Lecture 13: Introduction to Risk Analysis. February 23, Vandana Srivastava. Stop Order

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1 Investment Planning Lecture 13: Introduction to Risk Analysis February 23, 2015 Vandana Srivastava Stop Order buy or sell will be executed only when the security reaches a particular price (the stop price) Once the stock has reached this price, a stop order essentially becomes amarket orderand is filled advantageous to investors who are unable to monitor their stocks for a period of time 6 1

2 limit order vs stop order limit order:sets the maximum or minimum at which someone is willing to buy or sell a particular stock. eg: buy stock ABC, which is trading at Rs.12, a limit order for Rs10 can be set. This guarantees that no more than Rs. 10 will be paid to buy this stock Once the stock reaches Rs10 or less, predetermined amount of shares can be bought automatically If you own stock ABC and it is trading at Rs12, a limit order to sell it at Rs15 can be placed. This guarantees that the stock will be sold at Rs15 or more. Stop order: owns stock ABC, currently trading at Rs20. Place a stop order to sell it at Rs15, order will only be filled once stock ABC drops below Rs15 assume that stock XYZ was bought at Rs10 per share and now the stock is trading at Rs20 per share. Placing a stop order at Rs15 will guarantee profits of approximately Rs5 per share, depending on how quickly the market order can be filled. What is risk? likelihood to receive an outcome that one would not like eg: driving a car may lead to accident or speeding fines In Finance, Risk is: defined as the chance that an investment's actual return will be different than expected includes the possibility of losing some or all of the original investment upside risk: returns higher than expected downside risk: returns lower than expected combination of danger and opportunity -cannot have one without the other if one wants opportunity (higher returns), then one has to live with the higher risk 6 6 2

3 more on risk in financial terms: danger is termed as risk opportunity is termed as expected return 6 equity risk and expected return investors buying assets expect to earn returns over the holding period actual returns may vary from the expected return-> difference between actual and expected return is source of risk eg: buy a 1-yr T-bill (or any other discount bond) with a 5% expected return. At the end of 1 yr, the actual return will be 5% riskless or risk-free investment eg: buy a stock of Coal India with a 20% expected return in 1 year. At the end of 1 yr, the actual return may be higher or lower than 20% risky investment 6 6 3

4 equity risk and expected return actual return and expected return of a risk-free asset actual return and expected return of a risky asset expected return returns 6 Representation of risk and return spread of the actual returns around the expected return is measure by the variance or by standard distribution of the distribution of returns greater the deviation of actual return from expected return, greater the variance skewness represents the bias towards negative or positive return eg: in the fig, the distribution is positively skewed as there is higher probability of large positive returns than large negative returns 6 6 4

5 types of risk: fundamental Systematic Risk inherent to the entire market or an entire market segment also known as undiversifiable risk, volatility or market risk affects the overall market, not just a particular stock or industry unpredictable and impossible to completely avoid cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy eg: significant political event, Unsystematic Risk Company- or industry-specific hazard that is inherent in each investment also known as "specific risk," "diversifiable risk" or "residual risk," can be reduced through diversification by owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type eg: a new competitor, a regulatory change, a management change and a product recall types of risk: specific Credit or Default Risk company or individual will be unable to pay the specified interest or principal on its debt obligations particular concern to investors who hold bonds in their portfolios Government bonds, especially those issued by the central government, have the least amount of default risk and the lowest returns corporate bonds have highest amount of default risk but also higher interest rates investment grade bonds are considered to have lower chance of default, while bonds with higher chances are considered to be junk Bond rating services, such as Moody's, rates bonds as investmentgrade and junk bonds Country Risk a country won't be able to fulfill its financial obligations country defaulting on its obligations, can harm the performance of all other financial instruments in that country as well as other countries it has relations with applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country 6 5

6 types of risk: specific Foreign-Exchange Risk applies to all financial instruments that are in a currency other than one s domestic currency while investing in foreign countries investor must remember that currency exchange rates can change the price of the asset eg: As an example, if an American investor invests in some Australian stock in Australian dollars, even if the share value appreciates, he may lose money if the Australian dollar depreciates in relation to the American dollar Market Risk the day-to-day fluctuations in a stock's price also referred to as volatility and applies mainly to stocks and options volatility is not so much a cause but an effect of certain market forces measure of risk because it refers to the behavior, or "temperament", of investment rather than the reason for this behavior types of risk: specific Political Risk Interest Rate Risk represents the financial risk that a country's government will suddenly change its policies major reason of developing countries lacking foreign investment risk that an investment's value will change as a result of a change in interest rates affects the value of bonds more directly than stocks 6 6

portfolio in financial world group of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts held directly by investors

7 portfolio in financial world group of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts held directly by investors and/or managed by financial professionals Diversification: introduction investing all portfolio in one asset, say, TCS, will expose investor to both firm-specific and market risk the concept of creating a portfolio that includes multiple investments in order to reduce risk is called diversification diversification can reduce firm-specific risk or at the limit, eliminate it, because: weight of each asset is very small as compared to un-diversified portfolio, reducing the effect of rapid fluctuations in asset value firm-specific risk on asset price in a portfolio can be positive or negative for a large period; this will average out to zero in large portfolios effects of market movements will likely to affect all assets in the same direction with some getting more effected than others 6 6 7

Risk and Return (Introduction) Professor: Burcu Esmer

Risk and Return (Introduction) Professor: Burcu Esmer 1 Overview Rates of Return: A Review A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk Measuring Market