MEASUREMENT OF RISK

Risk in investment is associated with

return. The risk of an investment cannot be
measured without reference to return. The
return depends on the cash inflows to be
received from the investment.
Let us consider the purchase of a share.
While purchasing an equity share, an
investor expects to receive future dividends
declared by the company. In addition, he
expects to receive the selling price when the
share is finally sold. Suppose a share is
currently selling at 120. An investor who is
interested in the share anticipates that the
company will pay a dividend of 5 in the next
year. Moreover, he expects to sell the share
at 175 after one year.
The expected return from this investment
can be calculated as follows:

In this case the investor expects to get a

return of 50 per cent in the future.
But the future is uncertain. The dividend
declared by the company may turn out to be
either more or less than the figure
anticipated by the investor.
Similarly, the selling price of the stock may
be less than the price anticipated by the
investor at the time of investment. It may
sometimes be even more.
Thus, there is a possibility that the future
return may be more than 50 per cent or less
than 50 per cent.
Since the future is uncertain the investor has
to consider the probability of several other
possible returns. The expected returns may
be 30 per cent, 40 per cent, 50 per cent, 60
per cent or 70 per cent. The investor now
has to assign the probability of occurrence
of these possible alternative returns. An
example is given below:
This table gives the probability
distribution of possible returns from an
investment in shares.
Expected Return
The expected return of the investment is
the probability weighted average of all the
possible returns. If the possible returns are
denoted by Xi and the related probabilities
are p(Xi ), the expected return may be
represented as and can be calculated as:

It is the sum of the products of possible

returns with their respective probabilities.
The expected return of the share in the
example given above can be calculated as
follows:
Risk
Expected returns are insufficient for
decision-making. The risk aspect should also
be considered. The most popular measure
of risk is the variance or standard
deviation of the probability distribution
of possible returns. Variance is usually
denoted by σ 2 and is calculated by the
following formula:

Variance = 116 per cent

Standard deviation is the square root of the
variance and is represented as σ. The
standard deviation in our example is = 10.77
per cent.
The variance and standard deviation
measure the extent of variability of
possible returns from the expected return.

 The standard deviation or variance

provides a measure of the total risk
associated with a security.
 Total risk comprises of two
components, namely systematic risk
and unsystematic risk.
 Unsystematic risk is risk which is
specific or unique to a company.
 It can be reduced by combining it with
another security having opposite
characteristics. This process is known
as diversification of investment.
 As a result of diversification, the
investment is spread over a group of
securities with different
 characteristics. This group of
securities is called a portfolio.
 The unsystematic risk is not very
important as it can be reduced or
eliminated through diversification. It is
an irrelevant risk.
The risk that is relevant in investment
decision making is the systematic risk
because it is undiversifiable. Hence, the
investor seeks to measure the systematic risk
of a security.

Measurement of Systematic Risk

 Systematic risk is the variability in
security returns caused by changes in the
economy or the market.
 All securities are affected by such
changes to some extent, but some
securities exhibit greater variability in
 response to market changes. Such
securities are said to have higher
systematic risk.
 The average effect of a change in the
economy can be represented by the
change in the stock market index.
The systematic risk of a security can be
measured by relating that security’s
variability with the variability in the
stock market index.
 A higher variability would indicate
higher systematic risk and vice versa.
 The systematic risk of a security is
measured by a statistical measure called
Beta.
 The input data required for the
calculation of beta are the historical
data of returns of the individual
 security as well as the returns of a
representative stock market index.
 Two statistical methods may be used for
the calculation of Beta:
1. correlation method or the
2. regression method.
Using the correlation method, beta can be
calculated from the historical data of returns
by the following formula:

 The second method of calculating beta is

by using the regression method.
  The regression model postulates a linear
relationship between a dependent
variable and an independent variable.
 The model helps to calculate the values
of two constants, namely α and β.
 β measures the change in the
dependent variable in response to unit
change in the independent variable,
 while α measures the value of the
dependent variable even when the
independent variable has zero value.
The form of the regression equation is as
follows:
For the calculation of beta, the return of
the individual security is taken as the
dependent variable,
and the return of the market index is
taken as the independent variable.
The regression equation is represented as
follows:
Ri = α + βRm
where Ri = Return of the individual security.
Rm = Return of the market index.
α = Estimated return of the security when
the market is stationary.
βi = Change in the return of the individual
security in response to unit change in the
return of the market index.

 It is, thus, the measure of systematic

risk of a security.
 A security can have betas that are
positive, negative or zero.
 “The beta of an asset, βi , is a measure of
the variability of that asset relative to the
variability of the market as a whole.
 Beta is an index of the systematic risk of
an asset.”
 As beta measures the volatility of a
security’s returns relative to the market,
the larger the beta, the more volatile the
security.
 A beta of 1.0 indicates a security of
average risk.
 A stock with beta greater than 1.0 has
above average risk. Its returns would be
more volatile than the market returns.
For example, when market returns move
up by five per cent, a stock with beta of
1.5 would find its returns moving up by
7.5 per cent (i.e. 5 × 1.5). Similarly,
decline in market returns by five per cent
 would produce a decline of 7.5 per cent
in the return of the individual security.
 A stock with beta less than 1.0 would
have below average risk. Variability in
its returns would be comparatively lesser
than the market variability. Beta can also
be negative, implying that the stock
returns move in a direction opposite to
that of the market returns.
Beta is calculated from historical data of
returns to measure the systematic risk of a
security. It is a historical measure of
systematic risk. In using this beta for
investment decision-making, the investor is
assuming that the relationship between the
security variability and market variability
will continue to remain the same in future
also. To conclude, risk is the possibility of
variation in returns from an investment.
Many factors contribute to this variability in
returns. Some of these factors are system-
wide and affect all securities, while some are
unique and affect only specific securities.
Total variability or risk of a security can be
measured by calculating the standard
deviation or variance of the security’s
returns. Beta measures the systematic risk of
a security.