rising consumer price index may wipe off
the real rate of interest in the long term.
Investment diversification can also solve this problem to a
certain extent. The investor has to diversify his investment
in real estates, precious metals, arts and antiques along with
the investment in securities. One cannot assure that
different types of investments would provide a perfect
hedge against inflation. It can minimise the loss due to the
fall in the purchasing power.

Protection Against Business and Financial Risk

a. To guard against the business risk, the investor has to
analyse the strength and weakness of the industry to which
the company belongs. If weakness of the industry is too
much of government interference in the way of rules and
regulations, it is better to avoid it.
b. Analysing the profitability trend of the company is
essential. The calculation of standard deviation would yield
the variability of the return. If there is inconsistency in the
earnings, it is better to avoid it. The investor has to choose a
stock of consistent track record.
c.

The financial risk should be minimised by analysing the

capital structure of the company. If the debt equity ratio is
higher, the investor should have a sense of caution. Along
with the capital structure analysis,. he should also take into
account of the interest payment. In a boom period, the
investor can select a highly levered company but not in a
recession.

Notes

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