Risk Reward Ragas
Whenever we talk about investments, there is always some risk associated with all of them. Risk is the most dreaded word in all the financial markets across the globe. Any person, who is operating in the financial markets, in whatever capacity, has to face risk. So the question in most minds is, what exactly this RISK is? What does it mean?
In general terms, risk means any deviation from expectations. In Financial parlance, risk means any deviation from the expected returns. More specifically, the probability that the returns from any asset will differ from the expected yields is the risk inherent in that asset. We all face risk in our lives in one way or the other. So lets have an understanding of the risk
Risk inherent in equity investments
Equity investment is the most risky investment in all the financial markets. So one needs to have an understanding of risks associated with equity investments. Broadly, there are two types of risks associated with equity investments, viz., systematic risk and unsystematic risk. Lets have an understanding of these two types of risks.
Systematic risk: or the market risk, as it is called, this is the variation in the return on any scrip due to market movements. For example, suppose the Government announces a corporate tax cut or rise across the board, it is going to effect all the stocks in the market in the same way. This is the systematic risk of scrip, which exists because of market movements.
There is nothing much one can do about systematic risk of a security because it arises due to some extraneous variables. But there still exists some techniques, which help to hedge against the systematic risk of a security.
A good measure of an asset’s systematic risk is its Beta. Beta is calculated by regressing the returns of a particular asset on market returns. It can be interpreted as, say the beta of a stock is 1.25, then whenever the market moves by 1%, the stock will move by 1.25%.
Unsystematic risk: is the variation in the return of a scrip due to that scrip specific factors or movements. For example, say the Government announces tax sops to companies in a particular sector, it is going to effect the prices of the stocks of companies which are operating in that sector and not all the stocks.
We can measure risk in two ways – Ex post and Ex ante risk measurement. Ex post measurement is done after the happening of an event and Ex ante measurement is done before the happening of an event.
Ex post Risk
When risk is measured ex post, it is measured as Variance from the mean value. That is, it is the statistical measure of Variance associated with the returns on a particular asset. For example, if one wants to measure risk associated with a particular stock, he will take the returns generated on the stock over a period of time and then he will find out the variance in the return of that particular stock. That variance will be the risk of that stock.
Ex ante Risk
When it is measured ex ante, it is measured as the probability that the returns from an asset will deviate from the mean or the expected returns. For this, if the variable has a normal distribution, the Theory of Normal distribution can be easily applied to find out the probability of this deviation. Otherwise subjective estimates of the probability have to be made.
For example, say the changes in a stock price have normal distribution. One can take the mean return based on the past return of the stock. Then, using the Standard Normal probability distribution, he can find out the probability of the return on that stock falling below that mean or expected return.
If the stock price is not normally distributed, then he will have to make subjective estimates of probabilities of getting a particular return. Using that, he can find out what is the expected return on that stock. Then the risk on that stock is the statistical measure of variance in return of that stock from the expected return.
Hedging risks associated with equity investments
Risk Hedging encapsulates all the activities required to ensure that the exposure, one is having, on account of the risk, doesn’t transform into loss. That is, the exposure is only a notional loss, which might transform into actual loss on happening of a particular event, but if necessary steps are taken to control, manage and diversify away the risk, this exposure can be controlled. All the activities undertaken to do so collectively comes under the purview of risk hedging.
In the following section, we present some of the commonly used techniques for managing risks:
Use of derivatives: Derivatives are most commonly used to hedge against the market risk. The use of the type of derivative instrument depends upon the expectations. An example will make the point clear. Say, you have 100 Reliance shares, the market price of which is presently RS. 300. Now you expect that the price of Reliance might go down in the future due to some reason. To hedge yourself against this risk, you can buy a Put option on Reliance’s stock and lock in a price. If the price actually falls, you can sell those shares at the price you contracted through Put option. If you expect prices to rise and you want to buy shares in the future, you can buy a Call option on Reliance’s stock.
As of now, the use of derivatives on individual securities is not allowed in India. Sometime back, the use of any derivative instrument was not allowed in India. But now the SEBI has allowed the use of Index Futures on BSE and NSE. Soon, these Futures instruments will start trading on other exchanges also. And in due of course of time, the entire range of derivative instruments will be allowed in India.
Making a portfolio: To guard yourself against market risk, you can also make a portfolio of stocks whose returns are negatively correlated with each other. If you make a portfolio of two stocks whose correlation co-efficient is –1 (minus 1), then your market risk is minimized.