Concept of Risk

Risk is defined as variability in return or volatility in return. Risk is the chance of the
actual return being less than the expected return. Thus, risk means any deviation from expected returns.
More specifically the probability that the return from any asset will differ from the expected yield is the
risk inherent in that asset. In risk assessment, the probable outcomes of all the possible events are listed.
Once the events are listed subjectively, the derived probabilities can be assigned to the entire possible
events.
Risk includes the possibility of losing some or all of the original investment.  A
fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an
investor is willing to take, the greater the potential return. Investors need to be compensated for taking
on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free,
investments and when compared to a corporate bond, provides a lower rate of return. A corporation is
much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate
bond is higher, investors are offered a higher rate of return.

Factors Influencing Risk:

What makes financial assets risky? Traditionally, investors have talked
about several factors causing risk such as business failure, market fluctuations, change in the interest
rate inflation in the economy, fluctuations in exchange rates changes in the political situation etc. Based
on the factors affecting the risk the risk can be understood in following manners.

1. Interest Rate Risk: The variability in a security return resulting from changes in the level of
interest rates is referred to as interest rate risk. Such changes generally affect securities inversely, that is
other things being equal, security price move inversely to interest rate.

2. Market Risk: The variability in returns resulting from fluctuations in overall market that is, the
agree get stock market is referred to as market risk. Market risk includes a wide range of factors
exogenous to securities themselves, like recession, wars, structural changes in the economy, and changes
in consumer preference. The risk of going down with the market movement is known as market risk.

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3. Inflation risk: Inflation in the economy also influences the risk inherent in investment. It may
also result in the return from investment not matching the rate of increase in general price level
(inflation). The change in the inflation rate also changes the consumption pattern and hence investment
return carries an additional risk. This risk is related to interest rate risk, since interest rate generally rise
as inflation increases, because lenders demands additional inflation premium to compensate for the loss
of purchasing power.

4. Business risk: The changes that take place in an industry and the environment causes risk for the
company in earning the operational revenue creates business risk. For example the traditional telephone
industry faces major changes today in the rapidly changing telecommunication industry and the mobile
phones. When a company fails to earn through its operations due to changes in the business situations
leading to erosion of capital, there by faces the business risk.

5. Financial risk: The use of debt financing by the company to finance a larger proportion of assets
causes larger variability in returns to the investors in the faces of different business situation. During
prosperity the investors get higher return than the average return the company earns, but during distress
investors faces possibility of vary low return or in the worst case erosion of capital which causes the
financial risk. The larger the proportion of assets finance by debt (as opposed to equity) the larger the
variability of returns thus lager the financial risk.

6. Liquidity risk: An investment that can be bought or sold quickly without significant price
concession is considered to be liquid. The more uncertainty about the time element and the price
concession the greater the liquidity risk. The liquidity risk is the risk associated with the particular
secondary market in which a security trades.

7. Exchange rate risk: The change in the exchange rate causes a change in the value of foreign
holdings, foreign trade, and the profitability of the firms, there by returns to the investors. The exchange
rate risk is applicable mainly to the companies who operate oversees. The exchange rate risk is nothing
but the variability in the return on security caused by currencies fluctuation.

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8. Political risk: Political risk also referred, as country risk is the risk caused due to change in
government policies that affects business prospects there by return to the investors. Policy changes in the
tax structure, concession and levy of duty to products, relaxation or tightening of foreign trade relations
etc. carry a risk component that changes the return pattern of the business.

Component of Risk
Risk consists of the following two components.

1. Systematic Risk 2. Unsystematic Risk

1. Systematic Risk-
Systematic Risk affects the entire market. Often we read the news papers that the
stock market caught in a bear hug or is in a bull grip. This indicates that the entire market is moving in a
direction either down words or upwards. Economic conditions, the political situation or sociological
changes affect the security market. A recession can affect the profit prospects of the industry and the
stock market.
Systematic Risk is further sub-divided into the following.
(i) Market Risk- Jack Clark Francis has defined market risk as that portion of total variability of return
that is caused by the alternating forces of the bull and bear phase. A bull market tends to be associated
with rising investor confidence and expectation of further capital gains. A bear market is just reverse of
bull market. A bear market typified by falling stock prices, adverse economic news and low investors
confidence in economy.
(ii) Interest Rate Risk- Interest is the variation in the return caused by fluctuations in the market
interest rate. Most commonly, interest rate risk affects the Bond return and Cost of borrowings. Bond
return fluctuations in interest rates are caused by changes in government’s monetary policy and changes
that occur in the interest rates of treasury bills and government bonds. The Rise or fall in interest rate
affects the cost of borrowings also.
(iii) Purchasing Power Risk- Variations in returns are caused also by the loss of purchasing power of
the currency. Purchasing Power Risk is the probable loss in the purchasing power of the returns to be
received. Inflation is reason behind the loss of purchasing power. Inflation defined as the persistent
increase in prices, is a serious risk for any long term investors. Inflation may be Demand Pull and Cost
pull. In Demand pull inflation the demand for goods and services exceeds their supply. And in Cost pull
inflation the rise in prices caused by the increase in costs.

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2. Unsystematic Risk-
Unsystematic Risk unique and peculiar to a firm or an industry. If one’s
equity investment is in Tata Motors, HLL and Infosis, adverse news about Infosis will only impact
investment in Infosis; all other stock will not feel any impact. Unsystematic risk stems from financial
leverage, managerial inefficiency, technological change in the production process, availability of raw
material, changes in consumer preferences and labour problems. Broadly Unsystematic risk can be
classified as – (i) Business Risk and (ii) Financial Risk.

(i) Business Risk- Business Risk is that portion of unsystematic risk caused by the operating
environment of the business. Variation in the expected operating income reflects business risks.
Variations that occur in the operating environment are reflected in the operating income and expected
dividends. Business risk is concerned with the differences between revenue and EBIT (Earning before
interest and tax). It may be further divided in several points as below.
(A) Internal Business Risk (B) External Business Risk
(A) Internal business risk- It is associated with the operational efficiency of the firm. This differs from
company to company.
a. Fluctuations in sales- The sale level has to maintain. It is common in business to lose customers
abruptly because of competition. Loss of customers will lead to a loss in operation income.
b. Research and Development- Sometimes the product may go out of style or become obsolete. It is the
management that has to overcome the problem of obsolescence by concentrating on the in house R&D
programme.
c. Personal Management- Personal management in a company also contributes to the operational
efficiency of the firm. Frequent strikes and lockouts result in loss of production and high fixed capital
cost. Labour productivity can also suffer.
d. Fixed cost- The cost concept also generate the internal risk, If fixed cost are high in the total cost.
During recession or low demand for a product, the company can not reduce the fixed costs. At the same
time, in a boom period, it can not change the fixed factor at a short notice. Thus high fixed cost
components can be a burden to the firm.
e. Single Product- Internal business risks are higher for a firm producing a single product. The fall in the
demand for a single product can be fatal for the firm. Further, some products are more vulnerable to
business cycle while some products resist and can go against the tide.

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(B) External Business Risk- External business risk arises from operating conditions imposed on the
firm by circumstances beyond its control. The external environments in which it operate exerts some
pressure on the firm. These could be social and regulatory factors, monetary and fiscal policies of
government, business cycles or the general economic environment in which a firm or an industry
operates. A government policy that favours an industry will lead to a rise in the stock prices of the
particular industry. For instance, the Indian sugar and fertilizer industries are very vulnerable to external
factors.
a. Social and Regulatory factor- A harsh regulatory climate and legislation against environment
degradation may impair the profitability of an industry. Price control, volume controls. import/export
controls and environmental controls reduce the profitability of a firm.
b. Political risk- Political risk arises out of changes in government policy. With a change in the ruling
party policies also change.
c. Business Cycle- Fluctuation in business cycle may lead to fluctuation in the earning of a company.
As economic recession could lead to a drop in the output of many industries. Steel and white consumer
goods industries tend to move in tandem with the business cycle.
(ii). Financial Risk- This refers to the variability in income vis-à-vis the equity capital because of the
debt capital. Financial risk is associated with the capital structure of the company. This structure consists
of equity fund and borrowed funds. The presence of debt and preference capital results in a commitment
of paying interest or a pre-fixed rate of dividend.

Measurement of Risk
Standard Deviation as a Measure of Risk:
It is measure of the value of the variable around
its mean. In other words, it is the square root of the sum of the squared deviations of variable values
from the mean divided by the number of observances.
The following steps are involved in computing standard deviation:
(i) Calculate the mean of expected value of the distribution.
(ii) Calculate the deviation from each possible outcome.
(iii) Square each deviation.
(iv) Multiply the squared deviations by the probability of occurrence for its related outcome.
(v) Sum all the products. This is called variance.

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The standard deviation is determined by taking the square root of the variance:

The smaller the standard deviation, the higher the probability distribution and accordingly the lower the
riskiness of the project.

Covariance-
Covariance is a measure of the directional relationship between the returns on two
risky assets. A positive covariance means that asset returns move together while a negative covariance
means returns move inversely. Covariance is calculated by analyzing at-return surprises (standard
deviations from expected return) or by multiplying the correlation between the two variables by
the standard deviation of each variable.

Correlation Coefficient- The correlation coefficient is a statistical measure that calculates the
strength of the relationship between the relative movements of the two variables. The range of values for
the correlation coefficient bounded by 1.0 on an absolute value basis or between -1.0 to 1.0. If the
correlation coefficient is greater than 1.0 or less than -1.0, the correlation measurement is incorrect. A
correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows a
perfect positive correlation. A correlation of 0.0 shows zero or no relationship between the movement of
the two variables.

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Fundamental Analysis-
Fundamental analysis is the analysis of critical factors that affect the value
of a stock. The intrinsic value of an equity share depends on a multitude of factors. The earnings of the
company, the growth rate, and the risk exposure of the company have a direct bearing on the price of the
share. These factors in turn rely on a host of other factors like the economic environment in which they
operate, the industry they belong to, and companies own performance. The appraisal of the intrinsic
value of shares in this school of thought is done through-
 Economic Analysis
 Industry Analysis
 Company Analysis

Thus, Fundamental Analysis is a combination of economic, industry and company analysis to obtain a
stock’s current fair value and predict its future value. This kind of fundamental analysis also known as
‘Top-down-approach’ because the analysis starts from an analysis of the economy, moves to industry
and narrows down to the company. This is also called EIC (Economy, Industry and Company) analysis.

1. Economic Analysis-
Economic Analysis is a study of the general economic factors that go into an
evaluation of a security’s value. The stock market is an integral part of the company. When the level of
economic activity is low, stock prices are low, and when the level of economic activity is high, stock
prices are high, reflecting a booming outlook for the sales and the profits of the firm.
Economic forces affect decisions made in personal business activities, as well
as within business organizations, government entities, and nonprofit organizations. Changes in economic
conditions affect and are affected by supply and demand, strength of buying power and the willingness
to spend, and the intensity of competitive efforts. These changes propel fluctuations in the overall state
of the economy and influence courses of action and the timeliness of actions.
All business executives know that it is important to gain some idea of what
general business conditions will be in the months or years ahead. Fortunately, certain economic
indicators or indices enable decision makers to forecast oncoming changes in economic forces.

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The Process of Conducting an Economic Analysis-
Conducting an economic analysis requires
the application of scientific methods to break down economic events into separate components that are
easier to analyze. The remainder of this article discusses the steps included in this process.

Step 1—Identify Appropriate Economic Indicators-

The first step in the process of conducting an
economic analysis is to identify appropriate economic indicators for specific economic forecasts or
trends. While various indicators may be selected, they are usually classified as indicators that lead, lag,
and/or are coincident with economic conditions. Measures of data derived from economic indicators
yield valuable information for the identification of economic trends and the preparation of specific
economic forecasts.

Step 2—Collect Economic Data-

Once the identification of indicators has been completed, the second
step, which is the collection of economic data yielded by the indicators, can begin. Data collection is
accomplished through observation and/or by reviewing measures of economic performance, such as
unemployment rates, personal income and expenditures, interest rates, business inventories, gross
product by industry, and numerous other economic indicators or indices. Such measures of economic
performance may be found in secondary sources such as business, trade, government, and general-
interest publications.

Step 3—Prepare or Select an Economic Forecast-

Of course, simply gathering information about
economic indicators is not enough. Decision makers must use the data to identify trends and project
forecasts. Decision makers know that it is important to gain some idea of what economic conditions will
be in months or years ahead. As a result, they either use the collected data to prepare their own forecasts
or they use economic forecasts that have been prepared by experts who monitor economic activity.
Regardless of its origin, the forecast itself is essential if the decision maker is to recognize opportunities
and threats posed by the economic environment. Thus, using economic data to predict the future is the
third step in the process.

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Step 4—Interpret the Economic Data-
The fourth step requires decision makers to examine, assess, and
interpret the economic data collected and the subsequent forecast generated from the economic data.
Decision makers evaluate the data and forecast for accuracy, try to resolve inconsistencies in the
information, and—if it is warranted—assign significance to the findings. By analyzing economic data
and forecasts, decision makers should be able to recognize and identify potential opportunities and
threats linked to economic changes and developments.

Step 5—Monitor Intervening Forces-

Then, too, intervening forces can and do influence economic
activity. Such forces can shift or alter economic performance and trends and must be anticipated by
decision makers. Thus, anticipating and monitoring the government's manipulation of two powerful sets
of economic instruments, fiscal policy and monetary policy, becomes the fifth step in the process. Fiscal
policy is the government's combined spending and taxation program, while monetary policy represents
actions by the Federal Reserve System that affect the supply and availability of money and credit. The
two arms of policy can work to supplement each other when powerful stimulus or restraint is sought.

Step 6—Use the Economic Analysis for Decision Making-

Finally, decision makers use the results of an
economic analysis for decision making. Astute decision makers recognize that economic forces are
uncontrollable and that current strategies may need to be adjusted to cope with or overcome obstructing
economic changes. They approach with caution opportunities and threats discovered as a result of
economic scanning and analysis. They pursue a proactive approach, however, knowing that an economic
analysis enables them to choose from alternative approaches how to employ scarce or uncommon
resources and achieve objectives in the most efficient and cost effective manner.

2. Industry Analysis
An analysis of the performance, prospects and problems of an industry of
interest is known as industry analysis. Industry analysis is required because the return and risk level of
industries differ. The risk factors related to the automobile industry are different from those related to
the information technology industry. Consumer spending has a greater impact on the automobile
industry than on the IT industry. The performance of an industry reflects the performance of the
companies it consists of.
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 Industry analysis is a tool that facilitates a company's understanding of its
position relative to other companies that produce similar products or services. Understanding the forces
at work in the overall industry is an important component of effective strategic planning. Industry
analysis enables small business owners to identify the threats and opportunities facing their businesses,
and to focus their resources on developing unique capabilities that could lead to a competitive
advantage.

Kinds of Industries-
Industries can be classified on the basis of the business cycle. According to their reactions to the
different phases of the business cycle. They are classified as growth, cyclical, defensive and cyclical
growth industries.
1. Growth Industry
A growth industry is the sector of the economy experiencing a higher-than-average
growth rate. Growth industries are often associated with new or pioneer industries that did not exist in
the past. Their growth is related to consumer demand for new products or services that firms within the
industry are beginning to offer.
2. Cyclical Industry
A cyclical industry is a type of industry that is sensitive to the  business cycle, such
that revenues generally are higher in periods of economic prosperity and expansion and are lower in
periods of economic downturn and contraction. Companies in cyclical industries can deal with this type
of volatility by implementing employee layoffs and cuts to compensate during bad times and paying
bonuses and hiring en masse in good times.
3. Defensive Industry
A defensive industry is a corporation whose sales and  earnings remain relatively
stable during both economic upturns and downturns. Defensive companies tend to make products or
services that are essentials. That is, they are likely to be purchased whether the economy is booming or
in a recession. At the opposite end of the spectrum are companies that rely heavily on the strength of the
economy. These include restaurants and luxury goods companies that tend to do well when consumers
are doing well financially and feel confident in their economic future. Defensive industries may lag
behind other companies during periods of economic expansion due to the stability of demand for its
products and services and also due to the surge in demand for discretionary goods that occurs during
economic booms.

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4. Cyclical Growth Industry
This is the new type of industry that is cyclical and at the same time
growing. For example, the automobile industry experience periods of stagnation and decline but also
grows tremendously. Changes in technology and introduction of new models can help the automobile
industry to resume its growth path.

Industry Life Cycle-

An industry life cycle depicts the various stages where businesses operate,
progress, prospect and slump within an industry. An industry life cycle typically consists of five stages
startup, growth, shakeout, maturity and decline. These stages can last for different amounts of time,
some can be months or years.

1. Startup Stage
At the startup stage, customer demand is limited due to unfamiliarity with the new
product’s features and performance. Distribution channels are still underdeveloped, so there are very
few product supply and promotional activities. There are also lack of complementary products which
add value to the customers, limiting the profitability of the new product.

2. Growth Stage
As the product slowly attracts attention from a bigger market segment, the industry
moves on to the growth stage where profitability starts to rise. Improvement in product features leads to
easiness to use, thus increasing value to customers. At the growth stage, revenue continues to rise and
companies start generating positive cash flows and profits as product revenue and costs break-even.

 3. Shakeout Stage

Shakeout usually refers to the consolidation of an industry. Some businesses are
naturally eliminated because they are unable to grow along with the industry or are still generating
negative cash flows. Some companies merged with competitors or are acquired by those which were
able to obtain bigger market shares at the growth stage.
At the shakeout stage, growth of revenue, cash flows and profit start slowing down as industry
approaches maturity.

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 4. Maturity Stage
At the maturity stage, majority of the companies in the industry are well-established
and the industry reaches it saturation point. At this stage, companies realize maximum revenue, profits
and cash flows because customer demand is fairly high and consistent. Products become more common
and popular among the general public, and the prices are fairly reasonable compared to new products.

 5. Decline Stage

Decline stage is the last stage of an industry life cycle. The intensity of competition in
a declining industry depends on several factors: sped of decline, height of exit barriers and level of fixed
costs. To deal with decline, some companies might choose to focus on their most profitable product lines
or services in order to maximize profits and stay in the industry. Some larger companies will attempt to
acquire smaller or failing competitors to become the dominant player. For those who are facing huge
losses and do not believe there are opportunities to survive, divestment will be their optimal choice.

3. Company Analysis
Evaluating the financial performance of a company on the basis of Qualitative and
Quantitative factors is called company analysis. Qualitative factors are non-quantifiable factors that
represent certain factors of a company’s business. Integrating such information into evaluation of stock
prices can be quite difficult. At the same time, they cannot be ignored. The management factor is
qualitative factor. It is difficult to measure, yet exerts tremendous influence on the profitability or even
the existence of the company.
There two types of Factors that affect the value of company’s share.

1. Qualitative Factors
2. Quantitative Factors

1. Qualitative Factors-
Qualitative factors that affect the value of a company can be discussed as
below.

(i) Business Model- Even before an investor looks at a company's financial statements or does any
research, one of the most important questions that should be asked is: What exactly does the company
do? This is referred to as a company's business model – it's how a company makes money.
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Sometimes business models are easy to understand. Take McDonalds, for instance, which sells
hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's
a simple model, easy enough for anybody to understand. 
(ii) Competitive Advantage - Another business consideration for investors is competitive advantage. A
company's long-term success is driven largely by its ability to maintain a competitive advantage - and
keep it. Powerful competitive advantages, such as Coca Cola's brand name and Microsoft's domination
of the personal computer operating system, create a moat around a business allowing it to keep
competitors at bay and enjoy growth and profits. When a company can achieve competitive advantage,
its shareholders can be well rewarded for decades. 
(iii) Management - Just as an army needs a general to lead it to victory, a company relies upon
management to steer it towards financial success. Some believe that management is the most important
aspect for investing in a company. It makes sense - even the best business model is doomed if the
leaders of the company fail to properly execute the plan.  This is one of the areas in which individuals
are truly at a disadvantage compared to professional investors. You can't set up a meeting with
management if you want to invest a few thousand dollars. On the other hand, if you are a fund manager
interested in investing millions of dollars, there is a good chance you can schedule a face-to-face
meeting with the upper brass of the firm.
(iv) Corporate Governance - Corporate governance describes the policies in place within an
organization denoting the relationships and responsibilities between management, directors
and stakeholders. These policies are defined and determined in the company charter and its bylaws,
along with corporate laws and regulations. The purpose of corporate governance policies is to ensure
that proper checks and balances are in place, making it more difficult for anyone to conduct unethical
and illegal activities.

2. Quantitative Factors-
The quantitative factors of a company can be describe below.

(i) Earnings of the company- The earning of the company decide its stock value in the market. The
company pays dividend from its earnings. Growing earning result in high valuation of the stock.
Sometimes the prices of a stock may be high but not the earnings.
(ii) Financial Leverage- The degree of utilization of borrowed money in a business is known as
financial leverage. This depends upon the financial decision of the company. These decision involve the
selection of the appropriate financing mix and deciding the capital structure of leverage.
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(iii) Operating Leverage- If a firm’s fixed costs are a major portion of total costs, the firm is said to
have a high degree of operating leverage. Leverage is the use of a lever to raise a heavy object with little
force. A high degree of operating leverage implies that, other factor being constant a relatively small
change in sales result in a large change in return in equity.
(iv) Competitive edge- Major industries in India are composed of hundreds of individual companies.
The large companies are successful in meeting the competition. Once companies attain a leadership
position in the market, they seldom lose it. Over time, they prove their ability to withstand the
competition and retain a sizeable share of the market. The competitiveness of the company can be
assessed by market share, growth of annual sale and stability of annual sales.
(v) Production efficiency- Production efficiency means producing the maximum output at minimum
cost per unit of output. This efficiency measures how well the production or transformation process is
performing. Increasing efficiency boosts the capacity of a business, without any change in the number of
inputs employed.

Risk and Return

The simplest way to define risk / return tradeoff is the "ability-to-sleep-well-at-night" test. Some
investors handle financial risks better than others due to their current financial health, investment time
horizon and realistic returns expectations.
'Risk' is the probability that the actual returns on your investments are different compared to your
expectations. This is measured by standard deviation in statistics. Simply put, risk means that there is a
probability of losing some, or even all, of your initial investment.
Deciding what amount of risk you are willing to take comfortably with your investments is extremely
critical and will help you take crucial decisions while investing.
Risk/Return Tradeoff is all about achieving the fine balance between lowest possible risk and highest
possible return. Low levels of risk are usually associated with low potential returns while higher levels
of risk are normally expected to yield higher returns. The graph below depicts the typical risk / return
relationship.

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 It is important to note that higher risk does not always mean higher returns. While the risk /
return tradeoff indicates that higher risk gives us the probability of higher returns, there are no
guarantees. Higher potential returns could also lead to higher potential losses. The government securities
represent the lower end of this risk / reward scale since their chances of default are almost zero. This
represents risk-free return, which means, you can earn this rate of return virtually without any potential
risk. But, earning 6% in a scenario where inflation is around 8% means that the value of your savings is
steadily eroding. Traditionally, equity funds have given much more every year over the long term.

Beta as a Measure of Risk

Beta is a numeric value that measures the fluctuations of a stock to changes in the overall stock market.
Beta measures the responsiveness of a stock's price to changes in the overall stock market.

Beta is a statistical measure of the volatility of a stock versus the overall market. It's generally used as
both a measure of systematic risk and a performance measure. The market is described as having
a beta of 1. The beta for a stock describes how much the stock’s price moves in relation to the market. If
a stock has a beta above 1, it's more volatile than the overall market. As an example, if an asset has a
beta of 1.3, it's theoretically 30% more volatile than the market. Stocks generally have a positive beta
since they are correlated to the market.
If the beta is below 1, the stock either has lower volatility than the market or it's a volatile asset whose
price movements are not highly correlated with the overall market. The price of Treasury bills (T-
bills) has a beta lower than 1 because it doesn't move very much in relation to the overall market. Many
consider stocks in the utility sector to have betas less than 1 since they're not very volatile. Gold, on the
other hand, is quite volatile but has at times had a tendency to move inversely to the market. Lower beta
stocks with less volatility do not carry as much risk, but generally provide less opportunity for a higher
return.
For example, if a stock's beta value is 1.3, it means, theoretically this stock is 30% more volatile than
the market. Beta calculation is done by regression analysis which shows security's response with that of
the market. By multiplying the beta value of a stock with the expected movement of an index, the
expected change in the value of the stock can be determined. For example, if beta is 1.3 and the market
is expected to move up by 10%, then the stock should move up by 13% (1.3 x 10).
Beta is the key factor used in the Capital Asset Price Model (CAPM) which is a model that
measures the return of a stock.
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 Limitation of Beta Measure-
1. While calculating past Betas, the length of time will affect the beta size.
2. Beta done not describe casual relationship between security and the general market. Rather both
depends on the economy which cause change in systematic risk.
3. It is difficult to measure the individual stock.
4. Beta is not proper measure of pricing risk in the market.

Calculation of Beta
To calculate the beta of a security, the  covariance between the return of the
security and the return of market must be known, as well as the variance of the market returns.
 Covariance measures how two stocks move together. A positive covariance means the
stocks tend to move together when their prices go up or down. A negative covariance means the
stocks move opposite of each other.
 Variance, on the other hand, refers to how far a stock moves relative to its mean. For example,
variance is used in measuring the volatility of an individual stock's price over time. Covariance is
used to measure the correlation in price moves of two different stocks. 
The formula for calculating beta is the covariance of the return of an asset with the return of
the benchmark divided by the variance of the return of the benchmark over a certain period.

Similarly, beta could be calculated by first dividing the security's standard deviation of returns by the
benchmark's standard deviation of returns. The resulting value is multiplied by the correlation of the
security's returns and the benchmark's returns.

Selection of Portfolio-
Portfolio Selection (sometimes called Portfolio Build) is the process of
selecting the Portfolio Requests that will be included in scope for execution through a series of
leadership investment decisions. Leads directly to the "Portfolio Scoped" Milestone, and is refined
through Continuous Investment Review.

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Portfolio Build/Selection involves examining the collection of Portfolio Requests and
associated Business Cases to ensure that the Portfolio accurately reflects the Business Strategic
Direction. Portfolio Build/Selection can occur annually, quarterly or continuously.

Portfolio Selection is a set of critical business decisions that provides sustains or removes funding from
pieces of work. There is a fine balance to be struck between stopping failing work early (a positive
thing) and changing business priorities so often that programmes, projects and other delivery methods
have no stability which inhibits their forward planning, diminishes the ability of teams to settle in to a
delivery cadence and in turn reduces morale.
 
Objectives of Portfolio Management
The objective of portfolio management is to invest in securities is securities in such a way that one
maximizes one’s returns and minimizes risks in order to achieve one’s investment objective.
A good portfolio should have multiple objectives and achieve a sound balance among them. Any one
objective should not be given undue importance at the cost of others. Presented below are some
important objectives of portfolio management.
1. Stable Current Return: Once investment safety is guaranteed, the portfolio should yield a steady
current income. The current returns should at least match the opportunity cost of the funds of the
investor. What we are referring to here current income by way of interest of dividends, not capital gains.

2. Marketability: A good portfolio consists of investment, which can be marketed without difficulty. If
there are too many unlisted or inactive shares in your portfolio, you will face problems in encasing them,
and switching from one investment to another. It is desirable to invest in companies listed on major
stock exchanges, which are actively traded.

3. Tax Planning: Since taxation is an important variable in total planning, a good portfolio should
enable its owner to enjoy a favorable tax shelter. The portfolio should be developed considering not only
income tax, but capital gains tax, and gift tax, as well. What a good portfolio aims at is tax planning, not
tax evasion or tax avoidance.

4. Appreciation in the value of capital: A good portfolio should appreciate in value in order to protect
the investor from any erosion in purchasing power due to inflation. In other words, a balanced portfolio
must consist of certain investments, which tend to appreciate in real value after adjusting for inflation.

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5. Liquidity: The portfolio should ensure that there are enough funds available at short notice to take
care of the investor’s liquidity requirements. It is desirable to keep a line of credit from a bank for use in
case it becomes necessary to participate in right issues, or for any other personal needs.

6. Safety of the investment: The first important objective of a portfolio, no matter who owns it, is to
ensure that the investment is absolutely safe. Other considerations like income, growth, etc., only come
into the picture after the safety of your investment is ensured.

Markowitz Theory-
Harry M. Markowitz is credited with introducing new concepts of risk mea -
surement and their application to the selection of portfolios. He started with the idea of risk aversion of
average investors and their desire to maximize the expected return with the least risk. Markowitz model
is thus a theoretical framework for analysis of risk and return and their inter-relationships. He used the
statistical analysis for measurement of risk and mathematical programming for selection of assets in a
portfolio in an efficient manner. His framework led to the concept of efficient portfolios. An efficient
portfolio is expected to yield the highest return for a given level of risk or lowest risk for a given level of
return.

Markowitz emphasized that quality of a portfolio will be different from the quality of individual assets
within it. Thus, the combined risk of two assets taken separately is not the same risk of two assets
together. Thus, two securities of TISCO do not have the same risk as one security of TISCO and one of
Reliance. Risk and Reward are two aspects of investment considered by investors. The expected return
may vary depending on the assumptions.

A portfolio of assets involves the selection of securities. A combination of assets or securities is called a
portfolio. Each individual investor puts his wealth in a combination of assets depending on his wealth,
income and his preferences. The traditional theory of portfolio postulates that selection of assets should
be based on lowest risk, as measured by its standard deviation from the mean of expected returns. The
greater the variability of returns, the greater is the risk..

Thus, as per the Modern Portfolio Theory, expected returns, the variance of these returns and covariance
of the returns of the securities within the portfolio are to be considered for the choice of a portfolio. A
portfolio is said to be efficient, if it is expected to yield the highest return possible for the lowest risk or
a given level of risk.
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Assumptions of Markowitz Theory:

The Portfolio Theory of Markowitz is based on the following assumptions:

(1) Investors are rational and behave in a manner as to maximize their utility with a given level of
income or money.

(2) Investors have free access to fair and correct information on the returns and risk.

(3) The markets are efficient and absorb the information quickly and perfectly.

(4) Investors are risk averse and try to minimize the risk and maximize return.

(5) Investors base decisions on expected returns and variance or standard deviation of these returns from
the mean.

(6) Investors choose higher returns to lower returns for a given level of risk.

Diversification of Markowitz Theory:

Markowitz postulated that diversification should not only aim at reducing the risk of a security by
reducing its variability or standard deviation, but by reducing the covariance or interactive risk of two or
more securities in a portfolio. As by combination of different securities, it is theoretically possible to
have a range of risk varying from zero to infinity.

Markowitz theory of portfolio diversification attaches importance to standard deviation, to reduce it to

zero, if possible, covariance to have as much as possible negative interactive effect among the securities
within the portfolio and coefficient of correlation to have – 1 (negative) so that the overall risk of the
portfolio as a whole is nil or negligible.

In the example, if 2/3rds are invested in security (1) and 1/3rd in security (2), the coefficient of
variation, namely = S.D./mean is the lowest.
The standard deviation of the portfolio determines the deviation of the returns and correlation coefficient
of the proportion of securities in the portfolio, invested. The equation is-

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σ2p = Portfolio variance , σp = Standard deviation of portfolio , xi = Proportion of portfolio invested in
security i , xj = Proportion of portfolio invested in security j, rij = Coefficient of correlation between i
and J
σi standard deviation of i
σj standard deviation of J
N = number of securities

Parameters of Markowitz Diversification:

Based on his research, Markowitz has set out guidelines for diversification on the basis of the attitude of
investors towards risk and return and on a proper quantification of risk. The investments have different
types of risk characteristics, some called systematic and market related risks and the other called
unsystematic or company related risks. Markowitz diversification involves a proper number of
securities, not too few or not too many which have no correlation or negative correlation. The proper
choice of companies, securities, or assets whose return are not correlated and whose risks are mutually
offsetting to reduce the overall risk.

For building up the efficient set of portfolio, as laid down by Markowitz, we need to look into
these important parameters:
(1) Expected return.

(2) Variability of returns as measured by standard deviation from the mean.

(3) Covariance or variance of one asset return to other asset returns.

In general the higher the expected return, the lower is the standard deviation or variance and lower is the
correlation the better will be the security for investor choice. Whatever is the risk of the individual
securities in isolation, the total risk of the portfolio of all securities may be lower, if the covariance of
their returns is negative or negligible.

Single Index Model-

The single-index model (SIM) is a simple asset pricing model to measure both the risk

and the return of a stock. The model has been developed by William Sharpe in 1963 and is commonly
used in the finance industry. According to this model, the return of any stock can be decomposed into
the expected excess return of the individual stock due to firm-specific factors, commonly denoted by its
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alpha coefficient (α), the return due to macroeconomic events that affect the market, and the unexpected
microeconomic events that affect only the firm
To simplify analysis, the single-index model assumes that there is only 1 macroeconomic
factor that causes the systematic risk affecting all stock returns and this factor can be represented by the
rate of return on a market index, such as the S&P 500.
.

The Single Index Model

Relates returns on each security to the returns on a common index, such as the S&P 500 Stock Index
Expressed by the following equation
R i= α i + β i R M +e i
Where Ri is the expressed return of security.
αi is the intercept of the straight line or alpha co-efficient
βi is the slope of the straight line or beta co-efficient
RM is the rate of return of the market index
ei is the error term
According to this equation, the return of stock can be divided into two components the return due to the
market and the return independent of the market.
The index model is based on the following assumption
 Most stocks have a positive covariance because they all respond similarly to macroeconomic
factors.
 However, some firms are more sensitive to these factors than others, and this firm-specific
variance is typically denoted by its beta (β), which measures its variance compared to the market for
one or more economic factors.
 Covariance among securities results from differing responses to macroeconomic factors. Hence,
the covariance of each stock can be found by multiplying their betas and the market variance:
The single-index model assumes that once the market return is subtracted out the remaining returns are
uncorrelated:

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