Site Loader
Rock Street, San Francisco

A company ,which has a high intrinsic worth ,is not necessarily the best stock to buy .it may have no growth prospects or it may be overpriced .similarly a company that performs well during any one year may not be the best to buy .on the contrary ,a company which has been badly for sometime might have turn the corner and it may be the best to buy ,as its shares may be under prices and it has good prospects of growth hence an analysis of risk or return guides an investor in proper profitable investment . RETURNReturn is the primary motivating force that drives investment .it represents the reward for undertaking investment .since the game of investing is about returns, measurement of realized return is necessary to assess how well the investment manager has done. In addition historical return is often used as an important input on estimating future return.THE COMPONENT OF RETURNThe return of an investment consist of two componentCurrent return the component that often comes to mind when one is thinking about return is the periodic cash flow such as dividend or interest generated by the investment .current return is measured as the periodic income in relation to the beginning price of the investment.Capital return the second component of return is reflected in the price change called the capital return .it is simply the price appreciation (or depreciation) divided by the beginning price of the assets.Thus total return =current return + capital return RISKRisk refers to the possibility that the actual outcome of an investment will differ from its expected outcome .more specifically, most investors are concerned about the actual outcome being less than the expected outcome .the wider the range of possible outcomes the greater the risk  DIFFERENT TYPE OF RISKForces that contribute to variance in return-price or dividend-constitute the element of risk .some influence are external to the organization cannot be controlled other influence are internal to the organization that are controllable to a large extent .in an investment decision those factors which is uncontrollable is called systematic risk .on the other hand those factors are controllable and internal to the organization are called unsystematic risk these are the two broad categories of riskSYSTEMATIC RISKMARKET RISKThis is the most familiar of all risks. Also referred to as volatility, market risk is the day-to-day fluctuation in a stock’s price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market – volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or “temperament”, of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.Market risk is caused by investor’s reaction to the tangible as well as intangible events.expectation of lower corporate profile in general may cause the larger body of common stocks to fall in price .investors are expressing their judgment that too much is being paid for earning in the light of anticipated events .the basis for the reaction is a set of real, tangible, events – political, social or economic INTEREST RATE RISKInterest rate risk is the risk that an investment’s value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. the root cause of interest rate risk lies in the fact that ,if the RBI increase or decrease the interest rate (repo rate  the interest on government securities rise or fall ,the rate of return demanded on alternative investment vehicle ,such as stocks and bonds issued in the private sector ,rise or fall .in other words as the cost of money changes for nearly risk free securities, the cost of money to more risk prone issues will also changeINFLATION RISK (PURCHASING POWER RISK)The loss of purchasing power because of inflation, when inflation is present, the currency loses its value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value.LIQUIDITY RISKThe uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses.FOREIGN EXCHANGE RISKSUncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks.TRANSLATION RISKSUncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses.   TRANSACTION RISKUncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.UNSYSTEMATIC RISKUnsystematic risk are those risk which is firm specific or peculiar to a firm or industry the different type of unsystematic risk are discussing below.BUSINESS RISKThe uncertainty associated with a business firm’s operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflects the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management coursesBusiness risk can be divided into two board categories: external and internal .internal business risk is largely associated with the efficiency with which a firm conduct its operation within the border operating environment imposed upon it .each firm has it s on internal risk, and the degree to which it is successful in coping with them is reflected in operating efficiencyFINANCIAL RISKThe uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topicsDEFINATIONS BY AUTHORSIn the area of risk and return analysis two well known economist made effort to study the relation between risk and return and they are the people who quantify the risk and return aspects of an instrument .they are Harry Markowitz and William Sharpe.Very broadly the investment process consists of two tasks. The first task is security analysis which focuses on assessing the risk and return characteristics of the available investment alternatives. The second task is portfolio selection which involves choosing the best possible portfolio from the set of feasible portfolio.Portfolio theory, originally proposed by Harry Markowitz in the 1950’s was the first formal attempt to quantify the risk of portfolio and develop a methodology for determining the optimal portfolio .prior to the development of portfolio theory ,investors dealt with the concept of return and risk somewhat loosely .Harry Markowitz was the first person to show quantitatively why and how diversification reduce risk .in recognition of his seminal contribution in this field he was awarded the Nobel prize in economics in 1990.Harry Markowitz developed an approach that helps the investors to achieve his optimal portfolio position .in this contest William Sharpe and others try to find out an answer for a question ,what is the relationship between risk and return and they developed capital asset pricing theory .(CAPM)The CAPM, in essence, predicts the relationship between the risk of an asset and its expected return .this relationship is very useful in two important ways .first, it produces a bench mark for evaluating various instrument .second it helps us to make an informal guess about the return that can be expected from an assets that has not yet been traded in the market.De Bondt and Thayler study the price in relation to book value in a universe of all NYSE and American Stock Exchange equity issue. It has explained the relation between the market price and book value, with stock being assigned in quintiles from lowest price to book ratios. The earning yields effect on stock return is significantly positive only in January for the sub period.Piotroski investigates whether fundamental analysis can be used to provide abnormal returns, and right shift the returns spectrum earned by a value investor. He focused on high book to market securities, and show that the mean return earned by a high book to market investor can be shifted to the right by at least 7.5% annually.The authors developed portfolio based on four fundamental conditions namely: Single Value P/E, Market Price

Post Author: admin

x

Hi!
I'm Jeremy!

Would you like to get a custom essay? How about receiving a customized one?

Check it out