Question

Contribute Wiki on the topic: Systematic risk and expected returns in emerging markets.

Answer 1

Systematic Risk :

Due to dynamic nature of society the changes occur in the economic, political and social systems constantly. These changes have an influence on the performance of companies and thereby on their stock prices but in varying degrees. For example, economic and political instability adversely affects all industries and companies. When an economy moves into recession, corporate profits will shift downwards, and stock prices of most companies may decline. Thus, the impact of economic, political and social changes is system-wide and that portion of total variability in security returns caused by such system-wide factors is referred to as systematic risk. Systematic risk can be further subdivided into interest rate risk, market risk and purchasing power risk.

1. Interest Rate Risk: This arises due to variability in the interest rates from time to time and particularly affects debts securities like bonds and debentures as they carry fixed coupon rate of interest. A change in the interest rates establishes an inverse relationship in the price of security i.e. price of securities tends to move inversely with change in rate of interest, long term securities show greater variability in the price with respect to interest rate changes than short term securities. While cash equivalents are less vulnerable to interest rate risk the long term bonds are more vulnerable to interest rate risk.
2. Purchasing Power Risk: It is also known as inflation risk, as it also emanates from the very fact that inflation affects the purchasing power adversely. Nominal return contains both the real return component and an inflation premium in a transaction involving risk of the above type to compensate for inflation over an investment holding period. Inflation rates vary over time and investors are caught unaware when rate of inflation changes unexpectedly causing erosion in the value of realised rate of return and expected return. Purchasing power risk is more in inflationary conditions especially in respect of bonds and fixed income securities. It is not desirable to invest in such securities during inflationary periods. Purchasing power risk is however, less in flexible income securities like equity shares or common stock where rise in dividend income off-sets increase in the rate of inflation and provides advantage of capital gains.
3. Market risk: This is a type of systematic risk that affects prices of any particular share move up or down consistently for some time periods in line with other shares in the market. A general rise in share prices is referred to as a bullish trend, whereas a general fall in share prices is referred to as a bearish trend. In other words, the share market moves between the bullish phase and the bearish phase.

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 X and can be calculated as:

n

X = ∑ x i p(X i) i=1

i=1

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 shown below: Calculation of Expected Return

Possible returns(%) Xi	Probability p(Xi)	Xi p(Xi)
20	0.20	4.00
30	0.20	6.00
40	0.40	16.00
50	0.10	5.00
60	0.10	6.00
	n ∑ x i p(X i) i=1	37.00

Hence the expected return is 37 per cent