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1. Managing Investment risks: types and
measurement

3. Managing Investment risks
• In most financial literature, the two terms – “Risk and Uncertainty” are used
interchangeably.
• For most of the Investors, Risk means the uncertain future outcomes or it can be
said, a future out come that is different from expected outcome.

4. Sources of Risk
Sources of Risk can be –
• Interest rate risk, Liquidity risk,
• Default Risk, Reinvestment risk,
• Inflation risk, Exchange rate Risk,
• Political Risk, Regulatory Risk,
• Tax rate risk, Business Risk
• Investment Manager Risk.

5. Sources of Risk
• Broadly Risk can be classified in two types:
– Systematic risk (also known as Market Risk or non diversifiable risk) and
- Unsystematic Risk (also known as Specific Risk or diversifiable risk).
Total Risk = Systematic Risk + Unsystematic Risk
• Measure of total risk is called standard deviation and measure of systematic risk
is referred as Beta.

6. Total Risk
Total Risk = Systematic Risk + Unsystematic Risk
Systematic risk - is a risk which impacts the entire market/universe. These risks are not
diversifiable i.e. they cannot be avoided and are inherent in the investment.
This risk is not under control of any investor and cannot be mitigated to a large extent, e.g. Change
in Government policies, War in the country etc.
Unsystematic Risk or Diversifiable Risk -
This is the risk that is unique to a firm or an industry. This risk is related to particular
Investment and not related to overall market. The unsystematic risk can be reduced by diversifying
the portfolio, i.e. spreading the investment of the portfolio across asset classes and across number
of securities within a particular asset class. In a completely diversified portfolio, unsystematic risk is
considered to be zero, e.g. Risk involved due to scam in particular company.
The Satyam scam is classic case of unsystematic risk.

7. Measurement of Risk
The best known measures of risk are Variance, Standard Deviation and
Beta.
• Variance
It is a measure of variance of possible rates of return of the
investment from the expected rate of return. It is the degree to
which the return on an investment varies unpredictably.
The higher the variance for an expected rate of return, the
greater the dispersion of expected returns and the greater the
uncertainty, or risk, of the investment.

8. Continue..
Standard Deviation:
It is the square root of Variance and also a measure of total risk.
• The following example will explain how variance and standard deviation are
calculated in respect of a single security:
Probability Return expected
0.3 12%
0.4 14%
0.3 10%
Expected return in respect of the above scenario is:
(0.3*12+0.4*14+0.3*10)
= 3.6+5.6+3 = 12.2%

9. Continue..
Standard deviation is calculated as follows:
Probability Return Return-Exp. Ret (Return-Exp. Ret) squared Probability*(Return-Exp. Ret) squared
0.3 12% -0.2 0.04 0.012
0.4 14% 1.8 3.24 1.296
0.3 10% -2.2 4.84 1.452
Variance = (0.012+1.296+1.452) = 2.76
Standard deviation = square root of variance = square root of 2.76 = 1.661
• As standard deviation is a measure of total risk this should be as low as possible.
• It shows how much variation there is from the average (mean).
• A low SD indicates that the data points tend to be very close to the mean whereas a high SD
indicates that the data is spread out over a large range of values.

10. How to Manage Risk
• Risk can be managed in two ways:
i. Diversification
ii. Hedging
https://www.equityfriend.com/investment-charts/gold-and-nifty-chart.html
https://www.youtube.com/watch?v=3jTyZl25Llo

11. Diversification
Diversification
Before credit cards came in vogue, when you travelled you put some money in your
wallet some in your suitcase and some in the hand bag. The idea being in case you
lost your wallet you still had some money to return to your destination.
Types of Diversification
• Horizontal Diversification: Horizontal diversification means diversifying
investment across different securities within same asset class. E.g.: Investing in 5
different equity oriented Mutual Funds, Investing Equity portfolio in 10 different
stocks.
• Vertical Diversification: Vertical diversification means diversifying asset across
asset classes. E.g.: Investing in Equities, Bonds, Real estate, Gold etc.
• Geographical Diversification: Geographical diversification means diversifying
across borders. Global Assets (investment) have low co-relation with domestic
Investments and adding global securities in domestic portfolio increase risk
adjusted return of the portfolio.

12. Hedging
• Hedging is investment strategy where investment is made in order to
reduce the risk of adverse price movement in an asset, by taking an
off-setting position in related security such as an option on underlying
asset or a short sale of index etc. In simple ways hedging can be called
as Insurance.
• Investors can hedge their portfolio with the use of various derivative
contracts known as Futures, Option and Swaps.
Example: Suppose an Investor is very skeptical about the market in
near term and he believes that market would fall in a month’s time. But
he also does not want to sell his stock position because of tax
implication. In this case, investor can hedge his portfolio by going short
in Index for near month of similar value as per his overall portfolio.

13. Capital Gains
Types
1. Short Term Capital Gains (STCG)
• STCG arises when a capital asset is transferred within 36 months of buying the
asset; however there is an exceptional limit of STCG of transfer within 12
months for securities listed on the exchange, mutual fund units and zero
coupon bonds.
2. Long Term Capital Gains (LTCG)
• LTCG arises when transfer of capital asset exceeds the holding period limit for
STCG i.e. more than 36 months/ 12 months as the case may be.

14. Capital Gains
Types
1. Short Term Capital Gains (STCG)
• STCG arises when a capital asset is transferred within 36 months of buying the
asset; however there is an exceptional limit of STCG of transfer within 12
months for securities listed on the exchange, mutual fund units and zero
coupon bonds.
2. Long Term Capital Gains (LTCG)
• LTCG arises when transfer of capital asset exceeds the holding period limit for
STCG i.e. more than 36 months/ 12 months as the case may be.