CHAPTER III RISK MANAGEMENT Concept of Risk Risk is the quantified amount which arises due to the likelihood of the occurrence of a future outcome which one does not expect to happen. If one is participating in a game of chance, one would refer to risk as the possibility that one would lose the money. In investment analysis, Risk refers to the likelihood that one will receive a return on an investment that is different from the return one expects to make. In other words, risk can be referred as the volatility in the return with respect to the expected return. This concept of risk comes from the fact that investors who buy assets expect to earn specific returns over the particular period that they hold the asset. Their actual returns over this holding period may be different from the expected returns and it is this difference between actual returns and expected returns that is a source of risk. The spread of the actual returns around the expected return is mostly measured by the variance or standard deviation of the distribution. The greater is the deviation of the actual returns from the expected return, the greater will be the variance. If the actual return of an investment is equal to the expected return, such an investment is a risk free investment. In this case the probability of actual return being equal to expected return will be one and the variance of return will be zero. 58
In this way, Risk in an investment refers to the volatility in the return with respect to the expected return. It can be reduced by having a combination of assets instead of a single asset. As a matter of fact, the risk on a portfolio of assets differs from the risk of the individual investment. An individual investment may be more risky. Hence it is better to consider combinations of investments rather than the individual investments themselves. A portfolio is nothing but a combination of assets of investments. Investing in a portfolio helps one to reduce the risk as compared to investing completely in any one asset. Types of Risk Every investor has to face two types of risk: (i) Systematic Risk and (ii) Unsystematic Risk. Systematic Risk arises by dint of the economy-wide uncertainties and the tendency of individual securities to move together with the changes in the market. Investors are exposed to face such market risk even when they hold welldiversified portfolio of securities. Unsystematic risk arises due to the unique uncertainties of individual securities. These uncertainties are diversifiable if a large number of securities are combined to form well-diversified portfolio. Uncertainties of individual securities in a portfolio cancel out each other. Unsystematic risk can be totally reduced through diversification. Systematic and unsystematic risks together make total risk. Total risk of an individual security is the variance of its return. It consists of two parts: Total risk of a security = Systematic risk + Unsystematic risk 59
Systematic risk is the covariance of the individual securities in the portfolio. An investor has to suffer the systematic risk, as it cannot be diversified. The difference between variance and covariance is the diversifiable or unsystematic risk. The systematic risk cannot be diversified, and therefore, one will expect a compensation for bearing this risk. One will be more concerned about that portion of the risk of individual securities that one cannot diversify. Hence, every investor must consider both types of risk in one s view before making any investment into any security. Now a days a number of financial experts use to advise, even then risk can be reduced by diversification. Hence, when one invests in only one asset, one is exposed to both systematic and unsystematic risk. If one diversifies and invests in a portfolio, one can reduce one s exposure to unsystematic risk. Each investment in a diversified portfolio is a much smaller percentage of the total portfolio. Hence, the effects of firm s-specific actions on the individual assets in a portfolio can be either positive or negative. Thus, in very large portfolio, this risk will average out to zero and will not affect the value of the portfolio. The effects of market wide movements are likely to be in the same direction for most or all investments in a portfolio, though some assets may be affected more than the others. Since unsystematic risk can be eliminated by diversification, investors are not rewarded for this risk. They are rewarded by way of higher returns for assuming a higher systematic risk. 60
Measurement of Risk Return and Risk Management is one of the challenging task of a financial manager because a successful financial manager is one who achieves success in maximizing return and minimizing risk. As regards measurement of return in case of one individual asset, it is a very easy task but when there is a large number of assets in the portfolio, it is calculated with the help weighted average. Portfolio Variance Dispersion refers to the spread of the data-that is the extent to which the observations are scattered. Dispersion practically gives an additional information that enables one to judge the reliability of one s measure of central tendency. If data are widely dispersed, the central location is less representative of the data as a whole that it would be for data more closely centered around the mean. If a wide spread of values away from the centre is undesirable or presents an unacceptable risk, one need, to be able to recognize and avoid choosing those distributions with the greatest dispersion. In Security Analysis, one is concerned about the dispersion of a firm s earnings. Widely dispersed earnings-those varying from extremely high to low or negative levels-indicate a higher risk to shareholders that do earnings remaining relatively stable. The variance is calculated by finding the sum of the squared distances between the mean and each item and dividing the sum by n-1 where n is the number of observations. 61
The variance 1 on a portfolio consisting of assets 1 and 2 is given by the following formula : Where 2 2 2 2 2 p X1 1 X2 2 2X1X2 12 2 p Portfolio variance 2 1 = Variance of return on asset 1 2 2 = Variance of return on asset 2 X 1 and X 2 = Weights of assets 1 and 2 in the portfolio 12 = Covariance In practice, the covariance is calculated using the summation of the product of two deviations: the deviations of the returns on security 1 from its mean and the deviations of security 2 from its mean. As it is a product of two different deviations, it can be positive or negative. It will be large when the good outcomes for each stock occur together and when the bad outcomes for each stock occur together. In the first case, for good outcomes the covariance will be the product of two large positive numbers, which is positive. When the bad outcomes occur together, the covariance will be the product of two large negative numbers, which is again positive. This will result in a large value for the covariance and a large variance for the portfolio. Conversely, if good outcomes for one asset are associated with bad outcomes of the other, the covariance is negative. 1 Pandey, I.M., Financial Management, Vikas Publishing House Pvt. Ltd., New Delhi, P. 87. 62
Actually, covariance measures how returns on assets move together. If they have positive and negative deviations at similar times, the covariance is a large positive number. If they have the positive and negative deviations at dissimilar times, the covariance is negative. If the positive and negative deviations are unrelated, it tends to be zero. Dividing the covariance between the two assets by the product of the standard deviation of each asset produces a variable with the same properties as the covariance but with a range of 1 to +1. The measure is called the correlation coefficient. It is the correlation coefficient between securities 1 and 2 and it is defined as : 12 12 or 1 2 Covariance r 1 2 Where 12 = Covariance between returns on securities 1 and 2 1 = Standard deviation on return on Security 1 2 = Standard deviation on returns on Security 2. The possibility of reduction of risk through the construction of a portfolio depends on the value of correlation coefficient between the two assets. Risk in an investment is manifested in the form of actual returns being different than the expected returns. This happens because of two reasons : (i) Firm s specific reasons and (ii) Market wide reasons. 63
Firm s specific reasons affect only one or a few firms; whereas market wide reasons affect most of the firms in the market. Extent of success of a new project and the action of competitor firms are the specific reasons. Changes in interest rates, changes in economic conditions are termed as market-wide risk. Between these two types, there are reasons that will affect a particular sector. Beta of an Asset The non-diversifiable risk of an asset is measured by Beta of the asset which is defined as follows : Covariane of an asset with market portfolio Beta of an asset Variance of the market portfolio The Beta of a stock reflects the slope of a regression relationship in which the return on security is regressed on the return on the market portfolio. It indicates the extent to movement of the return of the stock with respect to the movement of market returns. Assets that are riskier than average will have Betas exceeding 1 and assets that are safer than average will have Betas lower than 1. The riskless asset will have a value of beta = o. The Beta of the market portfolio, or the average of Betas across all assets in the market is 1. Hence, Beta is defined as the covariance of the asset with market portfolio divided by the variance of market portfolio and measures the risk added by an investment to the market portfolio. Capital Asset Pricing Model Capital Assets Pricing Model is widely used in real-world analysis to study the risk and return. The capital asset pricing model assumes that; 64
(i) (ii) (iii) (iv) The capital market efficiency implies that share prices reflect all available information and individual investors are not able to affect the prices of securities. This means that there are large numbers of investors holding small amount of wealth. Risk aversion and mean-variance optimization Investors are riskaverse. They evaluate a security's return and risk in terms of the expected return and variance respectively. They prefer the highest expected returns for a given level of risk. This implies that investors are mean-variance optimizers and they form efficient portfolio. All investors have the same expectations about the expected returns and risks of securities. All investors' decisions are based on a single time period. All investors can lend and borrow at a risk-free rate of interest. They form portfolio from publicly traded securities like shares and bonds. The effect of the above assumptions is that investors can keep diversifying without additional cost. All investors would choose to remain on Capital Market Line. It implies that the relevant measure of an asset's risk is its covariance with the market portfolio of risky assets. The capital asset pricing model 1 is a model that provides a framework to determine the required rate of return on an asset and 1 Fisher D.E. & Jordan R.J., Security Analysis & Portfolio Management, Prentice Hall of India, New Delhi, 1990, P. 622. 65
indicates the relationship between return and risk of the asset. The required rate of return specified by Capital Asset Pricing Model helps in valuing an asset. One can also compare the expected rate of return on an asset with its required rate of return and determine whether the asset is fairly valued. Under Capital Asset Pricing Model, the security market line exemplifies the relationship between an asset's risk and its required rate of return. Under Capital Asset Pricing Model, risk of an individual risky security is defined as the volatility of the security's return vis-a-vis the return of the market portfolio. This risk of an individual risky security is its systematic risk. Systematic risk is measured as the covariance of an individual risky security with the market portfolio. The required rate of return on a security is equal to a risk-free rate plus the risk-premium for the risky security. The risk-premium on a risky security equals the market risk premium, that is, the difference between the expected market return and the risk-free rate. Since the market risk premium is same for all securities, the total risk premium varies directly with systematic risk measured by beta. For a given amount of systematic risk, Security Market Line shows the required rate of return. A security' s beta of 1 indicates systematic risk equal to the aggregate market risk and the required rate of return on the security remains equal to the market rate of return If the security's beta is greater than 1, then its systematic risk is greater than the aggregate market. This implies that the security's returns fluctuate more than the market returns, and the security's required rate of return will be more than the market rate of return On the other hand, a security's beta of less than 1 means that the security's risk is 66
lower than the aggregate market risk. This implies that the security's returns are less sensitive to the changes in 1 market returns. The security's required rate of return will be less than the market rate of return. As regards Implications and Relevance of Capital Asset Pricing Model, it is observed that Capital Asset Pricing Model is based on certain assumptions. However, it provides a logical basis for measuring risk and linking risk and return. It has implications: (i) Investors always combine a risk-free asset with a market portfolio of risky assets. They invest in risky assets in proportion to their market value; (ii) Investors are compensated only for that risk which they cannot diversify. This is the systematic risk. Beta, which is a ratio of the covariance between the asset returns and the market returns divided by the market variance, is the most appropriate measure of an asset's risk; (iii) Investors can expect returns from their investment according to the risk. This implies a linear relationship between the asset's expected return and its beta. The concepts of risk and return as developed under Capital Asset Pricing Model are quite simple to understand. Financial managers use these concepts in a number of financial decisionmaking such as valuation of securities, cost of capital measurement, investment risk analysis etc. However, in spite of its simplicity, Capital Asset Pricing Model suffers from a number of Limitations like : (i) It is far from the reality. It is very difficult to find a risk-free security. A short-term, highly liquid government security is considered as a risk-free security. It is unlikely that the government will default, but inflation causes uncertainty about the real rate of 67
return; (ii) The assumption of the equality of the lending and borrowing rates is also not correct. In practice, these rates differ; and (iii) investors may not hold highly diversified portfolio, or the market indices may not be well diversified. Under these circumstances, Capital Asset Pricing Model may not accurately explain the investment behaviour of investors and beta may fail to capture the risk of investment. One establishes that beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return because of a positive relation between returns and betas. But, this relationship did not prove as strong as predicted by Capital Asset Pricing Model. Further returns were also related to other measures of risk, including the firm-specific risk. In subsequent research, some studies did not find any relationship between betas and returns. On the other hand, other factors such as size and the market value and book value ratios were found as significantly related to returns. All empirical studies testing Capital Asset Pricing Model have a conceptual problem. One needs data on expected prices to test Capital Asset Pricing Model. Unfortunately, in practice the researchers have to work with the actual past (ex-post) data. This introduces bias in the empirical results. Beta is a measure of a security's future risk. But investors do not have future data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical ' data. Investors can use historical 68
beta as the measure of future risk. This implies that historical betas are poor indicators of the future risk of securities. In nut shell, Capital Asset Pricing Model is a useful device for understanding the risk-return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem in the use of Capital Asset Pricing Model is that many times the risk of an asset is not captured by beta alone. Arbitrage Pricing Theory The Capital Asset Pricing Model does not account for the difference in assets returns using their betas. This paved way for the development of an alternative approach, known as the Arbitrage- Pricing Theory for estimating the assets' expected returns 1. Arbitrage-Pricing Theory unlike Capital Asset Pricing Model, does not assume that investors employ mean-variance analysis for their investment decisions. However, like Capital Asset Pricing Model, Arbitrage-Pricing Theory is founded on the notion that investors are rewarded for assuming non-diversifiable risk; diversifiable risk is not compensated. Beta is considered as the most important single factor in Capital Asset Pricing Model that captures the systematic risk of an asset. In Arbitrage-Pricing Theory, there are a number of industryspecific and macro-economic factors that affect the security returns. Though a number of factors may measure the systematic risk of an asset under Arbitrage-Pricing Theory, the fundamental logic of 1 Ross, R.A., The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, Vol. 13 No. 3, 1976, P. 4. 69
Arbitrage-Pricing Theory is that investors always indulge in arbitrage whenever they find differences in the returns of assets with similar risk characteristics. In Arbitrage-Pricing Theory, the return of an asset is assumed to have two components: predictable (expected) and unpredictable (uncertain) return. Thus, Return on Asset = Predictable Return (risk-free return on a zero- beta asset) + Unanticipated part of the Return. The expected return depends on the information available to shareholders that has a bearing on the share prices. The uncertain return arises from the future information. This information may be the firm specific and the market-related. The firm-specific factors are special to the firm and affect only the firm. The market-related factors affect all firms. Thus the uncertain return may come from the firm s specific information and the market related information. Economy-wide information may relate to expected and unexpected parts. The government may announce that inflation rate would be 5 per cent next month. Since this information is already known, market would have already accounted for this and share prices would reflect it. After a month the government announces that the actual inflation rate was 6 per cent. Shareholders know now that the inflation is one per cent higher than the anticipated rate. This is surprise news to them. The expected part of information influences 70
the expected return while the unexpected part affects the unexpected part of return. As regards concept of Risk under Arbitrage Pricing Theory, it refers to the risk arising from the firm s specific factors. It is unsystematic risk. The risk arising from the market-related factors cannot be diversified. This represents systematic risk. In Capital Asset Pricing Model, market risk primarily arises from the sensitivity of an asset's returns to the market returns and this is reflected by the asset's beta. One factor - the market returns - affects the firm's return. Hence, Capital Asset Pricing Model is one-factor model. The betas of the firm would differ depending on their individual sensitivity to market. On the other hand, APT assumes that market risk can be caused by economic factors such as changes in gross domestic product, inflation, and the structure of interest rates and these factors could affect firms differently. Under Arbitrage Pricing Theory, multiple factors may be responsible for the expected return on the share of a firm. Therefore, under Arbitrage Pricing Theory the sensitivity of the asset's return to each factor is estimated. For each firm, there will be as many betas as the number of factors. As regards Total Return Under Arbitrage Pricing Theory, it is affected by Gross National Product, Inflation, Interest Rate, stock Market Index and Industrial Production. Further, one has information about the forecasts and actual values of these factors, and the firm's GNP beta, inflation beta, interest rate beta and the stock market beta. 71
The total return on the share is anticipated return plus unanticipated return. The anticipated return includes the effect of known information such as expected inflation and other factors. Therefore, one needs to determine the unexpected part in the systematic factors. The difference in the expected and actual values of the factors is an un- expectation. Shareholders are compensated for this. The difference multiplied by beta compensates shareholders for that factor's systematic risk free part. The total return consists of anticipated risk-free return and unanticipated return While Calculating Expected Return Under Arbitrage Pricing Theory (i)searching for the factors that affect the asset's return; (ii) estimation of risk premium for each factor and (iii) Estimation of beta are taken into account. As regards factors, there is no rule in Arbitrage Pricing Theory, yet industrial production, changes in default premium, changes in the structure of interest rates, inflation rate and changes in the real rate of return should be considered as significant factors. As regards risk premium for each factor. It refers to compensation, over and above, the risk free rate of return that investors require for the risk contributed by the factor. The beta of the factor is the sensitivity of the asset's return to the changes in the factor. One can use regression approach to calculate the factor beta. Risk and return concepts are basic to the understanding of the valuation of assets or securities. Return on a security consists of the dividend yield and capital gain. The expected rate of return on a 72
security is the sum of the products of possible rates of return and their probabilities. Thus, E(R) = R 1 P 1 + R 2 P 2 + + R n P n The expected rate of return is an average rate of return. This average rate may deviate from the possible outcomes. Variance or standard deviation is a measure of the risk of returns on a security. Generally, investors in practice hold multiple securities. The expected return on a portfolio is the sum of the returns on individual securities multiplied by their respective weights. That is a weighted average rate of return. It is observed that the magnitude of the portfolio risk depends on the correlation between the securities. The portfolio risk is equal to the weighted risk of individual securities if the correlation coefficient is + 1.0. For correlation coefficient of less than 1, the portfolio risk remains less than the weighted average risk. When the two securities are perfectly negatively correlated, i.e., the correlation coefficient is -1.0, the portfolio risk becomes zero. The minimum variance portfolio is called the optimum portfolio. As the number of securities in the portfolio increases, the portfolio variance approaches the average covariance. Thus diversification helps in reducing the risk. The portfolio opportunity set represents all possible combinations of risk and return resulting from portfolio formed by varying proportions of individual securities. It presents the investor with the risk-return trade-off. For a given risk, an investor prefers a portfolio with higher expected rate of return. 73
Similarly, when the expected returns are same, one prefers a portfolio with lower risk. The choice between high risk-high return or low risk-low return portfolio depends on the investor's risk preference. An efficient portfolio is one that has the highest expected returns for a given level of risk. The optimum risky portfolio is the market portfolio of all risky assets where each asset is held in proportion of its market value. It is the best portfolio since it dominates all other portfolio. An investor can thus mix one borrowing and lending with the best portfolio according to her risk preferences. One can invest in two separate investments a risk free asset and a portfolio of risky securities. Capital Asset Pricing Model explains risk-return relationship. It provides that in a well-functioning capital market, the risk premium varies in direct proportion to risk. Thus, APT is a multi-factor model to explain the return and return of a security. The factors influencing security return may include industrial production, growth in gross domestic product, the interest rate, inflation, default premium, and the real rate of return. Price-to-book-value ratio and size have also been found to explain to the differences in the security returns. In case Market Portfolio, the component of risk that is firmspecific, can be eliminated by diversification. If diversification reduces exposure to firm-specific risk and there are no costs associated with adding more assets to the portfolio, the logical limit 74
to diversification is to hold a small proportion of every traded asset in the economy. In real life, however, most investors limit their diversification to holding only a few assets. Even large mutual funds hold a limited number of stocks. This is because one can obtain most of the benefits of diversification from a relatively small portfolio and the marginal benefits of diversification become smaller as the portfolio gets more diversified. As regards Calculation of Expected Returns, Beta of an asset can be used to calculate the expected return on an asset by using the Security Market line relationship. The Security Market Line is based on a linear relationship between the expected return on an asset and the Beta of the asset. It can be expressed as : E(Ri) = Rf + i [E(Rm) Rf] Where Rf = Risk-free rate i = Beta of security i [E (Rm)-Rf] = Market Risk Premium The equation given above states that : Expected return on security i = Risk free Return + [Beta of security i Market Risk Premium] The risk free rate is the return on a risk less asset which is defined as an asset for which the investor knows the expected return with certainty for the time horizon of the analysis. Such an asset is free from default risk and is not correlated with returns from any other 75
investments in the economy. In practice, the rate of return on a government security like a Treasury bill or a government bond is used for this purpose. The Market risk premium is the premium demanded by investors for investing in the market portfolio, which includes all risky assets in the market, instead of investing in a risk less asset. The market risk premium varies for different economies based on factors like political risk, state of the economy and market structure. Risk Management In Securities Trading Corporation of India Limited Securities Trading Corporation of India Limited has been working as a primary dealer since June, 1994. The main activities of the company include (i) Underwriting of GOI Securities and Treasury Bills; (ii) Participation in the auctions of GOI's Securities and Treasury Bills; (iii) Market-making and Trading in GOI Securities and Treasury Bills; (iv) Trading in PSU Bonds and other Corporate Debt Instruments; (v) Participation in Repo Market of GOI Securities and Treasury Bills; (vi) Participation in the Inter-Bank Call, Notice or Term money market both as a borrower and as a lender; (vii) Trading in Equities and (viii) Portfolio Management Services. In this way, the company has been very successfully playing a significant role in financial system by making a balance in short term liquidity. As regards risk management in its business activities, the company has been following a policy of investing in risk free securities and earning through fixed interest providing securities. The analysis of Short Term Portfolio indicates that Government Securities 76
constitutes 55.85 percent, GOI Treasury Bills accounts for 18.45 percent and FI & Other Bonds amounts to be 13.72 percent on an average in the short term portfolio of the company. It infers that the company has been following a risk free strategy in its business operations. Besides, the company used to earn through risk free securities namely Reverse Repo Stock, pass through certificates, liquid mutual funds, commercial papers. In long term too, the company followed a policy of risk free business by investing its funds into 0% GOI 2000, 0% GOI 2000 (II), 0% Coupon 2000 (III), 12.60% GOI 2000, 13.55% GOI 2001, 13.75% GOI 2001, 11.15% GOI 2001, 6% GOI CIB 2002, 6.5% GOI 2002, Bonds-IOC, DBB 2004. However, this pattern underwent some changes in 2000-2001 when the company modified its long term investment policy by keeping fixed interest security such as 13.75% GOI 2001, 6% GOI CIB 2002, Bonds-IOC and DBB 2004 together with Equity Shares CCI Limited in its long term portfolio. In this way, the company entered in trading shares which are risky securities. This trend again changed in 2001-02 when the company invested its long term funds into 6% GOI CIB 2002, Bonds-IOC DBB 2004 and Equity Shares CCI Limited. However the company could not maintain its pattern in next two years when it preferred to invest its long term funds into DBB 2004 and Equity Shares CCI Limited. The company changed its long term investment pattern in 2004-05 when the company diversified its investment into 12% GOI 2008, 6.65% GOI 2009, 6.85% GOI 2012, 6.40% UDI Special Bonds 2010, 7.36% Gujrat 2014, 7.32% Karnataka 2014, 7.02% Karnataka 2015, Equity Shares CCI Limited, 6.40% Hindalco 2009, 6.2% IRFC 2006, 77
6.95 % RDFC 2007, 7% PFC 2001, 6.75 % IDBI 2008 and IOCDBB 2004 in its long term portfolio. However this trend again changed in 2005-06 when the company invested into four scripts namely 6.65% GOI 2009, 7.32% Karnataka 2014, Equity Shares CCI Limited and 6.40% Hindalco 2009. The company confined its long term investment in 2006-07 when it diversified its investment into Equity Shares CCI Limited and Equity Shares Standard Chartered- STCI Capital Markets Limited. However it could not be maintained in the next year in 2007-08 when the company widened its long term portfolio by including Equity Shares CCI Limited Equity Shares, STCI Primary Dealer Ltd., Equity Shares STCI Commodities Ltd. and Equity Shares Standard Chartered- STCI Capital Markets Limited. On the whole, it is observed that Securities Trading Corporation of India Limited went on changing its long term portfolio in view of the changes prevailed in the market so as to maximize its return. As regards risk management, the company is very alert and it has evolved different solutions regarding risk management. By virtue of such solutions, Securities Trading Corporation of India has been chosen as an 'IDEAL' primary dealer by Credence Analytics in terms of treasury and risk operations. The new application is being used as an integrated treasury application with front/mid/back office modules with capabilities to manage Government Securities, Bonds, Money Market Instruments, Interest Rate Derivatives, Equity and Equity F&O. The Market Risk module is suitable for interest rate risk management and measurement of capital adequacy as per Basel II guidelines. The company plans further to scale up treasury operations with strong processes and risk monitoring systems. 78