Stock Market: History Types of Stock Exchanges Function & Purpose

Risk Exposure in Share Market
CHAPTER 1
STOCK MARKET
Introduction History Types of Stock exchanges Function & Purpose
INTRODUCTION: A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at least for record keeping, but trade is increasingly less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of increased speed and reduced cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock market is driven by various factors that, as in all free markets, affect the price of stocks There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that derivatives and bonds are traded. Increasingly, stock exchanges are part of a global market for securities.
HISTORY:
House Ter Beurze in Bruges, Belgium.
In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers. A common misbelief is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred;[6] the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders and neighboring counties and "Beurzen" soon opened in Ghent and Amsterdam. In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. Italian companies were also the first to issue shares. Companies in England and the Low Countries followed in the 16th century. The Dutch East India Company founded in 1602 was the first joint-stock company to get a fixed capital stock and as a result, continuous trade in company
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stock emerged on the Amsterdam Exchange. Soon thereafter, a lively trade in various derivatives, among which options and repos, emerged on the Amsterdam market. Dutch traders also pioneered short selling - a practice which was banned by the Dutch authorities as early as 1610.
A bond issued by the Dutch East India Company, dating from 7 November 1623, for the amount of 2,400 florins.
Economist Ulrike Malmendier of the University of California at Berkeley argues that a share market existed as far back as ancient Rome. In the Roman Republic, which existed for centuries before the Empire was founded; there were societates publicanorum, organizations of contractors or leaseholders who performed temple-building and other services for the government. One such service was the feeding of geese on the Capitoline Hill as a reward to the birds after their honking warned of a Gallic invasion in 390 B.C. Participants in such organizations had partes or shares, a concept mentioned various times by the statesman and orator Cicero. In one speech, Cicero mentions "shares that had a very high price at the time." Such evidence, in Malmendier's view, suggests the instruments were tradable, with fluctuating values based on an organization's success. The societas declined into obscurity in the time of the emperors, as most of their services were taken over by direct agents of the state.
Tradable bonds as a commonly used type of security were a more recent innovation, spearheaded by the Italian city-states of the late medieval and early Renaissance periods. In 1171, the authorities of the Republic of Venice, concerned about their wardepleted treasury, drew a forced loan from the citizenry. Such debt, known as prestiti, paid 5 percent interest per year and had an indefinite maturity date. Initially regarded with suspicion, it came to be seen as a valuable investment that could be bought and sold. The bond market had begun. From 1262 to 1379, Venice never missed an interest payment, solidifying the credibility of the new instruments. Other Italian city-states such as Florence and Genoa became bond issuers as well, often as a means of paying for warfare. Bonds were traded widely in Italy and beyond, a business facilitated by bankers such as the Medicis. War between Venice and Genoa resulted in suspension of prestiti interest payments in the early 1380s, and when the market was restored, it was at a lower interest rate. Venice's bonds traded at steep discounts for decades thereafter. Other blows to financial stability resulted from the Hundred Years War, which caused monarchs of France and England to default on debts to Italian banks, and the Black Death, which ravaged much of Europe. Still, the idea of debt as a tradable investment endured. As with bonds, the concept of stock developed gradually. Some scholars place its origins as far back as ancient Rome. Partnership agreements dividing ownership into shares date back at least to the 13th century, again with Italian city-states in the vanguard. Such arrangements, however, typically extended only to a handful of people and were of limited duration, as with shipping partnerships that applied only to a single sea voyage. The forefront of commercial innovation eventually shifted from Italy to northern Europe. The Hanseatic League, an alliance of mercantile towns such as Bruges and Antwerp, operated counting houses to expedite trade. The term "bourse," which has become synonymous with "stock market," arose in Bruges, either from a sign outside a trading center showing one or a few purses (bursa is Latin for bag) or
because merchants gathered at the house of a man named Van der Burse; nobody's quite sure. By the late 1500s, British merchants were experimenting with joint-stock companies intended to operate on an ongoing basis; one such was the Muscovy Company, which sought to wrest trade with Russia away from Hanseatic dominance. The next big step was in Amsterdam. In 1602, the Dutch East India Company was formed as a joint-stock company with shares that were readily tradable. The stock market had begun. There are now stock markets in virtually every developed and most developing economies, with the world's biggest market being in the United States, United Kingdom, Japan, India, China, Canada, Germany's (Frankfurt Stock Exchange), France, South Korea and the Netherlands.
TYPES OF STOCK EXCHANGES: Stock markets are where traders gather to buy and sell ownership shares in companies, better known as stocks. Stock markets are around the world, although the United States traditionally has had three different types since the 1970's, exemplified by three separate exchanges. Each of these exchanges serves a different need within the securities market. 1. Function: Companies sell shares of stock to raise capital. When a person buys a share of stock, he becomes part owner of a company, and shares in the profits and losses generated by that company. Companies that are making a profit can command higher prices for their shares, while those that are not have shares that are worth less. Traders attempt to buy shares at a lower value and sell them when they reach a higher value, making a profit off the difference. Since the fate of a company can change from moment to moment and rumor can affect the value of a stock, shares may change hands several times during the course of a day.
2. New York Stock Exchange: The largest exchange in the world is the New York Stock Exchange, or NYSE. It was established in 1792 and grew to international prominence in the aftermath of World War I. The NYSE is the home of primarily large corporations. The NYSE has strict limits for the companies it will allow to register and stocks issued by registered companies cannot be sold outside the exchange. In 2007, the NYSE merged with Euronext, the leading market in Europe, which solidified the NYSE's place as the world's premiere exchange. 3. American Stock Exchange: The American Stock Exchange, or AMEX, was established in 1911 as the New York Curb Market. Started by independent traders who operated on the street, or "curb", it focuses on the stock of small or riskier companies, foreign companies and innovative financial products, such as derivatives, options and exchange traded funds (ETFs) such as Standard & Poor's Depositary Receipts. The NYSE merged the AMEX into its operations in 2008, keeping it open under the name of NYSE Amex Equities to continue AMEX's position as the primary market for small companies. 4. NASDAQ: NASDAQ, or the National Association of Securities Dealers Automated Quotations, began in 1971 as an all-electronic market. There is no NASDAQ trading floor --- every trade is done by computer or by phone. And traders do not have to be members, as they do with the NYSE and AMEX. NASDAQ lists companies from across the spectrum, but is the home of a large number of technology stocks, such as Microsoft and Intel. The requirement for permissible stocks is very liberal compared to those of the NYSE and NYSE Amex Equities; a company must have a minimum share trade price of only $1 and maintain a minimum total value of $1.1 million in outstanding stock. The NASDAQ Small Caps Market deals in companies unable to meet these criteria.
Types of Stock Exchange in India: India's economy, although still considered developing, is becoming one of the biggest in the world. This is due largely to the country's technical prowess and attractiveness to overseas countries looking to outsource. The country has a number of stock exchanges on which investors who wish to capitalize on India's growth story can invest their money. 1. Bombay Stock Exchange: The Bombay/Mumbai Stock Exchange is India's oldest. Commonly called the BSE, it was established in 1875 and includes more than 6,000 stocks. The BSE is the largest stock exchange in South Asia and is rapidly becoming one of the biggest in the world due to India's economic growth. The most commonly watched BSE index is called the sensitive index, or Sensex, of 30 large stocks. 2. National Stock Exchange: The National Stock Exchange, also located in Bombay/Mumbai, is India's other dominant stock market along with the BSE. The rapidly growing exchange was founded in 1992. The NSE and BSE are responsible for the vast majority of trading volume in India. The NSE's best-known index is the S&P CNX Nifty, which comprises the stocks of 50 large companies. 3. Other Stock Exchanges: Although the NSE and BSE are the two largest stock markets in India, there are a total of 22 stock exchanges in the country. They are located in other large Indian cities including Ahmadabad, Bangalore, Calcutta, Chennai and Delhi. There is also an over-the-counter stock exchange in India that is used to invest in smaller companies. 4. Foreign Investing in India: Foreign investments in India used to be harder to come by, but the country has recently opened things up. India, along with China, is believed to have ample economic growth potential. As a result, a number of U.S.-based mutual funds and
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exchange traded funds have now been created that allow investors to participate in India's stock market. 5. Regulatory Body: Funds that invest in India must register with the Securities and Exchange Board of India (SEBI), which is India's answer to the U.S. Securities and Exchange Commission. The SEBI is located in Bombay, the site of the country's major stock exchanges. It was founded in 1992 with a mission to "protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto."
FUNCTIONS AND PURPOSE: A mutual organization providing trading facilities to stockbrokers and traders to buy or sell stocks and other securities is known as Stock Market. Stock Market trades in securities that include shares issued by companies, investment bonds and other products. A common location usually deals with record keeping. However, the stocks are traded at different places and on different electronic networks that are speedy and involve less transactional costs. Only the members are eligible to trade on a stock exchange. A Stock Market is basically divided into two categories - Primary Market and Secondary Market. Primary market deals with the initial presentation and offering of stocks and bonds to investors while secondary market does the subsequent trading. For companies, the most important source of raising money is the Stock Market. The business houses can trade here publicly and raise additional capital or funds by selling the shares owned by the company in the Stock Market. The flexibility and liquidity provided by the Stock Market allows investors to sell and buy securities easily. This characteristic of Stock Market attracts more investors towards it rather than going in for real estate investment. If we go into the history, we will learn that the share prices have a great influence on the economy and the social atmosphere of a state. The wealth of households and
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their consumption greatly relies on the prices of shares held by them. Thus, the central banks always analyze the behavior of the Stock Market so that the financial system works smoothly. It is beneficial to invest in shares as it leads to a more lucid savings scheme as compared to the idle deposits with banks or consumption of the savings. Investment in shares especially promotes economic sectors such as, agriculture, commerce and industry, eventually leading to economic growth and higher productivity levels. It is generally observed that the companies whose shares are publicly-acquired gain more economic benefits than the privately-held companies. This is because the public companies have more scope to change owners and thus they are inclined towards improving their management standards and efficiency in order to satisfy the public shareholders, which ultimately leads to more returns to them. Even a small stock investor can invest in shares as there is no investment limit in Share Market. Thus, it is the wish of a stock investor to decide about the investment amount. Here, a person buys the number of shares he can afford. On the contrary, there are a large number of business houses that require huge capital investment. Sometimes, the government needs funds to finance infrastructure projects like water treatment plants and hospitals. In such cases, the government decides to sell a category of securities known as bonds. The Stock Market raises such bonds and the public buys them. It eventually leads to the provision of funds to the government. This prevents the need to directly tax the citizens. The fluctuations in the share prices can be of great help in order to analyze the trend in the economy. This is due to the fact that the share prices rise and fall depending mainly on the market forces.
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CHAPTER 2
BOMBAY STOCK EXCHANGE & NATIONAL STOCK EXCHANGE
Introduction History Trading at exchanges Members
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Bombay Stock Exchange (BSE)
INTRODUCTION: Bombay Stock Exchange is the oldest stock exchange in Asia What is now popularly known as the BSE was established as "The Native Share & Stock Brokers' Association" in 1875. Over the past 135 years, BSE has facilitated the growth of the Indian corporate sector by providing it with an efficient capital raising platform. Today, BSE is the world's number 1 exchange in the world in terms of the number of listed companies (over 4900). It is the world's 5th most active in terms of number of transactions handled through its electronic trading system. And it is in the top ten of global exchanges in terms of the market capitalization of its listed companies (as of December 31, 2009). The companies listed on BSE command a total market capitalization of USD Trillion 1.28 as of Feb, 2010. BSE is the first exchange in India and the second in the world to obtain an ISO 9001:2000 certification. It is also the first Exchange in the country and second in the world to receive Information Security Management System Standard BS 77992-2002 certification for its BSE On-Line trading System (BOLT). Presently, we are ISO 27001:2005 certified, which is a ISO version of BS 7799 for Information Security. The BSE Index, SENSEX, is India's first and most popular Stock Market benchmark index. Exchange traded funds (ETF) on SENSEX, are listed on BSE and in Hong Kong. Futures and options on the index are also traded at BSE.
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HISTORY:
The Phiroze Jeejeebhoy Towers house the Bombay Stock Exchange since 1980.
The oldest stock exchange in Asia (established in 1875) and the first in the country to be granted permanent recognition under the Securities Contract Regulation Act, 1956, Bombay Stock Exchange Limited (BSE) has had an interesting rise to prominence over the past 135 years. While BSE is now synonymous with Dalal Street, it was not always so. It traces its history to the 1850s, when four Gujarati and one Parsi stockbroker would gather under banyan trees in front of Mumbai's Town Hall where Horniman Circle is now situated. A decade later, the brokers moved their venue to another set of foliage, this time under banyan trees at the junction of Meadows Street and what is now called Mahatma Gandhi Road. As the number of brokers increased, they had to shift from place to place, but they always overflowed to the streets. At last, in 1874, the brokers found a permanent place, and one that they could, quite literally, call their own. The new place was, aptly, called Dalal Street ( Brokers' Street). In 2002, the name "The Stock Exchange, Mumbai" was changed to Bombay Stock Exchange. Subsequently on August 19, 2005, the exchange turned into a corporate entity from an Association of Persons (AoP) and renamed as Bombay Stock Exchange Limited.
BSE, which had introduced securities trading in India, replaced its open outcry system of trading in 1995, with the totally automated trading through the BSE
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Online trading (BOLT) system. The BOLT network was expanded nationwide in 1997.
TRADING AT BOMBAY STOCK EXCHANGE: Each company will generally trade its stock on one Exchange, unless the company is very large and, for example, trade in multiple countries. Each country may have several Exchanges where different companies are listed. As long as operating hours are obeyed, people around the world can trade in any country's Exchanges. Trading times are similar to, but slightly shorter than, a regular business day. Exchanges in New York are open from 9:30am to 4:00pm Eastern Time and other exchanges have similar trading hours in their local time zones. Japan, India, England, Germany, Switzerland, China, and the United States host the major world Stock Exchanges. Notable among these big players are the Tokyo Stock Exchange, Shanghai Stock Exchange, the NASDAQ, the NYSE, the AMEX, the London Stock Exchange, Frankfurt Stock Exchange, and the Bombay Stock Exchange. Each stock exchange has listed and permitted securities that are traded on it. There are two ways of organizing trading activity: 1. Open Outcry System: Under the open outcry system traders shout and resort to signal son the trading floor of the exchange which consists of several notional trading posts for different securities. A member (or his representative) wishing to buy or sell a certain security, reaches the trading post where the security is traded. Here, he comes in contact with others interested in transacting in that security. Buyers make their bid and sellers make their offers and bargains are closed at mutually agreedupon prices. In stock where jobbing is done, the jobber plays an important role. He stands ready to buy or sell on his account. He quotes his bid (buying) and asks (selling) prices. He provides some stability and continuity to the market. 2. Screen Based System: In the screen-based system the trading ring is replaced by the computer screen and distant participants can trade with each other through the computer network. A
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large screen based trading system (a) enhances the informational efficiency of the market as more participants trade at a faster speed; (b) permits the market participants to get a full view of the market, which increases their confidence in the market; and (c) establishes transparent audit trails. The BSE also presents an opportunity for traders all over the world to trade on its financial products online from any location on the globe through its BSEWEBX online trading platform. The securities that can be traded on the Bombay Stock Exchange include stocks, stock options, exchange traded funds, stock index futures and stock index options. Powered by a strong information and communication technology base for which India has come to be known, it is not unusual that the BSE SENSEX online trading platform can accommodate up to 8 million orders at once. The BSE is the second stock exchange in the world to receive the Information Security Management System Standard BS 7799-2-2002 for its BOLT System. With the creation of a BSE SENSEX Mobile Streamer, the BSE IPO Index and facilities for algorithmic trading, the BSE has positioned itself for the 21st century by expanding new frontiers in its push to provide traders with more than just the conventional trading experience. Introducing the next generation of online trading platforms eToro Openbook. Openbook offers traders a social trading platform where they can view online trading activity, locate the top traders and imitate their trades.
MEMBERS: Members information transactions in any stock exchange transaction are executed by members/traders who deal with investor. A member of a stock exchange is an individual or a corporate body who holds the right to trade in the stocks listed on the exchange. An investor can buy or sell securities only through one of the members of the exchange. The Bombay stock exchange has, at present (2004), 678 members, of whom 192 are individual members and 486 are corporate members.
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National Stock Exchange (NSE)
INTRODUCTION: National Stock Exchange of India (NSE) is India's largest Stock Exchange & World's third largest Stock Exchange in terms of transactions. Located in Mumbai, NSE was promoted by leading Financial Institutions at the behest of the Government of India, and was incorporated in November 1992 as a tax-paying company. In April 1993, NSE was recognized as a Stock exchange under the Securities Contracts (Regulation) Act-1956. NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. Capital Market (Equities) segment of the NSE commenced operations in November 1994, while operations in the Derivatives segment commenced in June 2000. NSE has played a catalytic role in reforming Indian securities market in terms of microstructure, market practices and trading volumes. NSE has set up its trading system as a nation-wide, fully automated screen based trading system. It has written for itself the mandate to create World-class Stock Exchange and use it as an instrument of change for the industry as a whole through competitive pressure. NSE is set up on a demutualised model wherein the ownership, management and trading rights are in the hands of three different sets of people. This has completely eliminated any conflict of interest. NSE was set up with the objectives of: Establishing nationwide trading facility for all types of securities Ensuring equal access to investors all over the country through an appropriate telecommunication network
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Providing fair, efficient & transparent securities market using electronic trading system Enabling shorter settlement cycles and book entry settlements Meeting International benchmarks and standards Within a very short span of time, NSE has been able to achieve its objectives for which it was set up. Indian Capital Markets are a far cry from what they were 12 years back in terms of market practices, infrastructure, technology, risk management, clearing and settlement and investor service. To ensure continuity of business, NSE has built a full fledged BCP site operational for last 7 years.
HISTORY:
National stock exchange, mumbai
In order to lift the Indian stock market trading system on par with the international standards. On the basis of the recommendations of high powered Pherwani Committee, the National Stock Exchange was incorporated in 1992 by Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI), all Insurance Corporations, selected commercial banks and others. Capital market reforms in India and the launch of the Securities and Exchange Board of India (SEBI) accelerated the incorporation of the second Indian stock exchange called the National Stock Exchange (NSE) in 1992. After a few years of operations, the NSE has become the largest stock exchange in India.
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Three segments of the NSE trading platform were established one after another. The Wholesale Debt Market (WDM) commenced operations in June 1994 and the Capital Market (CM) segment was opened at the end of 1994. Finally, the Futures and Options segment began operating in 2000. Today the NSE takes the 14th position in the top 40 futures exchanges in the world. In 1996, the National Stock Exchange of India launched S&P CNX Nifty and CNX Junior Indices that make up 100 most liquid stocks in India. CNX Nifty is a diversified index of 50 stocks from 25 different economy sectors. The Indices are owned and managed by India Index Services and Products Ltd (IISL) that has a consulting and licensing agreement with Standard & Poor's. In 1998, the National Stock Exchange of India launched its web-site and was the first exchange in India that started trading stock on the Internet in 2000. The NSE has also proved its leadership in the Indian financial market by gaining many awards such as 'Best IT Usage Award' by Computer Society in India (in 1996 and 1997) and CHIP Web Award by CHIP magazine (1999).
TRADING AT NATIONAL STOCK EXCHANGE: The Exchange is set up on a demutualised model wherein the ownership, management and trading rights are in the hands of three different sets of people. This has completely eliminated any conflict of interest. This has helped NSE to aggressively pursue policies and practices within a public interest framework. NSE's nationwide, automated trading system has helped in shifting the trading platform from the trading hall in the premises of the exchange to the computer terminals at the premises of the trading members located at different geographical locations in the country and subsequently to the personal computers in the homes of investors and even to hand held portable devices for the mobile investors. It has been encouraging corporatization of membership in securities market. It has also proved to be instrumental in ushering in scrip less trading and providing settlement guarantee for all trades executed on the Exchange. Settlement risks have also been eliminated with NSE's innovative endeavors in the area of clearing and settlement viz., establishment of the clearing corporation (NSCCL), setting up a
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settlement guarantee fund (SGF), reduction of settlement cycle, implementing online, real-time risk management systems, dematerialization and electronic transfer of securities to name few of them. As a consequence, the market today uses state-of-the-art information technology to provide an efficient and transparent trading, clearing and settlement mechanism. In order to take care of investors interest, it has also created an investors protection fund (IPF), that would help investors who have incurred financial loss due to default of broker. Advantages of trading at NSE Integrated network for trading in stock market of India Fully automated screen based system that provides higher degree of transparency Investors can transact from any part of the country at uniform prices Greater functional efficiency supported by totally computerized network
MEMBERS: The trading in NSE has a three tier structure-the trading platform provided by the Exchange, the broking and intermediary services and the investing community. The trading members have been provided exclusive rights to trade subject to their continuously fulfilling the obligation under the Rules, Regulations, Byelaws, Circulars, etc. of the Exchange. The trading members are subject to its regulatory discipline. Any entity can become a trading member by complying with the prescribed eligibility criteria and exit by surrendering trading membership. There are no entry/exit barriers to trading membership. A prospective trading member is admitted to any of the following combinations of market segments: Wholesale Debt Market (WDM) segment, Capital Market (CM) and the Futures and Options (F&O) segments, CM Segment, the WDM and the F&O segment.
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As at end March 2005, the Exchange had 891 members including 519 from nonMumbai centers. A large majority (89%) of them were corporate members, and the remaining, individuals and firms. There were 881, 75 and 661 members in the CM, WDM and F&O segments respectively.
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CHAPTER 3 RISK AND RETURN
Definition Types of Risk Identifying risk Risk and Return relation Investors attitude towards Risk & Return
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RISK IN SHARE MARKET
WHAT IS RISK? 1. The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. 2. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.
TYPES OF RISK: Unfortunately, the concept of risk is not a simple concept in finance. In the study of finance, there are a number of different types of risk that has been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. The stock market is at once both the biggest creator of wealth in modern times and a risky activity, and this is no coincidence. When economists analyze risk, defined in one sense as exposure to a chance or loss or damage, they tend to find that risk and potential reward are positively correlated. The stock market, one of the most profitable investment vehicles of our time, has a variety of risks, which new investors should recognize and understand.
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Basic categories of risk: 1) Systematic Risk: Systematic risk can be thought of as macro risk, or a game changing risk. For example, political events, natural disasters, nuclear attacks and other fairly unpredictable events could at any time affect the stock price of many stock market assets, and therefore your assets as well. It is very difficult to avoid systematic risk, although professionals try to anticipate these events because predicting them can be very profitable. 2) Unsystematic Risk: Unsystematic risk is not as unavoidable as systematic risk, and stems from specific events that would not affect the stock market generally, but would affect individual stocks. This includes fraud or allegations of fraud, a worker strike, recalls, mergers and other events. These risks are specific to either industries or even specific firms, and therefore, this risk is not impossible to avoid. Diversification, the strategy of investing in many different types of assets, reduces unsystematic risk. 3) Interest rate Risk: This arises due to variability in the interest rates from time to time. A changes in the interest rates establishes an inverse relationship in the price of the security i.e. price of securities trends to move inversely with change in rate of interest. Long term securities shows greater variability in compare to short term securities by this risk. 4) Purchasing Power Risk: It is also known as inflation risk and the inflation affects the purchasing power adversely. Inflation rates vary over time and changes unexpectedly causing erosion in the value of real return and expected return. Thus purchasing power risk is more in inflationary conditions especially in respect of bond and fixed income securities. It is not desirable to invest in such securities during inflationary situations. 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 gain.
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5) Business Risk: Business risk arises from sale and purchase of securities affected by business cycles, technological changes etc. Business cycles affect all types of securities viz. there is cheerful movement in boom due to bullish trend in stock price where as bearish trend in depression brings down fall in the prices of all types of securities. Therefore securities bearing flexible income affected more than the fixed rated securities during depression due to decline in their market price. 6) Financial Risk: This arises due to changes in the capital structure of the company. It is also known as leveraged risk and expressed in the terms of debt-equity ratio. Excess of debt over equity in the capital structure of a company indicates that the company is highly geared even if the per capital earnings (EPS) of such company may be more. Because highly dependence on borrowings exposes to the risk of winding up for its inability to honor its commitments towards lenders and creditors. So the investors should be aware of this risk and portfolio manager should also be very careful. 7) Credit Risk and Country Risk: Credit risk is the risk that a firm will be unable to deal with its obligations, and therefore the asset will become unprofitable. So long as the firm has adequate cash flows (visible by using the statement of cash flows, a required SEC filing for American firms), credit risk is not a major asset concern. Country risk refers to the risk that a country will change the rules under which its financial system operates in some way that affects that country's native financial instruments and assets; country risk is also known as political risk. This type of risk is more common in stock exchanges in the developing world, rather than in Western societies. 8) Market Risk: Market risk is risk associated with daily fluctuations in stock price. Market risk is also referred to as volatility; assets with high volatility (market risk) are likely to fluctuate greatly in stock price, whereas assets with low volatility are more immune to fast, large price changes. Volatility is important in the stock world for a variety of reasons. The more volatile a stock, the more potential for profit there
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may exist (which is why some investors focus on identifying growth stocks, which have the capability for explosive growth), but at the same time, there is also the possibility of dramatic loss. The less volatile the investment, the less on average the return will be to that investment. Stocks are the most volatile of financial assets. 9) Liquidity Risk: The final type of risk associated with stock market transactions is liquidity risk. Liquidity risk refers to risk that the stock will not be able to be traded fast enough to avoid or loss or capitalize on a potential profit. Liquidity risk can be avoided by making sure the daily volume of share trading is above a certain level, so that the investor can be more assured that the desired trades will go through in a timely manner.
IDENTIFYING SHARE MARKET RISK: In today's financial realm, there are plenty of avenues of education for potential investors who want to know what the rewards and the risks of the share market are before they get deeply committed with their capital. It makes perfect sense to have some way to count the costs associated with the various investment opportunities that are available in the trading of listed securities. Naturally, the benefits are fairly obvious. You can gain significant returns on your initial investment as the prices of shares rise and you can earn dividends as well. If the market runs in your favor and you make wise decisions, you should have no trouble making a profit. The bigger question that should be answered with more detail is this: What are the risks involved with investing in the share market? Risks are recognized on various levels from general market risk to very specialized categories of risk such as those related to the particular industry in which the business you've invested in is a part of as well as matters of market timing. As started previously, there is the reality of total or overall market risk. This is the broadest type of risk that has far-reaching effects upon the entire stock and securities market. The causes for this type of risk include political, economic,
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interest rate changes, etc. These exterior events of changes directly affect the flow of the share market. Similarly, but on a larger international scale, you can have what is called global risk. This is basically the risks to share prices that arise from international events or market factors. Global risk factors include changes to trade and tariff policies or exchange rates. More specific or targeted types of risk have to do with either the particular sector or industry that your investments fall into or even an individual equity investment's performance. The former has to do with the products or services of a company and their current demand in the consumer market as well as issues like commodity prices. The latter risks may be associated with internal practices or performance of the business you have purchased shares from; the stability of the company's infrastructure, liquidity of the investment, etc. Timing is everything or so it is said, but in the share market having bad timing can mean a bad financial loss if you do not take it into account as a risk. The best way to avoid losing your capital is to pace your investing and buy stocks little by little. There is a final type risk that has to do with certain types of investments that known as a speculative investments. These are also a matter of timing since the idea behind this type of investment is that the price could rise or fall dramatically at any time. If you want to profit from speculative investments you will have to take big risks. The share market is a delicate balance between all of these risks and the real potential for success.
RISK AND RETURN RELATION: The relationship between risk and return is a fundamental financial relationship that affects expected rates of return on every existing asset investment. The RiskReturn relationship is characterized as being a "positive" or "direct" relationship meaning that if there are expectations of higher levels of risk associated with a particular investment then greater returns are required as compensation for that higher expected risk. Alternatively, if an investment has relatively lower levels of expected risk then investors are satisfied with relatively lower returns.
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This risk-return relationship holds for individual investors and business managers. Greater degrees of risk must be compensated for with greater returns on investment. Since investment returns reflects the degree of risk involved with the investment, investors need to be able to determine how much of a return is appropriate for a given level of risk. This process is referred to as "pricing the risk". In order to price the risk, we must first be able to measure the risk (or quantify the risk) and then we must be able to decide an appropriate price for the risk we are being asked to bear. Example: X Company is evaluating the rate of return on two of its Assets, I and II. The Asset was purchased a year ago for $ 4,00,000 and since then it has generated cash inflows of $ 16,000. Presently, it can be sold for a price of $ 4,30,000 Asset II was purchased a few years ago and its market price in the beginning and at the end of the year was $ 2,40,000 and $ 2,36,000 respectively. The Asset II has generated cash inflows of $ 34,000. Find out the rate of return on these Assets. SolutionThe rate of return on these assets can be ascertained as follows: k = C + (PE PE)/PB Where, PE = Price of asset in the end of year PB = Price of asset in the beginning of year C = Cash inflow for the year
For Asset I, k = 16000 + (430000-400000)/400000 = 11.5% For Assets II, k = 34000 + (236000-240000)/240000 = 12.5%
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In this example, the rate of return of Asset II in higher at 12.5% though its capital value has reduced from $ 2,40,000 to $ 2,36,000 over the period. The reason for higher rate of return is the relatively higher cash inflows of $ 34,000 from the Asset II during the year. So, it is the combined effect of the change in value and the cash inflows that make up the rate of return on any asset. Thus, the return from an investment during a given period is equal to the change in value of the investment plus any income received from the investment. It is important therefore, that any capital or revenue income from the investment to the investor must be included; otherwise the measure of return will be deficient. The return from investment cannot be forecasted with certainty as there is risk that the cash inflows from project may not be as expected. The greater the variability between the estimated and actual returns the more risky the project.
INVESTORS ATTITUDE TOWARDS RISK AND RETURN: Investors attitude towards risk varies. Some investors are willing to take on greater risk in the hope for greater returns while other investors are less willing to take on risk. Investors can therefore be classified into three categories. 1. Risk adverse: Most investors are risk adverse, that is, they do not like risk. For any amount of risk a risk adverse investor takes on they must be compensated for bearing such risk with high returns. If an investor has the choice between two investments with the same expected return but different levels of risk, they will choose the investment with the lowest risk. If an investor has the choice between an investment with different expected returns and the same level of risk, they will choose the investment with the highest expected return. What happens if the two investments have differing returns and differing risk? It will depend how risk adverse the investor is. If an investor is really risk adverse then they are going to choose the investment with the lowest risk.
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2. Risk natural: A risk natural investor does not concern themselves with risk. They will seek the highest expected return regardless of the risk involved. If a risk natural investor has the choice between two investments, one with a higher risk and return than the other, they will always choose the investment with the highest return. 3. Risk seeker/lover: Hence as the name suggests, a risk seeking investor will always choose the investment with the highest risk regardless of return. If an investor has the choice between two investments, investment one has an expected return of 6 and a risk of 4 and the second investment has an expected return of 5 and a risk of 7 they will choose the second investment, i.e. the investment with the highest risk. Risk seekers actively seek out risky investments. Since most investors are risk adverse financial markets behave as if, collectively, they are risk-averse. This makes sense as investor control the financial markets, and if the majority of them as a whole are risk adverse then financial markets are expected to act the same way.
CHAPTER 4
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RISK EXPOSURE
Introduction Definition Problems SEBI guidelines for Investor
RISK EXPOSURE
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INTRODUCTION: Now that we understand risk capacity, the next step is to match the results of the risk capacity survey with a specific risk exposure. By doing this, investors position themselves to achieve personalized optimal returns. Not all investors have the capacity to expose their investments to high levels of risk; therefore, a continuum of risk exposures is needed to meet the unique risk capacities of each investor. This concept extends to larger institutional investments, such as fire and police pension plans, church funds, college endowments, and any other funds governed by committees. Most of the firms or companies now offer 100 Index Portfolios, but for ease of display there are 20 premixed portfolios of indexes presented in this step. These portfolios have a specific percentage allocation of asset classes that match 20 specific Risk Capacities. Each one is coupled with a specific risk capacity. Investors can be matched to one of these based on the results of Risk Capacity Survey. Once investors determine their best mix, they or their investment advisor can determine which available index funds will best represent the chosen mix of indexes.
DEFINITION: A problem when you have a number of possible risks is that it can be difficult to decide which risks are worth putting effort into addressing. Risk Exposure is a simple calculation that gives a numeric value to a risk, enabling different risks to be compared. Risk Exposure of any given risk = Probability of risk occurring x total loss if risk occurs A limitation of this calculation is that it will give the same scores to highprobability/low loss risks and low-probability/high loss risks. If you are concerned with these differences, a Risk Matrix may be a better way of evaluating risks.
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PROBLEMS/LINITATIONS: 1. How Much Risk is there? It is extremely rare for any stockbroker, investment advisor or mutual fund manager to quote the risk level of a client's whole portfolio or any part of it. This is one of the many reasons investors do so poorly. So where do investors obtain this rare and important data? The most convenient and accessible measurement is the standard deviation, and the data becomes more reliable the longer the time frame is considered. The standard deviation quantifies the variation of the returns around the average return. A larger variation or standard deviation often goes hand in hand with a higher risk that an investor may sell the investment out of fear or panic when it goes down. This obviously is an undesirable outcome. Ideally, a high risk exposure is accompanied by a high expected return. That is not always the case. Clearly there are high risks with low expected returns such as small growth and large growth indexes. Statisticians require a minimum of 20 years of data to reduce the error and increase the confidence to an acceptable level of the reported risk and return characteristics of any investment. This dramatically reduces the investments options to index mutual funds and ETFs, since the indexes they track provide more than 20 years of data. There are currently only 86 active managers in the Morningstar database with 20 years or more tenure. As with anything, the best strategies are useless without quality input "garbage in." A minimum of 20 years of data is necessary to generate quality output. So how much risk is in a fund or portfolio? A globally diversified portfolio of indexes with a 50-year history holds a risk with a standard deviation of approximately 14.1%. Coincidentally, the simulated return is also 13.4%. However, in order to handle this level of risk exposure, an investor must score 90% on The Risk Capacity Survey. 2. Investors Want to Avoid Risk
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Another problem related to risk exposure is that most investors do not like risk, but they do want returns. Unfortunately, it just does not work that way. To avoid risk is to avoid returns. If an investor is feeling uncomfortable taking a risk, not much return can be expected. The desire to avoid risk is at the very core of the poor performance many investors experience. Investors like to invest after the market has already gone up. They like to invest in companies that are best described as glamour stocks, otherwise known as large growth stocks. They like to turn their hard earned money over to the fund manager with favorable three to five years of market beating returns the manager that appears on the cover of Money Magazine. All these tendencies feel good, safe, and less risky. The fact is: these featured funds are all relatively expensive due to their popularity. These funds provide their sellers a low cost of acquiring an investor's capital. Here's the big lesson: an investor's expected return is the same as the seller's cost of capital. A low cost of capital exists in all high priced investments; therefore, investors end up with a low return, hence the adages, "No risk, no return. Nothing ventured, nothing gained. Buy low and risky, sell high and safe." Simply put, risk is good. Embrace it. 3. Risk is Good in Proper Doses: Investors must learn to relish risk and to realize it is the source of their returns, not their nemesis. It's all a matter of matching people with portfolios or risk capacity with risk exposure. This process results in the arrival of a risk exposure that each investor can hang onto through thick and thin, sickness and health, bull or bear markets, for richer or poorer or until there is a need to withdraw the money. In proper doses, risk is a beautiful thing. This concept is brought to investors by the brilliant minds of academics and Nobel laureates.
4. Portfolios get out of Balance Another concern for investors is the maintenance of risk exposure or portfolio rebalancing. As discussed in the definition of rebalancing, this procedure is far
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more complex than it appears, especially when it is conducted across several investment accounts with different tax considerations. There is also a balance between the transaction costs and capital gains generated by rebalancing. A tradeoff between risk exposure maintenance and transaction costs must be carefully weighed and include the changes in risk capacity since the previous measurement.
SEBI GUIDELINES FOR INVESTORS: "The three ply responsibilities cast upon SEBI covers development of Indian securities market, its regulation, and, more importantly, protection of investors. Such protection to be realistic at the operational level, SEBI has devised a number of measures in the first instance to regulate proper working of the securities market and different intermediaries connected therewith to be accountable and to diligently follow the rules, regulations and the code of conduct prescribed respectively for them. SEBI has also formulated detailed literature for guidance of the investors to understand and avail full benefit of the regulatory measures intended for their protection. The third line of protection is the plan/project of SEBI to empower investors through education on the functioning of the market as aforesaid. It was in recognition of this felt need that SEBI has launched an all India Securities Market Awareness campaign in close co-ordination with various intermediaries, participants, investor associations and the Government. SEBI strongly believes that investors are the backbone of the securities market. We must look after their interest aggressively which would contribute to their continued support to securities market. Many investors may not possess adequate expertise/knowledge to take informed investment decisions. Some of them may not be aware of the complete risk-return profile of the different investment options. Some investors may not be fully aware of the precautions they should take while dealing with market intermediaries and dealing in different securities. They may be unfamiliar with the market mechanism and the practices as well as their rights and obligations. Their education and awareness, therefore, hold the key to reviving and sustaining their interests in the securities market.
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In order to create awareness among investors all over the country, SEBI has launched a massive nationwide investor awareness program. As a part of the program, SEBI has prepared a variety of literature, which would be of interest to investors. Risks that an Investor Might Encounter While Investing in the Securities Market: 1. Your expectations of income and/or growth may not materialise. 2. Realisation of values of the investment of an equity holder is in the share market only. Thus this investment may not be easily liquid. 3. Disinvestment may result in capital losses also. 4. Running into problems with the trading and transfer of the securities. 5. Investor's Rights as a Shareholder 6. To receive the share certificates, on allotment or transfer (if opted for transaction in physical mode) as the case may be, in due time. 7. To receive copies of the Annual Report containing the Balance Sheet, the Profit & Loss account and the Auditor's Report. 8. To participate and vote in general meetings either personally or through proxy. 9. To receive dividends in due time once approved in general meetings. 10. To receive corporate benefits like rights, bonus etc. once approved. 11. To apply to Company Law Board (CLB) to call or direct the Annual General Meeting. 12. To inspect the minute books of the general meetings and to receive copies thereof. 13. To proceed against the company by way of civil or criminal proceedings, if need be. 14. To apply for the winding up of the company (as provided in the law).
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15. To receive the residual proceeds, in case if a company is wound up. Besides the above rights, which you enjoy as an individual shareholder, you also enjoy the following rights as a group1. 2. 3. 4. To requisition an Extra-ordinary General meeting. To demand a poll on any resolution. To apply to CLB to investigate the affairs of the company. To apply to CLB for relief in cases of oppression and/or mismanagement.
You may note that the above mentioned rights may not necessarily be absolute. For example, the right to transfer securities (in physical form) is subject to the company's right to refuse transfer as per statutory provisions. Investor's Responsibilities as a Share Holder: While you may be happy to note that you have so many rights as a stakeholder in the company that should not lead you to complacency; because you have also certain responsibilities to discharge. To be specific, To remain informed To be vigilant To participate and vote in general meetings To exercise your rights on your own or as a group
Advantages Derived by Investor in Dealing through a Recognised Stock Exchange: If you choose to deal (buy or sell) directly with another person, you are exposed to counter party risk, i.e. the risk of non-performance by that party. However, if you deal through a stock exchange, this counter party risk is reduced due to trade/settlement guarantee offered by the stock exchange mechanism. Further, you also have certain protections against defaults by your broker. When you operate through an exchange, you have the right to receive the best price prevailing at that time for the trade and the right to receive the money or securities
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on time. You also have the right to receive a contract note from the broker confirming the trade and indicating the time of execution of the order and other necessary details of the trade. If you have opted for transaction in physical mode, you also have the right to receive good delivery and the right to insist on rectification of bad delivery. If you have a dispute with your broker, you can resolve it through arbitration under the aegis of the exchange. Procedure for Dealing through a Stock Exchange: If you decide to operate through an exchange, you have to avail the services of a SEBI registered broker/sub-broker. You have to enter into a broker-client agreement and file a client registration form. Upon getting instructed by you, your broker is suppose to give you a contract note having details of the transaction as directed by you. Since the contract note is a legally enforceable document, you should insist on receiving it. You have the obligation to deliver the shares in case of sale or pay the money in case of purchase within the time prescribed. If you have opted for transaction in physical mode, in case of bad delivery of securities by you, you have the responsibility to rectify them or replace them with good ones. A well Informed investor is a well Protected investor: Before making investment decisions you must empower yourself through information. Many investors could have avoided trouble and losses, had they followed this advice. Remember, it is your hard earned money. Let your broker or mutual fund agent know that you are a serious and a smart investor who wants to know more about the risks and rewards before investing. A good broker or agent will welcome your questions, no matter what they are. They know that an educated investor is an asset to them. They would rather answer your questions before you invest, than afford to lose their business. Asking questions is the first step to information gathering. We have compiled a set of few questions which you should ask your brokers, mutual fund agent or to yourself before investment.
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Further, while being in the securities market, observing a few safeguards would help you avoid grievances later. To enable you to do the same we have compiled a few Do's and Don'ts for you. Dos and Donts of Security Market: I) Dos: 1. Always deal with the intermediaries registered with SEBI. 2. Always keep copies of all investment documentation (e.g. application forms, acknowledgment slips, contract notes). 3. Always keep copies of documents you are sending to companies etc. 4. Send important documents by a reliable mode/registered post to ensure delivery. 5. Ensure that you receive contract note at the end of the day / account statements for every transaction. 6. Ensure that you have money before you buy. 7. Ensure that you are holding securities before you sell. 8. Follow up diligently and promptly e.g. if you do not receive the required documentation within a reasonable time contact the concerned person i.e. the broker, company etc. immediately. 9. Give clear and unambiguous instructions to your broker/agent/depository participant. 10. Mention clearly whether you want to transact in physical mode or demat. II) Don'ts: 1. Dont deal with unregistered brokers/sub-brokers, intermediaries. 2. Dont forgo taking due documents of transactions, in good faith even from people whom you know. 3. Dont fall prey to promises of unrealistic returns.
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4. Dont get misled by companies showing approvals/registrations from Government agencies as the approvals could be for certain other purposes and not for the securities you are buying. 5. Dont transact based on rumors generally called tips. 6. Dont forget to take note of risks involved in the investment. 7. Dont get misled by guarantees of repayment of your investments through post-dated cheques. 8. Dont panic when facing a problem. 9. Dont hesitate to approach concerned persons and then the appropriate authorities.
CHAPTER 5
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RISK MANAGEMENT
Introduction Risk Management Process Measures of Risk Reduction and Control of Risk Benefits of Risk Management
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INTRODUCTION: The Exchange has been exposed to a large number of risks, which have been inherently borne by the member brokers for all times. Since the introduction of the screen based trading the nature of risks to which the members of the Exchange are exposed to has undergone radical transformation. At the same time the inherent risk involved with the trading of paper based securities still remains. Though the process of dematerialization has already begun, till such that it is made compulsory in all scripts, the risk of trading in fake/forged shares and instances of loss of shares etc. will continue to exist. The safe custody of these shares in physical form in the Exchange as well as in the member brokers offices is of prime importance. The Risks can be classified as under: 1. Risks associated with Paper Based Trading Lost/misplaced securities damage to securities loss of securities in transit 2. Client Risk Client default Client absconding Fake/ forged/stolen securities introduced by the clients
RISK MANAGEMENT PROCESS: There are several bodies that lay down the principles and guidelines for the process of risk management. The steps involved remain the same more or less. There are small variations involved in the cycle in different kinds of risk. The risks involved, for example, in project management are different in comparison to the risks involved finance. This accounts for certain changes in the entire risk management process. However the ISO has laid down certain steps for the process and it is almost universally applicable to all kinds of risk. The guidelines can be applied throughout the life of any organization and a wide range
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of activities, including strategies and decisions, operations, processes, functions, projects, products, services and assets. As per ISO 31000 (Risk Management - Principles and Guidelines on Implementation), risk management process consists of the following steps and substeps: Establishing the Context Identification Assessment 1. Establishing the Context: Establishing the context means all the possible risks are identified and the possible ramifications are analyzed thoroughly. Various strategies are discussed and decisions are made for dealing with the risk. The break-up of various activities in this stage is as follows: Identification of a risk in one particular domain. Planning out the entire management process. Mapping the manifestations of the risk, identification of objectives of risk etc. Outlining a framework. Designing an analysis of risks involved at each stage. Deciding upon the risk solution/s.
2. Identification: Once the context has been established successfully, the next step is identification of threats or potential risks. This identification can be at the level of the source or the problem level itself. Source analysis means that the source of risks is analyzed and appropriate mitigation measures are put in place. This risk source could be either internal or external to the system. Examples of the risk source could be employees of the company, operational inefficiency in a certain process etc.
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Problem analysis on the other hand means the effect rather than the cause of the risk is analyzed. For example a drop in production, threat of losing money etc! The choice of the method varies across industry, organizational culture and other factors. However some common methods of risk identification are: Taxonomy based Risk Identification: The possible risk sources are broke down, hence taxonomy. A questionnaire is made best on existent knowledge; the answers to the questions are the risk. Objective based Risk Identification: An organization or any business activity has a certain objective/s. Any activity that is deemed an obstacle in the achievement of the same is perceived as risk. Scenario based Risk Identification: Here various scenarios, which may be alternative ways to achieve an objective, are created. If an undesired scenario is created, a threat is perceived with the same. Common Risk Check: There are certain risks that are common to an industry. Each risk is listed and checked on time.
3. Assessment: Once the risks have been identified, they are then assessed on their likelihood of occurrence and the impact. This process can be simple as in case of assessment of tangible risks and difficult like in the assessment of intangible risks. This assessment is more or less a guessing game and the best educated guess decides the success of the plan. The industry practice or formula for arriving upon the risk is: Frequency of occurring Impact
MEASURES OF RISK:
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The future is uncertain. Investors do not know with certainty whether the economy will be growing rapidly or be in recession. As such, they do not know what rate of return their investments will yield. Therefore, they base their decisions on their expectations concerning the future. The expected rate of return on a stock represents the mean of a probability distribution of possible future returns on the stock. Example: 1. Expected return: The table below provides a probability distribution for the returns on stocks A and B. State 1 2 3 3 Probability 20% 30% 30% 20% Return on stock A 5% 10% 15% 20% Return on stock B 50% 30% 10% -10%
In this probability distribution, there are four possible states of the world one period into the future. For example, state 1 may correspond to a recession. A probability is assigned to each state. The probability reflects how likely it is that the state will occur. The sum of the probabilities must equal 100%, indicating that something must happen. The last two columns present the returns or outcomes for stocks A and B that will occur in the four states. Given a probability distribution of returns, the expected return can be calculated using the following equation:
Where,
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E[R] = the expected return on the stock, N = the number of states, pi = the probability of state i, and Ri = the return on the stock in state i.
Expected Return on Stocks A and B Stock A
Stock B
2. Variance and Standard Deviation: Risk reflects the chance that the actual return on an investment may be very different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. Consider the probability distribution for the returns on stocks A and B provided below. State
1 2 3 3
Probability
20% 30% 30% 20%
Return on stock A 5% 10% 15% 20%
Return on stock B 15% 30% 19% -10%
The expected return on Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%.
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Given an asset's expected return, its variance can be calculated using the following equation:
Where,

N = the number of states, pi = the probability of state i, Ri = the return on the stock in state i, and E[R] = the expected return on the stock.
The standard deviation is calculated as the positive square root of the variance.
Variance and Standard Deviation on Stocks A and B E[RA] = 12.5% and E[RB] = 20% Stock A
Stock B
Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to hold securities as part of a diversified portfolio.
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REDUCTION AND CONTROL OF RISK: As a measure of the pro-active risk control several measures have been initiated by the Exchange to reduce the risks to which the Exchange and the member brokers are exposed. In this regard the Exchange has initiated the following measures: 1. Know Your Client Scheme: Under the procedure the member brokers of the Exchange are compulsory required to obtain detailed information of clients prior to commencement of any transactions for new clients. A similar procedure is also to be followed for existing clients. This information is to be made available to the Exchange authorities whenever called for. In case the member brokers fail to furnish the same it is viewed seriously. 2. Database of lost, Stolen, Misplaced Securities: The Exchange maintains a database on all the shares that have been reported as lost, stolen, duplicate etc. by the Companies / registrars. The information available through the database is time relevant thus the database is modified on a regular basis and is downloaded by the members through BOLT on a weekly basis. This database is also provided to the Clearing House. The member brokers can thus reduce the instances of delivery of shares that have been reported by the Company as bad delivery by checking all the deliveries in their office with the database provided. The Exchange has designed and developed a software module for the above for the benefit of the members. The Clearing House also uses the database. At the time of pay-in the members of the Exchange are required to submit the details of the shares being deposited in the pay-in in a softcopy in a prescribed format.. These details are checked against the database and a report is generated in case a match is found. Such shares are then reported as bad delivery in the Exchange. Further follow-up is done with the delivering broker and they are directed to lodge a police complaint against the client introducing the stolen shares. 3. Client Caution Database: The Risk Management department in conjunction with the Bad Delivery Cell of the Exchange, the Exchange has designed and developed a client database. All
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member brokers whose clients / sub-brokers have introduced fake / forged shares are required to lodge a FIR / Police complaint against their clients and also report the same to the Exchange. The information of such clients is called for in a prescribed format. As per the scheme the members have to collect detailed information about the clients. These details are incorporated in the database, which is downloaded to the members, as a precautionary measure. The member brokers at the time of admitting new clients can refer to the client caution database for further verification. 4. Verification of shares at members office: The Risk Management Committee has outlined a process for minimizing the risks arising out of Fake/ forged /stolen shares introduced by the clients of the member brokers. As per the procedure outlined issued by the Exchange, in case the transaction in a script with one particular client in a settlement exceeds Rs. 10 lakhs then the member brokers are required to send the photocopies of the transfer - deeds and the share certificates to the Company / Registrar for verification of the material particulars. The members can select a random sample for the same from the lot. A similar procedure should also be followed in case the shares worth more than Rs. 10 lakhs are received from the Clearing House during pay-out in one scrip. The basic idea behind the introduction of this procedure is to prevent Fake/ forged/stolen shares from being introduced in the market. The Exchange issued a notice outlining the procedure to be followed. The above procedure is an important Risk Management Tool especially where there exists a large volume of deliveries. The Risk Management Department acts as a facilitator in this regard and has written to all "A" group and B1 group companies in this regard seeking their cooperation. 5. Inspection: The department is carrying out inspection of the member brokers records as regards compliance of the risk management procedures.
Integrated Comprehensive Insurance Policy for Members

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To reduce the systematic risk, Securities & Exchange Board of India ( SEBI) vide its circular ref. No SMD/SED/RCG/270/96 dated January 19th, 1996, had directed all stock exchanges to ensure that all active Members are properly insured. Insurance companies in consultation with BSE have offered an insurance policy which covers losses on account of trading as well as back office losses to the Members. The minimum sum insured is Rs.5 lakhs per Member Presently, all active Members obtain the said policy directly from the insurance companies and then inform BSE about the same. Property Insurance Policies The assets at BSE are fully covered through fire, burglary theft (including terrorism) insurance policies.
BENEFITS OF RISK MANAGEMENT IN STOCK MARKET: The benefits of risk management in the stock market make strategies to manage risk an essential part of successful investment management. Many investors have employed a simple buy and hold strategy that has destroyed wealth and has set back many retirement plans a decade or more. Remember, a 50% loss requires a 100% gain to breakeven. A 10% loss only requires an 11% gain to get back to breakeven. Portfolio risk management requires: 1. Identification of potential risks. 2. Assessment of the magnitude and probability of those risks occurring. 3. Choosing a path or technique to optimize the risks and rewards of the portfolio. The two major potential risk categories to identify are systematic risk and unsystematic risk. Systematic risk is risk associated with market returns. These are risks that are affected by macroeconomic factors that affect the market as a whole. These risks would include changes in interest rates, inflation, recessions, war, etc. Unsystematic risk is company specific or industry specific risk. This is risk specific
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to the individual investment or small group of investments and is uncorrelated with stock market returns. After identifying risks the next step is to assess the potential damage and the probability of the risk occurring. Systematic risk, or market risk, can be estimated from historical data. We can measure the volatility and frequency of market declines and estimate the damage and probability of that damage fairly accurately over a long period of time. Unsystematic risk, or specific risk, requires a great deal of analysis for an individual investment because of the hundreds, or even thousands, of risk factors that could influence a company or industry. Once identification and assessment are completed, there are 4 major risk management decision choices: 1. Avoid eliminate or withdraw from investment choice. 2. Control mitigate or optimize through action. 3. Transfer outsource through hedging or insurance 4. Accept make the investment knowing the risks Avoiding and accepting risks are fairly straightforward decisions. The other two decisions, control and transfer, require further decision making. First priority should be to mitigate unsystematic or specific risk because it is the easiest and offers the largest benefits of risk management. If a portfolio consists of just a few stocks the entire portfolio can suffer severe damage if one stock experiences a large decline. However, a portfolio that consists of many stocks would suffer minimal damage from the decline of one stock. Diversification can nearly eliminate specific risk from a portfolio. Systematic risk, or market risk, is not quite as easy to mitigate. Some investors may choose financial hedging; others may choose to partially avoid some market risk by increasing their asset allocation to fixed income or cash. The biggest benefit of risk management in the stock market is portfolio optimization of risk and reward. A portfolio manager, willing to take a given amount of portfolio risk, can purchase individual higher reward/higher risk investments because risk management techniques lower overall portfolio risk. In
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other words, risk management allows a portfolio manager to place more aggressive assets in a portfolio without increasing risk exposure for the whole portfolio.
CHAPTER 6
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CASE STUDIES
TYPES OF RISK WITH THEIR EXAMPLES: 1. Systematic risk and unsystematic risk:
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a) What It Is: Also called market risk or non-diversifiable risk, systematic risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets. Unsystematic risk is the risk that something with go wrong on the company or industry level, such as mismanagement, labor strikes, production of undesirable products, etc. Systematic risk + Unsystematic risk = Total risk b) How It Works/Example: Systematic risk is comprised of the unknown unknowns that occur as a result of everyday life. It can only be avoided by staying away from all risky investments. Systematic risk can also be thought of as the opportunity cost of putting money at risk. For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of Deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment. The most basic strategy for minimizing systematic risk is diversification. A welldiversified portfolio will consist of different types of securities from different industries with varying degrees of risk. The unsystematic risks will offset one another but some systematic risk will always remain. c) Why It Matters: Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio. This is extremely important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan. Unsystematic risk exposes you to adverse events on a company or industry level in addition to adverse events on a global level.
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2. Credit Risk: a) What It Is: Credit risk is the chance that a bond issuer will not make the coupon payments or principal repayment to its bondholders. In other words, it is the chance the issuer will default b) How It Works/Example: While the definition of credit risk may be straight forward, measuring it is not. Many factors can influence an issuer's credit risk and in varying degrees. Some examples are poor or falling cash flow from operations (which is often needed to make the interest and principal payments), rising interest rates (if the bonds are floating-rate notes, rising interest rates increase the required interest payments), or changes in the nature of the marketplace that adversely affect the issuer (such as a change in technology, an increase in competitors, or regulatory changes). The credit risk associated with foreign bonds also includes the home country's sociopolitical situation and the stability and regulatory practices of its government. Ratings agencies like Moody's and Standard & Poor's analyze bond offerings in an effort to measure an issuer's credit risk on a particular security. Their results are published as ratings that investors can track and compare with other issuers. S&P's ratings range from AAA (the most secure) to D, which means the issuer is already in default. Moody's ratings go from Aaa to C. Only bonds rated BBB or better are considered "investment grade." Bonds rated below BBB- or Baa3 are considered "junk." c) Why It Matters: Credit risk is one of the most fundamental types of risk. After all, it represents the chance the investor will lose his or her investment. All bonds, except for those issued by the U.S. government, carry some credit risk. This is one reason corporate bonds almost always have higher coupon payment amounts than government bonds.
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3. Liquidity risk: a) What It Is: Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. b) How It Works/Example: Liquidity risk generally arises when a business or individual with immediate cash needs, holds a valuable asset that it can not trade or sell at market value due to a lack of buyers, or due to an inefficient market where it is difficult to bring buyers and sellers together. For example, consider a $1,000,000 home with no buyers. The home obviously has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when market conditions improve and demand increases, the house may sell for well above that price. However, due to the home owners need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset. c) Why It Matters: Purchasers and owners of long term assets must take into account the salability of assets when considering their own short term cash needs. Assets that are difficult to sell in an illiquid market carry a liquidity risk since they cannot be easily converted to cash at a time of need. Liquidity risk may lower the value of certain assets or businesses due to the increased potential of capital loss.
4. Political risk: a) What It Is:

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Political risk is the risk of financial, market or personnel losses because of political decisions or disruptions. Also known as "geopolitical risk." b) How It Works/Example: There are many environmental factors facing business. Besides market-based causes, business can be affected by political decisions or changes. For example, political decisions by governmental leaders about taxes, currency valuation, trade tariffs or barriers, investment, wage levels, labor laws, environmental regulations and development priorities, can affect the business conditions and profitability. Similarly, non-economic factors can affect a business. For example, political disruptions such as terrorism, riots, coups, civil wars, international wars, and even political elections that may change the ruling government, can dramatically affect businesses ability to operate. Political risks are faced equally by investors in international businesses and investment fund portfolios. These political risks are part of the estimation and disclosure of risk factors, usually found in a company or portfolio's prospectus. c) Why It Matters: Political risk can affect the operations and profitability of a business as directly and quickly as any financial, physical, or market risk factor. The impact of political risk is considered to be long-term because the risk rises over time, given the greater potential for events and changes over time. Although political risk is extremely difficult to quantify, companies and investors must examine and understand the potential for political risks by closely examining the location's history, political institutions, and political forces at work in the region.
5. Market risk: a) What It Is:

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Market risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets b) How It Works/Example: Market Risk is also referred to as systematic risk or non-diversifiable risk. Market risk is comprised of the unknown unknowns that occur as a result of everyday life. It is unavoidable in all risky investments. It can also be thought of as the opportunity cost of putting money at risk. For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of Deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment. c) Why It Matters: Every investor faces market risk as a securities market follows economic indicators, recessions and the normal business cycle. The most basic strategy for minimizing market risk is diversification. A welldiversified portfolio consists of securities from various industries, asset classes and countries with varying degrees of risk. The specific risks will offset each other but some market risk will always remain. Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio. This is extremely important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan. Specific risk exposes you to adverse events on a company or industry level in addition to adverse events on a global, economic level.
6. Purchasing power risk/ inflation risk: a) What It Is:

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Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment won't be worth as much in the future because of changes in purchasing power due to inflation. b) How It Works/Example: For example, $1,000,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 3% inflation rate, every $1,000 produced by the portfolio will only be worth $970 next year and about $940 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds. Some securities attempt to address this risk by adjusting their cash flows for inflation to prevent changes in purchasing power. Treasury Inflation Protected Securities (TIPS) are perhaps the most popular of these securities. They adjust their coupon and principal payments for changes in the consumer price index, thereby giving the investor a guaranteed real return. Some securities inadvertently provide some load9-risk protection. For example, variable-rate securities provide some protection because their cash flows to the holder (interest payments, dividends, etc.) are based on indices such as the prime rate that are directly or indirectly affected by inflation rates. Convertible bonds also offer some protection because they sometimes trade like bonds and sometimes trade like stocks. Their correlation with stock prices, which are affected by changes in inflation, means convertible bonds provide a little inflation protection. c) Why It Matters: Although the record inflation of the 1970s is history, inflation risk is still a common worry for income investors. Inflation causes money to lose value, and any investment that involves cash flows over time is exposed to this inflation risk. The ramifications of this can be serious: The investor earns a lower return that he or she originally expected, in some cases causing the investor to withdraw some of a portfolio's principal if he or she is dependent on it for income.
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It is important to note that inflation risk isn't the risk that there will be inflation, it is the risk that inflation will be higher than expected. This is one reason investors and analysts speculate considerably about inflation rates and study indicators such as the yield curve to get a feel for where inflation rates are headed. For example, many economists believe that a steep normal yield curve means investors expect higher future inflation and a sharply inverted yield curve means investors expect lower inflation.
7. Interest rate risk: a) What It Is: Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment. b) How It Works/Example: Let's assume you purchase a bond from Company XYZ. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, its ability to be called, and other characteristics of the bond. One common way to measure a bond's interest rate risk is to calculate its duration. c) Why It Matters: In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that shortterm bonds carry less interest rate risk than long-term bonds, and some financial theorists cite this as support for a popular hypothesis that the higher yields of longterm bonds include a premium for interest rate risk. It is interesting to note that bond investors who intend to hold their bonds to maturity are less exposed to interest rate risk for two reasons. First, these investors
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are not interested in interim price movements because they intend to hold the bond until it matures. Second, the amount of principal the investor receives at maturity is unaffected by changes in interest rates. However, the buy-and-hold bond investor is still exposed to the risk that interest rates will rise above the bond's coupon rate, therefore leaving the investor "stuck" with below-market coupon payments. Interest rate risk accounts for approximately 90% of the risk involved with fixed income investing, according to research by BARRA International. Although analysts and investors spend countless hours analyzing interest rate trends and making forecasts, there is no way to tell for sure what rates will be tomorrow.
QUESTIONNAIRE
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1. What is risk? Ans: the possibility of suffering harm or loss in the share market. 2. What are the different types of risk in share market? Ans: Risk takes many forms. You take risk every time you act, from crossing the street to buying a stock to getting on an airplane to drinking a glass of pasteurized milk. Generally when people talk about risk, however, they focus on financial risk like Risk of losing money, Lack of sure returns or loss of returns, loss of principle amount etc. 3. How to measure it? Ans. There are different methods to measure the risk. But commonly risk is measure according to the market levels i.e. ups and downs in the market. Also it can be measure with time, comparing banks investment, investors age and their needs 4. Most commonly method used in share market to measure the risk? Ans: most commonly method to measure the risk is comparing rate of return with time or comparing different types of financial product with each other. 5. How to control and reduce the risk? Ans. Stock market is volatile and sentimental. Different things happening in the world affects the stock market in direct relation. If investor wants to invest in the stock market then he should not invest the whole amount into one stock/security. He should balance his fund by investing in different financial products like government bonds, Mutual Funds, Fixed Deposits, gold etc. While investing in the market broker/ trader should understand that more risk bearer earns money by taking more risk in market within short span of time. He can also earned money through derivatives, F& O and balancing the risk with hedging strategy.
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6. What are the points that investor should remember before investing in stock market? Ans. Before investing, he should collect all the information about the company, its reputation, returns on investment etc. in which he is thinking to invest. He should consult his broker or financial advisor before investing. He can also analyse the ups and downs in the market. These things are of a great help in taking a decision to invest or not. 7. Leading agencies in India which provide credit ratings to the companies in share market? Ans. CRISIL (Credit Rating Information Services of India Ltd.) ONICRA Credit Rating Agency of India Ltd. ICRA (Investment Information and Credit Rating Agency of India) Duff & Phelps Credit Rating India Private Ltd. (DCR India) These are the agencies which gives rating to the companies and their stocks.
(Answers given by Disha Wealth Solutions)
CONCLUSION
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Risk a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that Risks are events or conditions that may occur, and whose occurrence, if it does take place has a harmful or negative effect. Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with a probability of known loss.
A clear distinction should be made between risk and risk exposure in the market. Risk management over sees and ensures the integrity of the process with which risk are taken. To maintain objectivity, risk management cannot be part of a risk taking process. Individual should take proper steps to minimize risk, as it cannot be fully avoided. Market risk management is a complex and multifaceted process, which varies from one organization to the other. It should be visualized and ensured to be an on-going process, involving continual oversight, planning and modification as needs evolve.
SOURCE
BIBLIOGRAPHY:
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Bank Financial Statement ICFA International finance: A Business Prospective L.M.Bole
WEBLIOGRAPHY:
http://www.wikipedia.com http://bseindia.com http://nseindia.com http://www.articlesbase.com http://www.investinganswers.com http://blog.arborinvestmentplanner.com
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Stock Market: History Types of Stock Exchanges Function & Purpose

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Introduction History Types of Stock exchanges Function & Purpose

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