Page 85 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 5: Risk and Return Analysis

6. The government increases customs duty on the material used by the company. Notes

7. The company is not able to obtain adequate quantity of raw materials from the suppliers.
The other part of the risk arises on account of economywide uncertainties and the tendency of
individual securities to move together with changes in the market. This part of the risk cannot
be reduced through diversification and it is called systematic or markets risk. The examples of
systematic risk are:
1. The government changes the interest rate policy.
2. The corporate tax rate is increased.
3. The government resorts to massive deficit financing.
4. The inflation rate increases.

5. The Reserve Bank of India announces a restrictive credit policy.

Notes Investors are exposed to market risk even when they hold well diversified portfolios
of securities.

Total risk, which in the case of an individual security, is the variance (or standard deviation) of
its return can be divided into two parts.
Total risk = Systematic risk + Unsystematic risk

Self Assessment

Fill in the blanks:
10. The extent of benefits of portfolio diversification depends on the ……………..between
returns of securities.
11. Part of the risk that cannot be reduced through diversification is called ……………or
markets risk.

12. The ……………………..will always be between +1 and –1.
5.5 Capital Asset Pricing Model (CAPM)

CAPM provides a framework for measuring the systematic risk of an individual security and
relates it to the systematic risk of a well diversified portfolio. In the context of CAPM, the risk of
an individual security is defined as the volatility of the security’s return vis-à-vis the return of a
market portfolio. The risk (volatility) of individual securities is measured by  (beta). Beta is a
measure of a security’s risk relative to the market portfolio. Since diversifiable risk does not
matter, beta is thus a measure of systematic risk of a security.
Risk free security has no volatility and it has a zero beta:
The Capital Asset Pricing Model is given in equataion:
K = R +  × (km – Rf)
1 f 1
Where K = required rate of an asset I
1
Rf = risk-free rate of return, commonly measured by return on treasury
bills or government securities
 = beta coefficient or index of non diversifiable risk for the asset I
1
Km = market rate of return on the market portfolio of assets

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