Deals with basic concepts of investment and risk

2. Investment
 Investment is the employment of funds on assets with
the aim of earning income or capital appreciation.
 Financial Investment is the allocation of money to
assets that are expected to yield some gain over a
period of time. It is an exchange of financial claims
such as stocks and bonds for money.

3. Speculation
 It is about taking up the business risk in the hope of
achieving short-term gain.
 It involves buying and selling activities with the
expectation of making a profit from price fluctuations.

4. Difference between Investor and
Speculator
Investmet Speculation
 Plans for a longer time
horizon and holding period
ranges from 1 to few years.
 Assumes moderate risk.
 Likes to have moderate return
for the limited risk.
 Considers fundamental
factors.
 Uses his own funds and
avoids borrowed funds.
 Plans for a very short period and
holding period varies from few
days to months.
 Willing to undertake high risk.
 Like to have high returns for
assuming high risk.
 Considers inside information
here says and market behaviour.
 Uses borrowed funds to
supplement his personal
resources.

5. Investment Objectives
 Maximizing the return
 Minimizing the risk
 Maintaining Liquidity
 Hedging against inflation
 Increasing safety
 Saving tax

6. Stages of Investment Process
Investment
Process
Investment
Policy
Investible
Fund
Objectives
Knowledge
Security
Analysis
Market
Industry
Company
Valuation
Intrinsic
Value
Future
Value
Portfolio
Construction
Diversification
Selection and
allocation
Portfolio
Evaluation
Appraisal
Revision

7. Risk
 Risk is defined as variability in return or volatility in
return.
 Risk is the chance of the actual return being less than
the expected return. It means any deviation from the
expected return.

8. Types of Risk
1. Systematic Risk:
a. Market Risk
b. Interest rate risk
c. Purchasing power risk
2. Unsystematic Risk:
a. Business Risk
b. Financial Risk

9. Systematic Risk
 Systematic Risk affects the entire market. The entire
market is moving in a direction either downwards or
upwards.
 Systematic risk is unavoidable and beyond the control
of the corporation or investor.
Example: Economic Conditions, Political Situations,
Sociological Changes.

10. Market Risk
 Market Risk: It is the portion of the variability of
return that is caused by the alternating forces of the
bull and bear phases.
 Bull Market- The index moves from a low level to its
peak. It is due to the rising investor confidence and
expectations of further capital gains.
 BearMarket- Index declines haltingly from the peak to
a market low point for a significant period.

11.  Tangible Events – Real events such as earthquake, war,
political uncertainty and fall in the value of currency.
 Intangible Events – They are related to market
psychology which are affected by real events.
Reactions to real events become over reactions and
push the market either upward or downward.

12. Interest Rate Risk
It is the variation in the return caused by fluctuations in the
market interest rate.
It affects:
1. Bond Return:
- When interest rate rise, new issues will hit the market
with higher interest rate resulting in less demand for old
bonds.
- When interest rate declines, new bonds will yield low
returns making the old bonds worth more.
- Demand for bond goes up when the stock market is
depressed and the demand for government bond goes up
when the govt issues attractive bonds than the private
sector.
2. Cost of Borrowing:

13. Purchasing Power Risk
 It is the probable loss in the purchasing power of the
returns to be received. Inflation is the reason for
purchasing power risk.
 Inflation- Persistent increase in price.
- Demand Pull Inflation
- Cost Push Inflation
- Real Rate of Return

14. Real Rate of Return = {(1 + r)/(1+IR) } – 1
Where IR = Inflation Rate r = return
Investor gets a return of 12% on his investment and the
inflation rate is 6.8%
Real Rate of Return ={( 1+ 0.12)/(1+0.068)}-1
= {1.12/1.068}-1
RR = 1.0486-1=0.0486=4.86%

15. Unsystematic Risk
 It is unique and peculiar to a firm or an industry. It stems
from financial leverage, managerial inefficiency,
technological change in the production process ,
availability of raw material, change in consumer
preferences and labour problems.
1. Business risk refers to the difference between
revenue and EBIT
2. Financial risk refers to the difference between EBIT
and EBT. Financial risk is associated with capital
structure of the company.

16. Business Risk
Internal Business Risk
Fluctuations in sales
Research and Development
Personnel Management
Fixed Cost
Single Product
External Business
Risk
Social and Regulatory Factors
Political Factors
Business Cycles

17. Minimizing Risk Exposure
 Protection against market risk – studying the past
price behaviour of the stock.
 Protection against Interest rate risk- Holding the
investment to maturity, Buying TB and bonds of short
maturity, investing in bonds with different maturity
dates.
 Protection against inflation- investment in short
term securities and diversification in investment.
 Protection against Business and Financial Risk-
Analyzing the strengths , weakness, profitability and
capital structure of the company.

18. Risk Measurement
 Ex-post risk- Variance from mean value measures the
ex-post risk using historical data.
 Ex-ante risk- Variance is calculated with the help of
probable returns.
 Characteristic Regression Line (CRL): It is a simple
linear regression model estimated for a particular
stock against the market index return to measure it’s
diversifiable and undiversifiable risks.

19. CRL formula
Ri = αi + βi Rm + ei
where
Ri = Return of the ith stock, αi = Intercept, βi = Slope of the
ith stock, Rm = Return of the market index, ei =The error
term.
β = n Σ XY – (ΣX)(ΣY)
--------------------- , α = Ỳ - βX
n Σ X2 - (ΣX)2

20. Beta and its intrepretation
 Beta : It is the slope of the CRL. It describes the
relationship between stock return and the index
return.
 Beta = 1=> 1% change in the market index return
causes exactly 1 % change in the stock return.
 Beta = 0.5 => The stock is less volatile compared to the
market.
 Beta = 2 => The stock return is more volatile.
 Negative Beta indicates that the stock moves in the
opposite direction to the market return.

21. Characteristic Regression Line
Market Return
Stock Return
A
l
p
h
a
Beta