Risk and Return

Return refers the amount of total monetary benefits a investors receive from a security.
Return of a financial security consists two component-periodical cash payments received at specified time intervals.
And market appreciation/depreciation of the security value over the investment time period.

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Concept of Return

Return refers the amount of total monetary benefits a investors receive from a security.
Return of a financial security consists two component-periodical cash payments received at specified time intervals. And market appreciation/depreciation of the security value over the investment time period.

Where, Pt is price of security in time period t, Pt-1 is price in last time period, Div is dividends.

Return Calculation

Reliance Ind.

Time Opening Price Closing Price Div.

May-07 1752.0 1760.0 10.0

It indicates that Reliance Ind. has offered 1.07% return to the investor on 7th of May.

The Annualized return will be 1.07X365=390.55%.

*

Realized Return vs. Expected Return

Realized return is the return which is realized by the investor over the investment time period.

Expected return is the return which is expected to earn over the investment time period by the investor.

Historical Return

Historical return is that return which has been offered by the security to the investors during the past.

Historical return of a security is used to analysis of risk and return prospectus of that security. For example sensex has offered -23.02 percent return in 2001, whereas in 2007 sensex has offered 56.13 percent return.

YearSensex return (%)2001-23.022002-27.26200384.283200419.638200548.421200636.86200756.13

Absolute Return

Absolute return refers the gross return which is realized by the investor.

For example on 1 Jan 2010 the price of Infosys stock was 1500 and it was 2500 on 30 June 2010.

So the absolute return is Rs 1000 (2500-1500).

And the relative return will be 66.7% (1000/1500).

Average or Airthematic Return

Average return is that return which is on average return offered by a security to the investors over a particular period of time. For e.g. in the last slide different level of annual return is offered by BSE 100 from 1995 to 2007. But the average return will be-

The average return which is offered by BSE 100 from 1995 to 2007 to the investors is 23.28%.

Annual Return Vs Annualized Return

Annual return refers the return which is obtained by the inventor during a year.

For example, on Jan. 1, 2010 the price of the Infosys stock was Rs 1000, and on Dec. 31, 2010 it is Rs 1300, and dividend in between is Rs 200, than annual return is: 50%.

If Infosys price was Rs 1000 on Jan 2010, and 1050 on Jan 31, 2010. It means the monthly return of Infosys is: 5%.

Annualized return will be: 5x12=60%.

Risk in Investing Financial Security

Risk in the capital market refers the Variation in the mean rate of return . Volatility in the stock market indicates risk which affects the value of the stocks.

Risk is segregated into two Categories:

Systematic Risk-

Systematic risk refers to that portion of total probability in return caused by factors affecting the prices of all securities.

Unsystematic Risk-

Unsystematic risk is the portion of total risk that is unique to a firm or industry.

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Total Risk

Systematic Risk

Unsystematic Risk

Business Risk

Financial Risk

Market Risk

Purchasing Power Risk

Interest Rate Risk

Forex Risk

*

Systematic Risk

Market Risk-

Market risk refers to that portion of total variability in the return caused by factors affecting the whole market. Economic, political and sociological changes are sources of this type risk.

Purchasing Power Risk-

Purchasing risk is associated with inflation and deflation. If an investor gets 5 percent rate of return and prevailing inflation is 5.5 percent, it means that investor is realizing 0.5 percent loss on the investment over the period of time.

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Systematic Risk..cont.

Interest Rate Risk-

Interest rate risk is associated with fluctuations in rate of return caused by variation in general interest rate. Interest rate risk is becoming prominent as not only domestic interest rate but also interest rate prevailing in the international market can cause volatility in the stock market.

Foreign Exchange Risk-

Foreign Exchange Risk is caused by changes in foreign exchange rate.

Market risk can not be diversified by enlarging the portfolio. This risk affects the market as a whole and each stock seems to co-vary in the same direction with the emergence of this risk.

Unsystematic Risk

Business Risk-

Business risk, emerges because of operating conditions, variability in business conditions, dividend decisions etc.

Financial Risk-

Financial risk caused by the way a firm finances its activities or expansion plans. If a firm raises debt in the market it increases its obligation to pay fixed amount of fund, viz., interest to the debtors. Investors perceive it risky to invest in those stocks whose debt equity ratio is high.

Non-market risk is specific and associated with individual stocks. This risk can be eliminated by enlarging and diversifying the portfolio by holding different stocks of different industries.

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Measurement of Total Risk

Risk of financial security refers the variation in the rate of return of that financial security.

Standard deviation is used to calculate the total risk of any financial security.

Where, R is return of the security, n is number of observations.

Measurement of Systematic Risk -beta

Systematic risk refers to that portion of total risk or variation in rate of return which are caused by factors affecting the prices of all securities.

Beta of financial securities is used to measure the systematic risk. It indicatives the level of sensitiveness of each security to the market.

Where, R is return on security, X is return on Market Index like Sensex.

A high beta value is the indication of high risk, and low beta value is the indication of low risk.

Measurement of Systematic Risk -beta

Beta value is widely used by the investors in analyze of the stocks. A stock with high beta value indicates high risk of the stock, on the other hand stock with low beta value is the indication of the low risk of the stocks.

Investor who are looking capital gain should invest in stocks with high beta value.

On the other hand investors which avoid to take high risk, should invest in low beta value stocks.

If the beta value of Infosys is 0.16. It means if sensex goes to 1% either side. Infosys return will vary 0.16% accordingly.

Calculation of Alpha value

Alpha of any financial security indicates the minimum level of return which an investor can expect from that security.

The income looking investor can invest in the stocks with high alpha values.

Where, is average return of the security, is the beta of the stock, is the average return of the stock.

Coefficient of variation

Coefficient of variation measures how much variation in the rate of return of a security comes due to variation in rate of return of market index like sensex.

All the stocks are the part of the stock market. When there will be any fluctuations in the rate of return of market index like sensex, correspondingly fluctuations will occur in the rate of return of the stock return.

Where, R is return on security, X is return on Market Index like BSE 100.

Financial Market

Financial Market is the market from where short and long term financial resources are raised. Financial market is divided in two sub markets-capital market and money market.

Capital market is that segment of money market from where long term capital is raised from the investors by issuing the different financial securities such as bonds, common equity shares and preference shares.

Money market on the other hand is that segment of the market from where short term capital is raised from the investors by issuing the securities such as treasury bills, certificate of deposits, commercial papers etc.

Organization of Indian Financial Market

Financial

Market

Capital

Market

Money

Market

Long Term

Loan

Stock

Market

Primary

Market

Secondary

Market

Organized

Banking

Sector

Unorganized

Banking

Sector

Sub

Markets

Call Money

Market

Treasury

Bills

Certificate

of Deposits

Commercial

Papers

PrimaryMarket
Primary Market is the market where a company issue its common shares very first time to the investors through the any method given below.

Company

Public Issue through Prospectus (IPO)

Through Offer for Sale

Private Placement

Right Issue

Book Building

Stock Option

Investors

Issue of Bonus Shares

Secondary Market

Investors

Primary

Market

Secondary

Market

BSE

&

NSE

Investors

Public Issue through Prospectus

Company directly issue a prospectus to the investors.

Features

Names and addresses of the company promoters, managers, board members, legal advisor, bankers etc.

The date of opening and closing of subscriptions.

Details regarding the project, plant location, technology, collaboration, infracutures facilities.

Past performance of the company.

Management perception regarding the risk factors involved in the project.

Credit rating obtained from recognized rating agency like, CRISIL, ICRA, and CARE.

Offer for Sale

Company issue its shares through some intermediary such as Issuing House or Stock Broker.

Company

Stock Brokers

Investors

Agreed Price

Placement of Securities

Under this system the shares are acquired by the issuing houses directly from the issuing company at an agreed price, and then these are placed only to selected investors.

Company

Broker

Bank

Merchant Bank

Institutional Investors

Parent Co.

Individual Investor-X

Individual Investor-Y

Individual Investor-Z

Agreed Price

Advantages-

EconomicalEffective decision makingEasy to convenience to investors.Speedy decision making.

Disadvantages-

Concentration of power.Influence of share holders.Less publicity of the company.Less possibility of market appreciation of share value..

Right Issue

Right issue involves issuing of shares by an existing company to its existing shareholders in proportion to the number of shares already held by them.

Merchant Bank (25%)

Institutional Investors (20%)

Parent Co. (20%)

Individual Investor-X (5%)

Individual Investor-Y (10%)

Company

Bank (10%)

Individual Investor-Z (10%)

Existing Share

Holders

Issue of Fresh shares

in proportion to their share holding

Book Building

Book building is a process wherein company hire some merchant banker or issuer house which further invites bids from investors between a range of share price.

Company

Stock Brokers

Or

Merchant Banker

Investors

Bonus Shares

Issue of bonus shares does not result in raising of fresh capital. It is process of conversion of dividends, and other reserves into share capital.

Merchant Bank (25%)

Institutional Investors (20%)

Parent Co. (20%)

Individual Investor-X (5%)

Individual Investor-Y (10%)

Company

Bank (10%)

Individual Investor-Z (10%)

Existing Share

Holders

Issue of Fresh shares

in lie of their dividends

Stock Options

Stock option is a process wherein company issue its shares only to its top executives.

Marketing Manager

HR Manager

Labour Union

Board of Directors

Company

Finance Manager

Money Market

Call money market is important segment of money market from where borrowing and lending is done for a short time period ranging from overnight to fortnight.

Call Money-

when money is lent or borrowed for overnight.

Notice Money-

when money is lent or borrowed more that one day and upto fourteen days.

Treasury Bills

Treasury bills are the promissory notes or a kind of financial bill issued by RBI on behave of central government with discount for a fixed period, not extending beyond one year.

TBs are issued with a promise to pay the amount stated therein to the bearer of the instruments.

TBs are issued on discount basis.

Periodicity of TBs-

14 days TBs, 91 days TBs, 182 days TBs, 364 days TBs.

Commercial Papers

Commercial papers are debt instruments issued by corporates for raising short term resources from the money market. CPs are unsecured debts-no provision is made behind the CPs.

Corporates having approval from RBI are eligible to issue CPs.

CPs are issued on interest/discount basis.

Certificates of Deposits

A certificate of deposit is a marketable document of title to a time deposit for a specified period.

CDs is a receipt given to the depositor by a bank or any other institution entitled to issue CD.

A CD is issued at a discount and it is negotiable instrument.

Regulation of Indian Financial Market

Regulation of Money Market

Money market is that market from where capital can be raised for short time period.

Reserve bank of India (RBI) is the statutory body which is authorized to regulate the Indian money market.

Regulation of Capital Market

Capital market is that market from where capital can be raised for long time period.

Securities and Exchange Board of India (SEBI) is the statutory body which is authorized to regulate the Indian capital market.

Euro Market/International Market

Euro market refers raising capital from international market by issuing the financial securities denominated in the foreign currencies.

These financial securities which are denominated in the foreign currency are commonly called euro issue. Some of the euro issues are:

ADR (American Depository Receipt)European Depository Receipt)Global Depository Receipt)Foreign bondsEuro bonds

International Bond Investing

Bonds are a debt instrument which are issued for a certain period of time and promises to give fixed yield.

In international market mainly two types of bonds are available.

1.Foreign Bond-

2. Euro Bond-

1. Bonds in International Market-

I. Foreign Bonds-

Infosys Tec.

(Foreign Co.)

US Dollar denominated

Bonds

US Market

(Investors)

Foreign Bonds

A bond thatis issued in a domestic market by a foreign entity, in the domestic market's currency. Foreign bonds are regulated by the domestic market authorities. Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractivebecause they can add foreign content to their portfolios without the added exchange rate exposure.

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2. Euro Bonds-

Infosys Tec.

(Foreign Co.)

Yen denominated

Bonds

US Market

(Investors)

Euro Bonds

A bondissued in a currencyother thanthe currency of the country or market inwhich itis issued. Usually, aeuro bond is issued by an international syndicate and categorized according to the currency in which it is denominated. A euro dollar bond thatisdenominated in U.S. dollars and issued in Japan by an Australian company would be an example of a euro bond. The Australian company in this example could issue the euro dollar bond in any country other than the U.S.

*

American Depository Receipt

If a foreign firm plans to issue its common equity shares in US market, it can issue through ADR in US capital market. The foreign firm will issue its share to some international bank which will in turn convert the equity shares into certain number of depositories. And that depositories will be sold the U.S. investors

For example XYZ Inc. plans to issue one lakh shares in US market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the US market.

American Depository Receipt

Infosysis Co.

(Foreign Co.)

US Market

Equity Shares

NYSE

International

Bank

Re/$

Dividends in US Dollar

Depositories

US Investors

Dividends in Re.

*

Europe Depository Receipt

If a foreign firm plans to issue its common equity shares in Europe, it can issue through EDR in European capital market. The foreign firm will issue its share to some international bank which will in turn convert the equity shares into certain number of depositories. And that depositories will be sold to the European investors.

For example XYZ Inc. plans to issue one lakh shares in Europe market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the European market.

European Depository Receipt

Infosysis Co.

(Foreign Co.)

London Market

Equity Shares

London St.

Mkt

International

Bank

Re/

Dividends in pounds

Depositories

U.K. Investors

Dividends in Re.

*

Global Depository Receipt

If a foreign firm plans to issue its common equity shares in global market , it can issue through GDR in global capital market. The foreign firm will issue its share to some international bank which will in turn convert the equity shares into certain number of depositories. And that depositories will be sold to the investors across the world.

For example XYZ Inc. plans to issue one lakh shares in global market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the global market.

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