Risk and Return - A Comprehensive Study of Aspects Ans Facts(2)

8/8/2019 Risk and Return - A Comprehensive Study of Aspects Ans Facts(2)

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BESS INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

Report On Comprehensive Study on Risk and Return

(Security Analysis and Portfolio Management)

Submitted To: Prof. Vardrajan

Submitted by

Vidya hanchate

Viraj Sanghvi (45)

Sagar Korday

Ankush Singh (48)

Sudarshan khedekar ()


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RISK AND RETURN

In almost all aspects of life, the largest risks have the largest payoffs. In competitive financial

markets, this holds true almost universally. Learn about how investors use the principle of

risk return trade off to make wise financial investments.

What is Risk?

Return expresses the amount which an investor actually earned on an investment during a

certain period. Return includes the interest, dividend and capital gains; while risk represents

the uncertainty associated with a particular task. In financial terms, risk is the chance or

probability that a certain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with an increase in risk. It is

important for an investor to decide on a balance between the desire for the lowest possiblerisk and highest possible return.

The principle that potential return rises with an increase in risk. Low levels of uncertainty

(low risk) are associated with low potential returns, whereas high levels of uncertainty (high

risk) are associated with high potential returns. According to the risk-return tradeoff,

invested money can render higher profits only if it is subject to the possibility of being lost.

Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when

choosing investments for your portfolio. Taking on some risk is the price of achieving

returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to

find an appropriate balance - one that generates some profit, but still allows you to sleep at

night.

Risk, in traditional terms, is viewed as a negative. Websters dictionary, for instance,

defines risk as exposing to danger or hazard.

Game of Risk and Return

In life it is generally true that greater rewards are acheived through greater risk-taking. The

principle of risk-return trade-off suggests that there is a strong positive relationship betweenthe potential rewards of a decision and the risk needed to realize those rewards. In fact, it can

be said that with great risk comes the possibility of great reward and great loss. This is the

essence of the risk-return trade-off in investing.

It is reasonable to assume that investors work toward making decisions that will yield a high

return with low risk. Given the choice between two alternatives that carry the same rewards

yet one of the alternatives is less risky, most investors will choose the less risky alternative.


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This is why investors understand that risk and return are two indelibly linked concepts when

it comes to investing money in any security, asset, or property.

The principle of risk aversion suggests that people, in general, avoid risky choices when

alternatives exist that allow for the same level of benefit or return. In the psychology

literature, risk aversion is an often-cited construct that captures a significant amount ofbehavior variability. In financial markets, investors are constantly on the lookout for either

the same risk for a larger return, or the same return for lower risk. Doing so ensures that

enough return is realized for a given risk level or not an excessive amount of risk is borne

given the expected return of an investment.

Most investors are risk averse, seeking to minimize risk and maximize return. This behavior

collectively creates intense rivalry among investors to seek out the best alternatives for

themselves because investors are all looking out for their own self-interest. However, how

does an investor decide how much risk is too much? What is an acceptable amount of risk

given an expected return on an investment?

Each investor has a unique combination of goals and knowledge. It is often true that younger

investors should invest in riskier assets to realize larger returns and risk the possibility of

lower returns because with youth comes plenty of time to correct a course of action before it

is too late. Older investors should risk less and thereby gain less to avoid a bad outcome

which cannot be corrected or offset by time. The point is that there is no optimal risk-return

trade-off sought by investors.

With so many alternatives to choose from and so many levels of risk available, most investors

evaluate their situation and take on a level of risk appropriately. Of course, some investors

take on too much risk, realize too many bad outcomes and go bankrupt. Such is the game ofrisk and return.

Types of Financial Risk

Participants in both clearing systems and typical financial markets are exposed to several

types of financial risk. First, they bear credit risk. This is the risk that a counterparty will not

meet an obligation when due, and will never be able to meet that obligation for full value.

The bankruptcy of a counterparty is often associated with such difficulties, but there may be

other causes as well. In a payment netting system, losses from defaults due to the bankruptcy

of counterparties can be measured as the principal amount due less recoveries from defaulting

parties. Forgone interest can also be an important loss. In an obligations netting system,losses from the default of a counterparty would typically be calculated from the replacement

costs of one or more contracts that are not settled. If, however, one party to a contract defaults

after having received settlement payments from another party, but before making required

counter-payments (in the same or another currency), the loss would again be for a principal

amount (less recoveries).3


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Second, participants bear liquidity risk. Narrowly defined, this is the risk that clearing, or

settlement, payments will not be made when due, even though one or more counterparties do

have sufficient assets and net worth ultimately to make them. For example, a temporary

inability to convert assets to cash, operational difficulties of various kinds, or the inability of

correspondents to perform settlement functions will all create liquidity problems.

The risk that a party will default on clearing obligations to one or more counterparties is

sometimes referred to as settlement risk. This risk may contain elements of either credit risk

or liquidity risk, or both. The usage of the term "settlement risk" varies considerably, and

may also depend on the situation being analysed. For purposes of clarity in this report, the

term is not used or discussed further. Instead, the concepts of credit or liquidity risk are

employed when one of these is the ultimate financial risk being addressed.

The concept of liquidity risk is usually defined more broadly, with reference to a whole range

of obligations that participants in financial markets incur, including payments due within

specific clearing systems. The risk is that a financial market participant will have insufficient

liquid resources to make all its payments on the due date, including its liabilities in a paymentsystem. This notion is useful because it implicitly recognises that liquidity problems in a

payment system can add to, or be part of, much larger liquidity difficulties in an economy.

Third, payment systems and financial markets generally can be subject to system, or

systemic, risk. This is the risk that the inability of one participant in a payment system, or in

the financial markets, to meet obligations when due will cause other participants to fail to

meet their obligations when due. For some analytical purposes it is possible to distinguish

"systemic liquidity risk" from "systemic credit risk". Of the various kinds of risk, it is usually

systemic risk in some form that is of most concern in assessing the risks associated with

payment systems.

5 types of financial risk that every human must know

1. Inflation Risk

We all know what Zimbabwe is famous for.Rising prices for consumer goods will eventually

reduce the purchasing power of dollars.There are some items that you need to buy now,

like a good vacation during prime time of life like 20s and 30s, instead of waiting until 70

years old.Because the cost of going for a vacation to the same place will definitely

increase 40 years later, not to mention the fact that you may get rammed over by a car the

next day so that your relatives can go for holidays at exotic locations after inheriting whatyou have left.But for the purchasing ofpersonal computers, one should only buy it later,

as and when it is necessary. This is simply because the same $2000 one year later can buy a

computer with double the processor speed, memory and hard drive space, etc.

2. Income Risk


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If you know that you are someone who is not good in interpersonal skills and work

capabilities is also not that outstanding either. Then you do face a higher risk of losing your

job and earned income.Or that realize the fact that age is catching up and you know that you

are not really indispensable to the whole company, then one also need to prepare for that

day of being fired and/or retrenched which is another better sounding word for fired.

3. Liquidity Risk

Liquidity risk is simply the loss in value when converting assets into cash within a short

notice.

Real estate and properties have a higher liquidity risk than stocks and fixed deposits. If

a house is worth $1 million and need to be sold and converted into cash within the next few

days, there is a good chance that you wont be able to find someone who can buy your house

for $1 million in the next few days.But if you sell it at a price of $10, you know that you can

quickly find a buyer but there is significantly lost in value. That is liquidity risk.

4. Interest Rate RiskAs an ordinary person, without the wealth of Buffet, one does need to

burrow when buying cars and save in certificates of deposits for a rainy day.Changing

interest rates will affect your interest for good or worse.

For example, placing cash in fixed deposits when interest rate is low reduces return. But

burrowing money at low interest rate means that you are paying less interest on your debt.

5. Personal Risk

This is what an individual does and his habits that can affect their financial standing now and

in future.It is hard for a hard core gambler and smoker to change their costly habits. This

basically results in much more additional spending on gambling, cigarettes and increased

premiums on insurance polices.When it comes to investing in stocks, most people are

greedy when others are also greedy and fearful and others are also fearful, instead of the

other way round.Only a select few, who master this particular personal risk and is the other

way round like Warren Buffet,become very rich while the masses lose money in the stock

market.

What are investment returns?

Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in:

Dollar/Rupee terms.


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Percentage terms.Example

What is the return on an investment that costs ` 1,000 and is sold

after 1 year for ` 1,100?

Return

= `Received - ` Invested

`1,100 - `1,000 = `100.

Percentage return

` Return/ ` Invested

` 100/ ` 1,000= 0.10 = 10%.

What is investment risk?

Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.

Importance of Risk-Return Relationship

The relationship between risk and return is a fundamental financial relationship that affects

expected rates of return on every existing asset investment. The Risk-Return relationship is

characterized as being a "positive" or "direct" relationship meaning that if there are

expectations of higher levels of risk associated with a particular investment then greater

returns are required as compensation for that higher expected risk. Alternatively, if an

investment has relatively lower levels of expected risk then investors are satisfied with

relatively lower returns.

This risk-return relationship holds for individual investors and business managers. Greaterdegrees of risk must be compensated for with greater returns on investment. Since

investment returns reflects the degree of risk involved with the investment, investors need to

be able to determine how much of a return is appropriate for a given level of risk. This

process is referred to as "pricing the risk". In order to price the risk, we must first be able to

measure the risk (or quantify the risk) and then we must be able to decide an appropriate

price for the risk we are being asked to bear.


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This module provides the student with an understanding of various forms of risk that allow

the incorporation of risk adjustments into financial management decision making and the

asset pricing processes. In the introductory discussions, different types of risk are defined

and explored. At more advanced levels, various definitions of risk are quantified and with

the help of financial theory, appropriate risk adjusted returns are identified.

Calculating and Interpreting Risk Measurements

It is safe to say that few, if any, non-professional investors, have the faintest idea how to

calculate and/or interpret these measurements. That is the so-called bad news. The good news

is that Morningstar and Value Line fund reports do all the statistical analysis for us and

provide easy-to-understand risk and return evaluations. Essentially, these come in five

different varieties: high, above-average, average, below-average, and low, or words to that

effect.

It is a universally accepted principle of investing that risk and return are commensurate. This

fancy terminology simply tells us that the level of risk determines the level of return. As a

result, it is unusual that a low-risk investment will produce a high return. Of course, the

inverse of this relationship is also true.

Asset Allocation and Diversification

Prior to selecting individual mutual funds, or any other investment, for a portfolio, an

investor should decide on an appropriate asset allocation. For the sake of this discussion, let's

say that a moderate 60% stock and 40% bond apportionment is made. Diversifying within

these allocations then requires that the investor select investments (funds, stocks, and/or

bonds) that are complementary this moderate risk-return investing strategy. (For more

insight, see Achieving Optimal Asset Allocation.)

Risk is an inherent part of investing. In order to get a reasonable return on an investment, riskhas to be present. A riskless asset will produce little or no return. The intelligent investor

manages risk by recognizing its existence, measuring its degree in any given investment and

realistically assessing his or her capacity to take risk. There is nothing wrong with investing

in a high-risk fund if the fund's return is equally high. The questions to ask are: Can I afford

the loss if it occurs? Am I emotionally prepared to deal with the uncertainties of high-risk

investments? Do I need to take this kind of risk to achieve my investment goals?

A prudent investor will seek to match and/or offset risk by assembling a reasonable number

of mutual funds with favorable risk-return profiles in a diversity of fund categories. This is

done by first identifying a mix of mutual funds according to company size (market-cap),

investing style (value, growth, and blend) and asset allocation (stock and bond). By choosingfrom these funds, you can find those that are characterized as having returns that exceed their

risks, or at least match them. This would represent a favorable risk-return profile, or spread,

and is a key fund investment quality.

Risk-Adjusted Return


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A concept that refines an investment's return by measuring how much risk is involved in

producing that return, which is generally expressed as a number or rating. Risk-adjusted

returns are applied to individual securities and investment funds and portfolios.

There are five principal risk measures: alpha, beta, r-squared, standard deviation and the

Sharpe ratio. Each risk measure is unique in how it measures risk. When comparing two or

more potential investments, an investor should always compare the same risk measures to

each different investment in order to get a relative performance perspective.

1. Alpha

Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the

volatility (price risk) of a security or fund portfolio and compares its risk-adjusted

performance to a benchmark index. The excess return of the investment relative to the return

of the benchmark index is its "alpha".

Simply stated, alpha is often considered to represent the value that a portfolio manager adds

or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has

outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would

indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it

is.

2. Beta

Beta, also known as the "beta coefficient," is a measure of the volatility, or systematic risk, of

a security or a portfolio in comparison to the market as a whole. Beta is calculated

using regression analysis, and you can think of it as the tendency of an investment's return to

respond to swings in the market. By definition, the market has a beta of 1.0. Individual

security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A

beta of less than 1.0 indicates that the investment will be less volatile than the market, and,

correspondingly, a beta of more than 1.0 indicates that the investment's price will be more

volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20%

more volatile than the market.

Conservative investors looking to preserve capital should focus on securities and fund

portfolios with low betas, whereas those investors willing to take on more risk in search of

higher returns should look for high beta investments.

3. R-Squared

R-Squared is a statistical measure that represents the percentage of a fund portfolio's or

security's movements that can be explained by movements in a benchmark index. For fixed-

income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury

Bill and, likewise with equities and equity funds, the benchmark is the S&P 500 Index.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-


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squared value between 85 and 100 has a performance record that is closely correlated to the

index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios,

which are generally criticized by analysts as being "closet" index funds. In these cases, why

pay the higher fees for so-called professional management when you can get the same orbetter results from an index fund?

4. Standard Deviation

Standard deviation measures the dispersion of data from its mean. In plain English, the more

that data is spread apart, the higher the difference is from the norm. In finance, standard

deviation is applied to the annual rate of return of an investment to measure its volatility

(risk). A volatile stock would have a high standard deviation. With mutual funds, the standard

deviation tells us how much the return on a fund is deviating from the expected returns based

on its historical performance.

5. Sharpe Ratio

Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted

performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond)

from the rate of return for an investment and dividing the result by the investment's standard

deviation of its return.

The Sharpe ratio tells investors whether an investment's returns are due to smart investment

decisions or the result of excess risk. This measurement is very useful because although one

portfolio or security can reap higher returns than its peers, it is only a good investment if

those higher returns do not come with too much additional risk. The greater an investment's

Sharpe ratio, the better its risk-adjusted performance.

Risk Analysis

Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk

in investment is defined as the variability that is likely to occur in future cash flows from an

investment. The greater variability of these cash flows indicates greater risk.

Variance or standard deviation measures the deviation about expected cash flows of each of

the possible cash flows and is known as the absolute measure of risk; while co-efficient of

variation is a relative measure of risk.

For carrying out risk analysis, following methods are used-

y Payback [How long will it take to recover the investment]y Certainty equivalent [The amount that will certainly come to you]y Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler

and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even

analysis] allows estimating the impact of change in the behavior of critical variables on the


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investment cash flows. Conservative forecasts include using short payback or higher discount

rates for discounting cash flows.

Investment Risks

Investment risk is related to the probability of earning a low or negative actual return as

compared to the return that is estimated. There are 2 types of investments risks:

1. Stand-alone riskThis risk is associated with a single asset, meaning that the risk will cease to exist if

that particular asset is not held. The impact of stand alone risk can be mitigated by

diversifying the portfolio.

Stand-alone risk = Market risk + Firm specific risk

Where,

o Market risk is a portion of the security's stand-alone risk that cannot beeliminated trough diversification and it is measured by beta

o Firm risk is a portion of a security's stand-alone risk that can be eliminatedthrough proper diversification

2. Portfolio riskThis is the risk involved in a certain combination of assets in a portfolio which fails to

deliver the overall objective of the portfolio. Risk can be minimized but cannot be

eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk

while a non-balanced portfolio increases risk.

Sources of risks

o Inflationo Business cycleo

Interest rateso Managemento Business risko Financial risk

Return Analysis


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An investment is the current commitment of funds done in the expectation of earning greater

amount in future. Returns are subject to uncertainty or variance Longer the period of

investment, greater will be the returns sought. An investor will also like to ensure that the

returns are greater than the rate of inflation.

An investor will look forward to getting compensated by way of an expected return based on3 factors -

y Risk involvedy Duration of investment [Time value of money]y Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any

risk premium and inflation. This rate generally remains stable; but in the long run there could

be gradual changes in the RRFR depending upon factors such as consumption trends,

economic growth and openness of the economy.

If we include the component of inflation into the RRFR without the risk premium, such a

return will be known as nominal risk free rate [NRFR]

NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1

Third component is the risk premium that represents all kinds of uncertainties and is

calculated as follows -

Expected return = NRFR + Risk premium

Risk and return trade off

Investors make investment with the objective of earning some tangible benefit. This benefit

in financial terminology is termed as return and is a reward for taking a specified amount of

risk.

Risk is defined as the possibility of the actual return being different from the expected return

on an investment over the period of investment. Low risk leads to low returns. For instance,

incase of government securities, while the rate of return is low, the risk of defaulting is also

low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term

returns on stocks are much higher than the returns on Government securities, but the risk oflosing money is also higher.

Rate of return on an investment cal be calculated using the following formula-

Return = (Amount received - Amount invested) / Amount invested


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Models of Risk and Return (Aswath Damodaran)

1.First Principles

Invest in projects that yield a return greater than the minimumacceptable hurdle rate.

The hurdle rate should be higher for riskier projects and reflect the

financing mix used - owners funds (equity) or borrowed money

(debt)

Returns on projects should be measured based on cash flows generated

and the timing of these cash flows; they should also consider both positive

and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the

assets being financed.

If there are not enough investments that earn the hurdle rate, return the

cash to stockholders.

The form of returns - dividends and stock buybacks - will depend upon

the stockholders characteristics.

Objective: Maximize the Value of the Firm

The notion of a benchmark

Since financial resources are finite, there is a hurdle that projects have to cross before being

deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A

simple representation of the hurdle rate is as follows:

Hurdle rate = Riskless Rate + Risk Premium

Riskless rate is what you would make on a riskless investment

Risk Premium is an increasing function of the riskiness of the project

2. The Capital Asset Pricing Model

Uses variance as a measure of risk

Specifies that only that portion of variance that is not diversifiable is rewarded.

Measures the non-diversifiable risk with beta, which is standardized around one.

Translates beta into expected return -

Expected Return = Riskfree rate + Beta * Risk Premium

Works as well as the next best alternative in most cases.

The Importance of Diversification.

The concept of diversification suggests that putting all of ones eggs in ones basket is a risky

decision. Spreading investments over multiple, unrelated securities reduces the likelihood of

a sudden, fatal outcome. Learn how investors offset risk with a diversified portfolio.

One of the simplest concepts in finance theory is that of diversification. Diversification


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involves spreading a valuable asset over a variety of locations or situations such that loss of

one part of the asset does not affect the other parts. In competitive capital markets, investors

seek to diversify their investment portfolios such that if an unexpected event occurs reducing

the value of one security, not all of the investors value is at risk.

If would be foolish for an investor to invest all of his money in one security, say in the stockof just one company. Market downturns specifically affecting the market in which the

company competes could spell disaster for the investor because his wealth is directly

dependent on the performance of one company. Investing in multiple companies within the

same industry has a similar effect but is somewhat better because at least the investor is

diversified enough to avoid losing all of his wealth if one of the companies falls on bad times.

Diversification has the direct effect of lessening the risk taken on by an investor. Keep in

mind, however, that it lowers the risk of the investor; it does not lower the risk of the

underlying securities. Risk is a matter of market trends, economic trends, currency trends,

and other factors. There is no way that an investor can reduce the risk of securities

themselves.

Large companies such as banks have some of the most diversified portfolios in the world. A

portfolio is simply the collection of securities that make up the total investment decisions of a

person, group, or organization. The more diversified a portfolio, the less total risk is taken on

by its owner(s).

The concept of diversification is not limited to portfolios. Organizations diversify by

competing in difference market, making unrelated products, and acquiring shares of other

companies different from themselves. In addition, they diversify sources of supply, do

business outside of their home country, and outsource non-essential operations to othercompanies. Investors benefit from this diversification because it lowers the risk of owning a

part of the organization.

In competitive markets, diversification is not only a good idea, it is necessary to stay

competitive. Investors who do not diversify are taking on more risk than is necessary for a

given return and have a higher probability of losing everything because of a single event that

solely affects the underlying security.

The risk (variance) on any individual investment can be broken down into two sources. Some

of the risk is specific to the firm, and is called firm-specific, whereas the rest of the risk is

market wide and affects all


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investments. The risk faced by a firm can be fall into the following categories

(1) Project-specific; an individual project may have higher or lower cash flows than

expected.

(2) Competitive Risk, which is that the earnings and cash flows on a project can be

affected by the actions of competitors.

(3) Industry-specific Risk, which covers factors that primarily impact the earnings andcash flows of a specific industry.

(4) International Risk, arising from having some cash flows in currencies other than the

one in which the earnings are measured and stock is priced

(5) Market risk, which reflects the effect on earnings and cash flows of macro economic

factors that essentially affect all companies.

The risk-return tradeoff

TRADITIONAL wisdom on the risk-return relationship is that the greater the risk associated

with an investment, the higher should be the compensation -- otherwise described as the risk

premium.

An investment decision should, thus, depend primarily on the returns realised after taking

into account the risk. This can be assessed using an indicator of the returns expressed as a

unit of risk. The actual number is arrived at by dividing the returns by the variation in returns

as measured by the standard deviation of the returns.

Business Line analysed the returns per unit of risk on the Nifty stocks on monthly, quarterly,

half-yearly and yearly basis. On an absolute return basis, 20 stocks posted positive average

annual returns above the average bank deposit rate of 10 per cent. However, after adjusting

for risks, only 12 provided returns over the average bank deposit rate. The best performers,

post-adjustment for risk, include FMCG and technology players.

An interesting trend that emerged from the returns per unit of risk analysis was that some of

the leading FMCG companies, such as HLL, Britannia, Nestle and ITC, performed well, over

the last seven years. Historically, FMCG stocks had lower volatility than some of the fancied

sectors.

This is a positive factor for investors in times of volatility. A portfolio of FMCG stocks loses

value during periods of volatility at a much lower rate than a portfolio of non-FMCG stocks.

This is a fundamental difference between investing in technology and FMCG stocks.

Both the technology and FMCG sectors posted fairly good returns over the seven-year period.

However, the risks associated with the former is higher than that for the latter. The reason is

fairly simple. Because of the evolutionary nature of the business, the perception of value of

technology businesses and the premium associated with companies in this sector vary among

market players.


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This uncertainty induced by changing perceptions leads to higher risk, as reflected in the

price movements. This is evident from the fact that HCL Infosystems and Satyam Computers

have monthly return volatility levels of 3.51 per cent and 3.80 per cent respectively.

Compared to this, the FMCG stocks have a lower level of volatility. The reasons could be

that the market understands the business of these companies better than it does that oftechnology firms. Even historically, FMCG stocks have recorded good returns, making them

good defensive plays. Consequently, these stocks may be viewed more as defensive stocks,

leading to lower speculation in the market. Hence, prices tend to be more stable.

This is evidenced by the fact that Nestle and Britannia have risk levels on monthly returns of

1.71 per cent and 1.41 per cent. Further, the risk level of the FMCG giant, HLL, is around

1.80 per cent, close to the index volatility level of 2 per cent. Hence, HLL may be a good

proxy for the index per se.

The only major in the FMCG sector to have registered significant losses is Colgate

Palmolive. The company has been losing market share to HLL over the last few years. Its

poor price performance can be attributed to this. At the same time, its risk level is close to

HLL's.

Safe options

Among all investment avenues, equity is the riskiest. Theoretically, there is a possibility that

at times when the equity market volatility is high, most stocks are going through a volatile

phase. This may lead to some investors moving from the high-risk equity class to the lower-

risk bonds and bank deposits. In mid-1998, for instance, when the equity market was beinghammered down, many investors moved to such safer options treasury bonds.

India does not have a deep debt market. Most investments in debt securities are likely to be in

bank deposits and fixed deposits of manufacturing companies. For instance, the fixed deposit

programme of Tata Power, an index-based stock, offers a yearly rate of return of around 11

per cent.

However, over the last seven years, the company's equity returns have been lower than 5 per

cent. It goes to show that, in some cases, especially Old Economy stocks, investors may be

better off investing in debt than in equity.

Taking a more conservative position, an analysis of the number of stocks that recorded an

average annual return greater than the bank deposit rates indicates that only 20 managed to

post positive returns. One has to consider the fact that the average bank rate may have been

conservative, given the higher interest rates prevailing in the market before 1999. Overall, the

indications are that a long-term investment in the equity market may not pay off.


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What is the difference between the risk and issue?

Risk is a future event that may have an impact on triple constraint (Budget, scope and

schedule). An issue is present problem or concern influencing triple constraints.

A risk can become an issue, but issue is not risk - it has already happened.

How Financial Firms Manage Risk

Over the past several years, there has been a steady march toward financial integration across

product lines among larger financial firms. The trend is in part due to the increasing

globalization of financial markets, the development of new financial instruments, and

advances in information technology.

The attraction to firms of offering an array of financial services can stem from the potential

advantages of cross-selling several products to customers or from the similarity in underlying

expertise and information systems used. However, from a supervisory perspective, it isimportant to recognize that different financial activities typically give rise to different types

of underlying risks.

Common risk categories

Financial firms face four common risks: market risk, credit risk, funding risk, and operational

risk. Market risk refers to the possibility of incurring large losses from adverse changes in

financial asset prices, such as stock prices or interest rates. Standard risk management

involves the use of statistical models to forecast the probabilities and magnitudes of large

adverse price changes. These so-called "value-at-risk" models are used to set capital against

potential losses. In practice, while models provide a convenient methodology for quantifying

market risks, there are limitations to their ability to predict the magnitude of potential losses.

To address these limitations, firms also use stress tests that examine the impact of large

hypothetical market movements on their portfolio values.

Credit risk is the risk that a firm's borrowers will not repay their debt obligations in full when

they are due. The traditional method for managing credit risk is to establish credit limits at

the level of the individual borrower, industry sector, and geographic area. Such limits are

generally based on internal credit ratings. Quantitative models are increasingly used to

measure and manage credit risks .

Funding (or liquidity) risk is the risk that a firm cannot obtain the funds necessary to meet its

financial obligations, for example short-term loan commitments. Three common techniques

for mitigating funding risk are diversifying over funding sources, holding liquid assets, and

establishing contingency plans, such as backup lines of credit. Generally, firms set funding

goals as benchmarks to measure their current funding levels, and take mitigating actions

when they are below certain thresholds.


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Finally, operational risk is the risk of monetary loss resulting from inadequate or failed

internal processes, people, and systems or from external events .Although operational risk

management is a rapidly developing field, standard risk mitigation techniques have not yet

been developed.

Common risk management techniques

A key element of financial risk management is deciding which risks to bear and to what

degree. Indeed, a financial firm's value-added is often its willingness to take on specific risks.

Correspondingly, risk management involves determining what risks a firm's financial

activities generate and avoiding unprofitable risk positions. Other important components are

deciding how best to bear the desired risks and what actions are needed to mitigate undesired

risks by shifting them to third parties.

Financial firms protect themselves from risk by setting aside funds to cover losses. Broadly

speaking, these funds are known as provisions and capital. Provisions are funds set aside to

cover expected (or average) losses, and capital refers to funds set aside to cover unexpected

(or extraordinary) losses. Capital takes several forms on the balance sheets of financial firms,

but typically it includes such items as shareholder equity. The reliance on provisions and

capital varies among financial firms engaging in banking, securities, and insurance activities

due to differences in their underlying risks.

Since financial firms have similar general goals regarding risk bearing, some of their risk

management techniques are similar. For example, all firms have procedures to ensure that

independent risk assessments are conducted and that controls are in place to limit the amount

of risk individual business units take. In addition, hedgingi.e., paying third parties to take

on some of the risk exposureis common to all types of financial activities. Market risk isthe easiest to hedge, because of the wide variety of exchange-traded and over-the-counter

derivatives available. Increasingly, credit risk is hedged using credit derivatives, which are

over-the-counter derivatives for which payments are based on borrower credit quality.

Finally, certain risk exposures arising from insurance activities can be hedged using the

reinsurance market.

At the same time, important differences in risk management techniques exist. As noted in the

2001 report by the Joint Forum consisting of international bank, securities, and insurance

supervisors, financial firms tend to invest more in developing risk management techniques

for the risks that are dominant in their primary business lines. The report also found that risk

management still is conducted mainly on the basis of specific business lines. The following

sections highlight the key differences in risk management techniques across financial

activities.

Financial risks of commercial banking


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A defining characteristic of commercial banking is extending credit to borrowers of all types.

Hence, commercial banks' main risks are the credit risk arising from their lending activities

and the funding risk related to the structure of their balance sheets. Banks hold loan loss

provisions to cover expected losses, but capital to cover unexpected credit accounts for a

larger share of the balance sheet. Banks are required to hold minimum levels of regulatory

capital, and bank regulators in most countries adhere to the 1998 Basel Capital Accord. Asmentioned, credit risk management is placing greater emphasis on producing detailed

quantitative estimates of credit risk. These measures are used to form better estimates of the

amount of provisions and capital necessary at the portfolio level and to price and trade

individual credits; in addition, they would be used for regulatory capital purposes under

proposed changes to the Basel Capital Accord.

Commercial banks are particularly vulnerable to funding risk because they finance illiquid

longer-term lending commitments with short-term liabilities, such as deposits. Broadly

speaking, funding risk management consists of an assessment of potential demands for

liquidity during a stressful period relative to the potential sources of liquidity. To avoid a

shortfall, banks seek to expand the size and number of available sources, for example, the

interbank market. In the United States, banks also have access to the Federal Reserve

discount window.

Financial risks of securities activities

Securities firms engage in various financial activities, but key among these are serving as

brokers between two parties in transfers of financial securities and as dealers and

underwriters of these securities. The degree to which individual securities firms engage in

these activities varies widely. In general, a large share of securities firms' assets are fully

collateralized receivables arising from securities borrowed and reverse repurchasetransactions with other market participants. Another asset category is securities they own,

including positions related to derivative transactions. The main risk arising from securities

activities is the market risk associated with proprietary holdings and collateral obtained or

provided for specific transactions. Securities firms generally do not maintain significant

provisions because their assets and liabilities can be valued accurately on a mark-to-market

basis. Hence, hedging techniques and capital play dominant roles in risk management for

securities firms.

With respect to credit risk, securities activities generate fewer credit exposures than

commercial bank lending. With fully secured transactions, securities firms mitigate theircredit risk exposures by monitoring them with respect to the value of the collateral received.

For partially secured or unsecured transactions, such as funds owed by counterparties in

derivative transactions, they mitigate credit risk by increasing or imposing collateral

requirements when the creditworthiness of the counterparty deteriorates. In addition, with

frequent trading counterparties, securities firms enter into agreements, such as master netting

and collateral arrangements, that aggregate and manage individual transactions exposures.


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Securities firms have significant exposure to funding risk because a majority of their assets

are financed by short-term borrowing from wholesale sources, such as banks. The liquidation

of their asset portfolios is viewed as a source of funding only as a last resort. Accordingly, the

primary liquidity risk facing securities firms is the risk that sources of funding will become

unavailable, thereby forcing a firm to wind down its operations. To mitigate this risk,

securities firms hold liquid securities and attempt to diversify their funding sources.

Financial risks of insurance activities

Insurance activities are broadly divided into life and non-life insurance, and firms

specializing in either category face different risks. Specifically, these two types of activities

require firms to hold different technical provisions, by virtue of both prudent business

practices and regulatory mandates. For life insurance companies, technical provisions

typically are the greater part of their liabilitiesabout 80%, according to the Joint Forum

reportand they reflect the amount set aside to pay potential claims on the policies

underwritten by the firms; capital is a relatively small percentage. Thus, the dominant risk

arising from life insurance activities is whether their technical provisions are adequate, as

measured using actuarial techniques. While term-life insurance policies are based solely on

providing death benefits, whole-life insurance policies typically permit their holders to invest

in specific assets and even to borrow against the value of the policies. Hence, life insurance

companies also face market and credit risks.

For a non-life insurance company, technical provisions make up about 60% of liabilities,

which is less than observed for life insurance companies. The different balance between

provisions and capital for non-life insurance companies reflects the greater uncertainty of

non-life claims. The need for an additional buffer for risk over and above provisions accounts

for the larger relative share of capital in non-life insurance companies' balance sheets.

Regarding funding risk, insurance activities are different from other financial activities

because they are prefunded by premiums; for this reason, insurance companies do not rely

heavily on short-term market funding. Life insurance companies have more than 90% of their

assets in the investment portfolio held to support their liabilities. Hence, whether the

investment portfolio generates sufficient returns to support the necessary provisions is a

major financial risk. Investment risks include the potential loss in the value of investments

made and therefore include both market and credit risk. These investment risks traditionally

have been managed using standard asset-liability management techniques, such as imposing

constraints on the type and size of investments and balancing maturity mismatches betweeninvestments and liabilities.

Conclusion

Several factors have contributed to the convergence of the financial service sectors. Yet,

significant differences in their core business activities and risk-management techniques


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remain. There are also important differences in the regulatory capital frameworks, reflecting

differences in the underlying businesses.

As firms become active participants in new markets and take on new types of financial risks,

it is important that appropriate policies and procedures be put into place to measure and

manage these risks. However, risk management still is conducted on the basis of specificbusiness lines. Hence, the challenge for risk managers is to aggregate different financial risks

across the firm accurately. At present, there are significant practical and conceptual

difficulties associated with these calculations. Because of differing time horizons and the

difficulty of precisely measuring correlations across financial risks, many firms calculate the

amount of economic capital separately for each risk type and aggregate. Clearly, simple

summation is too conservative, since it ignores any possible diversification.

Risk and Return - A Comprehensive Study of Aspects Ans Facts(2)

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