Sharpe Index Model
In Investment analysis, Risk means variability of possible returns associated with an investment. Risk refers to the chance that the actual return from an investment will differ from the expected return. Between equities and debentures, equities are more risky.
Risk and Uncertainty
Risk is a situation where probabilities can be assigned to an event on the basis of facts and figures available regarding the decision, while uncertainty is a situation where either facts and figures are not available, or the probabilities can be assigned. Risk can be classified into Systematic Risk and Unsystematic Risk.
i) Systematic Risk- Systematic Risk refers to that portion of variation in return caused by factors that affect the price of securities. The effect of systematic risk causes the price of all individual shares to move in the same direction. This movement is generally caused due to economic, social and political factors. When the stock market is bullish, prices of all stocks indicate rising trend and when the market is bearish, the prices show declining trends. Systematic risk can be classified into:
a) Market Risk-The Market risk refers to variability in return due to change in market price of investment. In bull phase, market price of all shares tend to increase while in bear phase the prices tend to decline.
b) Interest Rate Risk- The interest rate risk refers to the variability in return caused by the change in level of interest rates. When the interest rate rises, the price of existing securities fall and vice-versa.
c) Inflation Risk- The Inflation risk arises due to the uncertainty of purchasing power of the amount to be received from investments in future.
ii) Unsystematic Risk- Unsystematic Risk refers to that portion of the risk which is caused due to factors unique or related to a firm or industry. The unsystematic risk can be eliminated or reduced by diversification of portfolio. The Unsystematic Risk is the change in price of stocks due to factors which are particular to stock.
Unsystematic Risk can be classified into:
a) Business Risk- Business Risk is that portion of the Unsystematic Risk caused by the operating environment of the business.Business Risk is further classified into:
1) Internal Business Risk- Internal Business Risk is associated with the operational efficiency of the firm in sales ,HRD,R&D,etc.
2) External Business Risk- External Business Risk is the result of operating conditions imposed on the firm by circumstances beyond its control. The external business factors are social , regulatory factors, monetary and fiscal policies of the government.
b) Financial Risk- Financial Risk refers to the degree of financial leverage or degree of loans used by the firm in the capital structure. Thus, Financial Risk is associated with the capital structure of the firm. Higher the degree of debt financing, greater is the degree of financial risk.
Concept of Return
The Return is the motivating force and the principal reward in the investment process. So, every investor prefers a higher return. The investment decisions are based on EXPECTED RETURN. The Expected Return is the return which the investor anticipates to earn over a period of time. The expected return may be in the form of Dividends, Bonus, Interests, Capital Gain,etc.
The HISTORICAL or REALIZED RETURN is the return which was actually earned in the form of dividends, interests and capital gains due to price changes. It may be more or less than the Expected Return.
