LITERATURE REVIEW

INTRODUCTION

The risk/return relationship is a fundamental concept in not only financial analysis, but in every aspect of life. If decisions are to lead to benefit maximization, it is necessary that individuals/institutions consider the combined influence on expected (future) return or benefit as well as on risk/cost. The requirement that expected return/benefit be commensurate with risk/cost is known as the "risk/return trade-off" in finance.

This session discusses the trade-off and, using conventional statistical tools, provides a method for quantifying risk. Two categories of risk borne by the firm's stockholders, business risk and financial risk, are discussed and demonstrated, as is the concept of leverage. The session also examines risk reduction via portfolio diversification and what requirements need to be met for firms to experience the benefits of diversification. The Capital Asset Pricing Model (CAPM) is used to demonstrate the risk/return trade-off by relating the required return on the firm's investments to its beta (or market) risk. Important Learning Terms Risk Systematic risk Unsystematic risk Return Portfolio Beta

Systematic Risk Systematic Risk, as the name suggests is the risk inherent in the economic system. Macro factors such as domestic as well as international policies, employment rate, the rate and momentum of inflation and general level of consumer confidence etc. are what constitute systematic risk. Generally, investors cannot hedge or diversify against this risk as it affects all kinds of asset classes and affects the entire economy as such.

Unsystematic Risk This is the risk inherent in a particular asset class. The best way to combat this risk is by diversification. However, one must remember that the diversification must be in the class of asset and not the asset itself. An example of the above is evenly distributing your portfolio in bank deposits, Reserve Bank of India (RBI) bonds, real estate and equities. That way if a certain unsystematic risk affects let's say the real estate market (say the prices crashes), then the presence of other classes of assets in your portfolio saves you from a total washout. However, note that diversifying within the same asset class (buying different equity shares) is not strictly combating unsystematic risk.

Understanding Unsystematic Risk The one thing that almost all investors would agree upon is the fact that equity is definitely more risky than debt. Irrational exuberance with a rising market has left many an investor losing their shirts and in some cases even more sensitive garments.

However, does this mean that investing in debt instruments is entirely risk-free? Unfortunately, the answer is in the negative though the volatility is much less. So first, let us examine what kind of risks do debt instruments pose.

Interest Rate Risk Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Interest rates in the economy may fluctuate due to several factors such as a change in the RBI's monetary policy, Cash Reserve Ratio (CRR) requirements, forex reserves, the level of the fiscal deficit and the consequent inflation outlook etc. Extraneous factors such as energy price fluctuations, commodity demand and supply and even capital flows may result in rates fluctuating.

Then there are the event-based factors that affect interest rates. For example, the 11/9 episode in the United States of America and 13/12 in India. If there is a war, interest rates will rise.

However, typically such events are temporary in nature and in fact a good fund manager can actually take advantage of such hiccups.

To illustrate how fluctuations in interest rates affect the returns, let us take the example of mutual funds (MFs). Adjusting the portfolio to the market rate of returns is called 'marking to market'.

We assume that the current Net Asset Value (NAV) of the MF is Rs. 10 and its corpus is Rs. 1000 crores. This means that if the fund sells all the assets of the scheme and distributes the money on equitable basis to all the unit holders, they will receive Rs. 10 per unit. Now suppose, the interest rate falls from 10% to 9%. Immediately, thereafter you wish to invest Rs. 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs. 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs. 1 lakh at the lower rate of 9%.

This is injustice to the existing investors. Therefore, something has got to be done to protect their interest. Here comes the 'mark to market' concept. The fund raises its NAV to Rs. 11.11. You will be allotted only 9,000 units and not 10,000. The returns on 9,000 units at 10% would be identical with the returns on 10,000 units at 9%. In other words, the NAV rises when the interest falls.

Credit Risk This is the risk of default. What if the company whose fixed deposit you invested in goes bankrupt? There have already been several such cases. Deposits with plantation companies and time-share resorts are more cases in point. True, you have legal remedy...but everyone knows how much time our courts take.

The only factor, which dilutes this risk somewhat, is the credit rating. Fixed income earning instruments get rated for varying degrees of safety. Investing in a highly rated instrument is safe but not sufficient. Firstly, the instrument may be down graded; you have to be on the lookout for

the same. Then there have been cases where the issuer has got rated by different agencies but chooses to indicate only the higher ones.

Elimination of Risks There is some good news though. Credit risk can be simply eliminated by investing in sovereign securities --securities issued by the government. There is simply no risk of default. Or so we hope, for retail investors, MFs offer gilt schemes, where almost the entire corpus is invested in sovereign securities thereby achieving the same result.

Interest rate risk discussed earlier is always prevalent. However, it comes into play only when a transaction is undertaken during the pendancy of the fixed income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest rate risk.Investments such as Public Provdent Fund (PPF), Relief Bonds etc. are normally held till maturity. These are examples where both the risks inherent in debt instruments are at a bare minimum

Government Action Risk This is a unique kind of risk, which has reared its ugly head in recent times. In the previous paragraph, it is mentioned that the interest rate risk is eliminated by simply holding the instrument till maturity.

However, such principles of investment had not contended with unilateral governmental action. For example, the rates of PPF over the past three years have been consistently reduced by the authorities from 12% p.a. to 8% p.a. To add insult to injury these rates are applicable on the entire corpus and not on additional investment. Relief Bonds have come down to 8%. Rates on other small saving instruments have also been slashed across the board. Unfortunately, there is no escape from this risk --- that of our government

Measuring Risk So far, we have acquainted ourselves with the kinds of risks inherent in investment instruments. However, merely knowing this much may not be enough to take an informed decision. The article began with the premise that return is

Risks In equity investment: Although an equity investment is the most rewarding in terms of returns generated, certain risks are essential to understand before venturing into the world of equity. These can be described as follows: a. Market/ Economy Risk: The performance of any company depends on the growth of an economy. An economy, which continues to prosper, ensures that companies operating in it benefit from its growth. However, an equity shareholder also runs the risk of any downturn in the economy affecting the performance of his company. Economy related risks are usually reflected in the factors such as GDP growth, inflation, balance of payment positions, interest rates, credit growth etc. A slowdown in the economy pinches almost all sectors, especially infrastructure, services and manufacturing companies. b. Industry Risk: All industries undergo some kind of cyclical growth. Shareholders get rewarded most during the expansion stage. For instance, the last few years have been very rewarding for investors in real estate. However, once the industry reaches a maturity stage, the rewards from investment are limited. Further, companies belonging to industries where growth has retarded incur losses or declining gains. Industry specific government regulations too impact returns from investments made therein. c. Management Risk: The management is the face of an enterprise. It is the team which gives direction to the future course of action that a company will take. Quality of management is hence paramount. Management changes often have a serious impact on policy matters of companies, thereby impacting the share price. A management which is unable to meet the challenges posed by competition is likely to suffer in performance. d. Business Risk: Business risk is a function of the operating conditions faced by a company and the variability that these conditions inject into operating income and hence expected dividends. Business risk can be classified into two broad categories: external and internal. Internal business risk is largely associated with the efficiency with which a

company conducts its operations within the broader environment imposed upon it. External risk is the result of operating conditions imposed upon the company by circumstances beyond its control. e. Financial Risk: Financial risk is associated with the way in which a company finances its activities. A company, borrowing money for business, creates fixed payment obligations in form of interest that must be sustained. Beyond a specified limit, the residual income left for shareholders gets reduced, thereby affecting the returns on shares. More importantly, it increases default risk, i.e, a heavily leveraged company, is at a greater risk of not being able to meet its liabilities and hence going bankrupt. f. Exchange Rate Risk: Companies today earn sizeable revenues from outside their parent country. Hence, any appreciation in the currency, as was recently witnessed with technology companies, adversely affects earnings, which results in falling or stagnant share prices. g. Inflation Risk: Rising prices or inflation reduces purchasing power for the common man resulting in a slowdown in the demand in the economy. This has implications for all the sectors in the economy. Hence, in an inflationary environment, share prices of most companies face a downturn as the expected fall in demand reduces their future expected income. h. Interest Rate Risk: Interest rate risk refers to the uncertainty of future market values and size of future income, caused by fluctuations in the general level of interest rates. Rising interest rates increase cost of borrowing, which results in an increase in the prices of products and a corresponding slowdown in demand. Hence, an interest rate hike affects share prices of companies cutting across the board.

How to overcome risks: Most risks associated with investments in shares can be reduced by using the tool of diversification. Purchasing shares of different companies and creating a diversified portfolio has proven to be one of the most reliable tools of risk reduction. How to overcome risks:

Most risks associated with investments in shares can be reduced by using the tool of diversification. Purchasing shares of different companies and creating a diversified portfolio has proven to be one of the most reliable tools of risk reduction.

The process of Diversification: When you hold shares in a single company, you run the risk of a large magnitude. As your portfolio expands to include shares of more companies, the company specific risk reduces. The benefits of creating a well diversified portfolio can be gauged from the fact that as you add more shares to your portfolio, the weightage of each companys share gets reduced. Hence any adverse event related to any one company would not expose you to immense risk. The same logic can be extended to a sector or an industry. In fact, diversifying across sectors and industries reaps the real benefits of diversification. Sector specific risks get minimized when shares of other sectors are added to the portfolio. This is because a recession or a downtrend is not seen in all sectors together at the same time.

However all risks cannot be reduced: Though it is possible to reduce risk, the process of equity investing itself comes with certain inherent risks, which cannot be reduced by strategies such as diversification. These risks are called systematic risk as they arise from the system, such as interest rate

Risk and inflation risk. As these risks cannot be diversified, theoretically, investors for taking systematic risk for equity investment

are reward .

The Risk/Return Trade-off in Financial Analysis It is widely accepted that the major determinant of the required return on the asset (or the rate to be applied to a stream of receipts to capitalize its value) is its degree of risk. Risk refers to the probability that the return and therefore the value of an asset or security may have alternative outcomes. Risk is the uncertainty (today) surrounding the eventual outcome of an event which will occur in the future. Example: when tossing a coin, some one is not sure exactly what will be the outcome. The outcome may be to have a Tail or the Head, so there is a concept of risk. In a football match, three outcomes can be experienced: win, lose or draw. In business, the same can happen regarding the expected return on the investments in various sectors. In Financial Analysis, the risk/return trade-off states that financial decisions that subject stockholders to more risk must offer a higher expected return. Risk a version is the tendency to try to avoid risky situations unless adequate compensation is offered. Example: The risk adverse individual faced with two events each having the same expected outcome will choose t he outcome with the lower level of risk

Measurement of risk & return The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates.

Categories of Risk and Leverage Faced by the Firm and by Stockholders

This type of risk is magnified by the degree to which the firm relies on fixed operating expenses in producing sales.

In many cases there is not much the firm can do about this type of risk; some industries have more volatile sales and higher fixed operating expense than others.

Operating leverage results when the firm has fixed operating expenses in its cost structure.

These expenses do not disappear when sales drop, nor do they increase when sales increase.

Operating leverage tends to magnify any change in sales on Earnings before Interest and Taxes (EBIT).

Stockholders are the ultimate bearers of the risk that results from leverage and they are the residual recipients of higher EBIT should sales increase.

B: Financial risk This type of risk arises primarily because of the fixed interest payments firms must make to their long-term creditors (debt capital).

This type of risk is reflected in volatile Net Income and Earnings per Share.

Financial leverage Results when the firm finances some portion of its assets with borrowed funds

Financial leverage means that changes in EBIT will magnify changes in net income and Earnings Per Share

As a firm increases its degree of financial leverage, its expected return (net income and Earnings Per Share) increases as does its risk

The financial manager has some discretion in determining the extent of financial leverage.

RISK DIVERISIFICATION Diversification occurs when different assets make up a portfolio.

The benefit of diversification is risk reduction; the extent of this benefit depends upon how the returns of various assets behave over time.

The market rewards diversification. We can lower risk without sacrificing expected return, and/or we can increase expected return without having to assume more risk.

Diversifying among different kinds of assets is called asset allocation. E.g. A telephone operator with many physical assets such as houses can diversify by acquiring financial assets which in turn earns return to the company. Compared to diversification within the different asset classes, the benefits received are far greater through effective asset allocation e.g. diversifying among different types of financial assets.

Example of diversification in Telecom industry is when a licensed mobile operator who provides fixed line telephones services also operates the community based telecenters, teleshops, card phones, etc. Other ways to reduce risk include the use of the following strategies:

Mass advertising to reduce erratic sales and hence to increased profit Entering into long-term sales or purchase contracts Recapitalizing toward more equity and less debt so as to reduce the burden of fixed financial expenses

The use of temporary labour instead of permanent employees

RISK IN A PORTFOLIO A portfolio is a collection of risky assets. If we view individual assets as one big asset we have a portfolio.Because of risk reduction, the nature of risk is fundamentally different when an asset is viewed as part of a portfolio instead of being viewed in isolation.

Measuring the Expected Return and Standard Deviation of a Portfolio The expected return on a portfolio is the weighted average of the returns of individual assets, where each asset's weight is determined by its weight in the portfolio.

This equation gives the theoretically correct required rate of return on a project based upon its systematic (or beta) risk.

The formula is applicable only in situations where all diversifiable risk has been eliminated. The risk-free rate (RFR) is a base rate reflecting the fact that the project should at a minimum offer a return equal to what could be earned in the Treasury bill market. Even risk less investments has a positive required rate of return.

The market risk premium, (km - RFR), indicates the premium investors require over the risk-free rate to invest in the general market index.

The required return on a project is positively related to the project's beta.

A very risky project (say a new expansion venture) will have a high beta coefficient, whereas low risk projects (such as a replacement machine) will have a lower beta.

Knowing a project's beta (and thus its minimum required return) is important for good financial management, because it indicates whether or not the expected rate of return is above, equal to, or below the required rate of return and whether or not stockholders are being properly compensated for the non-diversifiable risk they bear due to the project.

Formulas:

CLOSING PRICE-OPENING PRICE RETURNS -----------------------------------------------OPENING PRICE (R-r) 2 Variance (2) = -------------N Standard Deviation () = () 2 x100

Summary: Understanding Return and Risk At the core, understanding how to invest is all about returns and risk. Return is measured by how much one's money has grown over the investment period. Returns are not known in advance. Instead, you can only make an educated guess as to what kind of return to expect. Expecting a return of 25% just because your stock-investing friend say's that's what you will make may be unreasonable. Most expectations are based on what's happened in the past. Unfortunately history doesnt always repeat itself! We have all seen the highs of 2007, followed by the lows in 2008, haven't we? However we can draw reasonable conclusions about future returns by looking at longer-term data - 5yr and 10yr records - ofcourse with the express understanding that these returns are not guaranteed. Even if your return expectations are reasonable, there is the possibility that your actual returns turn out different than expected. You run the risk of losing some or all of your original investment. Why is that? Because of an uncertain future ( e.g. global economic environment), uncertainity over the quality and stability of investment, and some other uncertainities. In general, greater the uncertainity, greater the risk. Some common sources of uncertainity or risks that we must absorb, while we learn how to invest, are: Business and Industry Risk There might be a industry-wide slowdown, or even a global economic recession as we are experiencing now. That presents an uncertain future for any business, isn't it. Or the business might see its earnings dropping significantly say, due to management ineptitude/wrong decisions. The lower earnings (due to any of the above) may cause the companys stock to fall. Inflation Risk The money you earn today is always worth more than the same amount of money at a future

date. This is because goods and services usually cost more in the future, due to inflation. So its important that your investment return beats the inflation rate. If it merely keeps pace with inflation then your investment return is not worth much. We have seen inflation soaring upto 11% in 2008, now in 2009 its at 1 or 2% levels. Perhaps an average inflation rate over next 10 years may work out at 5-6%. Who knows, there's enough uncertainity here too. Market Risk Market Risk is about the uncertainity faced in the stock market. Several macro and micro economic details singularly or plurally can spook the market. We have seen how the massive mandate in elections 2009 has re-invigorated the market. On the other hand, A fragmented hung parliament may have caused the market to nosedive? Even for a well-managed business growing profitably, its stock may drop in value simply because the overall stock market has fallen. Liquidity Risk Sometimes you are not able to get out of your investment conveniently, and at a reasonable price. For example in 2008, you may have found it tough to sell your house at a price you wanted. In 2007 however you could have gone laughing to the bank. The market may simply be inactive or it may be just volatile - and that means you cant sell your investment or get the price you want, if you needed to sell immediately. Now here comes an important takeway in learning how to invest - understanding the risks associated with different asset classes. The degree of risk varies widely between asset classes and even among investment options in a asset class. We all appreciate that a govt-backedbond like a NSC or PPF scheme is safer than that offered by a reputed corporate. Next consider inflation risk - stocks face far lesser inflation risk than bonds. While bonds have managed to just keep pace with inflation, stocks have historically outpaced inflation, by some 10% annually on an average in India. However short-term bonds and money market investments face very little liquidity risk, while stocks face relatively greater liquidity risk. The risk return trade-off

The next important takeaway in learning how to invest, is understanding risk/return analysis or trade-offs. Every investor would want the highest possible return for the level of risk (uncertainity) that he is willing to accept. In a competitive marketplace, this results in a trade-off. Low-risk investments naturally are associated with low potential returns and high-risk investments with high potential returns. If we look at long term returns, stocks in India have historically produced returns that average 15% annually, while bonds have averaged 6-9% annually. This reflects the risk/return trade-off. Its important to remember that this is on an average for the asset class. Specific investment options may produce far higher or lower returns. For example an investment in ITC for the last 15 years has provided returns in excess of 30% annually. It's useful to remember that the risk is in the uncertainity. If you can evaluate a stock investment and weigh the potential returns with the uncertainities (or, relative lack of uncertainity) vis-a-vis another stock investment, you stand to gain tremendously from these trade-offs too! There's another useful service these risk/return trade-offs serve. They flag off highly risky investments. Any scheme advertising high potential returns usually flags high risk, even though the risks may not be apparent at first glance. For example, quite often we see Corporate Bonds offering far higher yields than usual (usually, from unknown companies), don't we - now that you know how to invest basics and the risk/return trade-offs, I am sure you will treat these with caution and a healthy dose of skepticism! Diversification: Mitigating Risks Diversification is a strategy that can be neatly summed up by the timeless adage "Don't put all your eggs in one basket." We have learnt how to invest, is all about returns and risk principles. You will now probably look to invest in a stock only after analysing that you will be compensated well (for the risk you are taking by investing in the stock), from the stock's returns. Now consider the scenario that you are invested in a single stock ABC Ltd. What happens if ABC Ltd. performs badly. You will not be compensated for the risk you have taken with the stock. Now consider the other scenario when you are invested in a portfolio of 10 stocks - ABC

Ltd. and 9 other unrelated stocks. What happens again if ABC Ltd. performs badly? Your total returns are not hurt as badly, right. You have mitigated the business risk substantially by diversifying your investment among 10 different stocks! The return of ABC Ltd. remains the same, please note. Also note that, each stock's return is affected by different factors (say the stocks belonged to different sectors -telecom, Banking, Steel,etc.) and they face different risks. So its important to invest across different categories or stocks - to diversify and reduce risks substantially. We have seen before that different asset categories - stocks, fixed-income and money market investments -face varying degree of risks w.r.t. liquidity, inflation and market risks. So it makes sense that you should diversify across these major investment categories. Diversification within an asset category such as stocks (across sectors and large-cap, mid-cap, blue-chip stocks) and even fixed-income products (long term bonds, money market funds) will further reduce market and inflation risks. And we have already seen business risk can be mitigated by diversifying across a portfolio of unrelated stocks. Now don't go overboard and over-diversify (say across 100 stocks). You run the overdiversification risk then! There are bound to be pockets of similarity, the incremental risk mitigation will be minimal. And you lose the benefits of stock concentration (as opposed to diversification) - but that's another discussion and let's leave it for another article. As a senior investor once put to me: Invert the logic. If you do not diversify, you are putting all your eggs in one basket, and are taking on too much of a risk; it's likely you will not get compensated for it, by your returns. Time Diversification There is another important how to invest mechanism through which we can mitigate risks substantially - remain invested for a longer time and across different market cycles. Let's say you invested in 2006 and 2007 in the Indian stock market. If you had to withdraw money anytime in 2008, you would have incurred substantial losses. However if you remained invested through

2008 till now you would have pared your losses significantly and even made gains in some. This works even better across longer time-periods of 5 years to 10 years. This is diversification over time and it ensures that you avoid the worst periods of economic cycles. Time diversification is especially useful for highly volatile investment categories such as stocks, where prices can fluctuate over the short term. Staying invested over longer term smoothes these fluctuations. Which brings us to another important how to invest takeway. If you cannot remain invested in (volatile) stock investments for relatively long time periods, you should avoid such investments. Obviously time diversification is less important for relatively stable investments such as bonds, Money market investments and fixed deposits. Another senior investor time diversification tip: It is always better to invest or withdraw large sums of money gradually over time, instead of bulk investment or withdrawl. Use time diversification to average out costs/gains and reduce risks. How to invest: is the foundation strong? Let's try and ensure that you truly absorb the how to invest principles of return and risk. Your investing success depends on how strong this foundation is. 1. Returns are not known in advance. So, you must make your investment decision using return expectations that are reasonable and mesh with reality 2. Your actual return may not meet your expectations. Be aware of that possibility while making all investments 3. Risk comes from the uncertainty surrounding the actual outcome of your investment; greater the uncertainty, greater the risk 4. Business or industry risk, inflation risk, liquidity risk, and market risk - these are the major sources of risk. All investments face each of these risks, but to varying degrees

5. There is a trade-off between risk and potential return: higher the potential returns, greater the risk; lower the potential returns, lower the risks. Be wary of claims of high returns, there may be hidden risks 6. These risks can be reduced significantly through diversification. Always diversify across asset categories (stocks, bonds,money market instruments), within asset categories, and across individual securities 7. Diversification is also important across market environments the longer your holding period, the better. Do not invest in volatile investments like stocks if you cannot remain invested for atleast three to five years