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A risky affair

A N Shanbhag

As an investor your objective is simple - maximise return and minimise risk. The first part of the equation, the return, is relatively easy to understand. It is objective in nature, in as much as, when you undertake an investment, you have a fairly good idea as to what the return is going to be. It is quantifiable, it is a number.

However, what about risk? How do you quantify it? How do you minimise it? How do you achieve the fine balance required between risk and return to optimise your investment consistent with your goals? Well, let us begin with understanding the concept of risk and how it differs for various instruments.

The one thing that almost all investors would agree upon is the fact that equity is definitely more risky than debt. Those who didn't would have learnt this painful lesson post the meltdown in equity prices not only in India but across the globe.

However, does this mean that investing in debt instruments is entirely risk-free? Unfortunately, the answer is in the negative though the volatility is much lower. So first, let us examine what kind of risks do debt instruments pose.

Interest rate risk

Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa.

Interest rates may fluctuate due to several factors such as a change in the RBI's monetary policy, cash reserve ratio requirements, forex reserves, the level of the fiscal deficit and the consequent inflation outlook, etc. Extraneous factors such as energy price fluctuations, commodity demand and supply and even capital flows may result in rates fluctuating.

Then there are event based factors that affect interest rates. For example, the 9/11 episode in the US and 13/12 in India. If there is a war, interest rates will rise. However, typically such events are temporary in nature and in fact a good fund manager can actually take advantage of such hiccups.

To illustrate how fluctuations in interest rates affect returns, let us take the example of mutual funds. Adjusting the portfolio to the market rate of returns is called 'marking to market'.

We assume that the current net asset value of the mutual fund is Rs 10 and its corpus is Rs 10 billion. This means that if the fund sells all the assets of the scheme and distributes the money on equitable basis to all the unit holders, they will receive Rs 10 per unit.

Now suppose, the interest rate falls from 10 per cent to 9 per cent. Immediately thereafter you wish to invest Rs 100,000 in the scheme. The entire corpus of the fund stands invested at an average return of 10 per cent. If the fund sells the units to you at it's current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10 per cent, though the fund will be forced to invest your Rs 100,000 at the lower rate of 9 per cent.

This is injustice to the existing investors. Therefore, something has got to be done to protect their interest. Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The returns on 9,000 units at 10 per cent would be identical with the returns on 10,000 units at 9 per cent. In other words, the NAV rises when the interest falls.

Credit risk

This is the risk of default. What if the company whose fixed deposit you invested in goes bankrupt? There have already been several such cases. Deposits with plantation companies and time share resorts are cases in point. True, you have legal remedy but everyone knows how much time our courts take.

The only factor that dilutes this risk somewhat is the credit rating. Fixed income earning instruments get rated for varying degrees of safety. Investing in a highly rated instrument is safe but not sufficient.

Firstly, the instrument may be downgraded and you have to be on the lookout for the same. A case in point is BPL which was downgraded from 'A+' directly to 'D', the default grade! Then there have been cases where the issuer has has been rated by different agencies but chooses to indicate only the higher ones.

Elimination of risks

There is some good news though. The credit risk can be simply eliminated by investing in sovereign securities - securities issued by the government. There is simply no risk of default. Or so we hope! For retail investors, mutual funds offer gilt schemes where almost the entire corpus is invested in sovereign securities thereby achieving the same result.

The interest rate risk discussed earlier is always prevalent. However, it comes into play only when a transaction is undertaken during the pendancy of the fixed income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest rate risk.

Investments such as PPF, Relief Bonds etc, are normally held till maturity. These are examples where both the risks inherent in debt instruments are at a bare minimum.

Government action risk

This is a unique kind of risk which has reared its ugly head in recent times. In the previous paragraph it is mentioned that the interest rate risk is eliminated by simply holding the instrument till maturity.

However, such principles of investment had not contended with unilateral governmental action. For example, the rates of PPF over the past three years have been consistently reduced from 12 per cent per annum to 9 per cent per annum. To add insult to injury, these rates are applicable on the entire corpus and not on additional investment.

Relief Bonds have come down to 8 per cent. Rates on other small saving instruments have also been slashed across the board. But in these cases, happily, the rates are applicable prospectively. Unfortunately, there is no escape from this risk - that of our government!

Measuring risk

So far, we have acquainted ourselves with the kinds of risks inherent in investment instruments. However, merely knowing this much may not be enough to take an informed decision. The article began with the premise that return is objective since it is quantifiable. Then, can we not try and quantify risk?

Well, age-old statistical tools like standard deviation and regression help us do precisely that. Next time we shall touch upon these basics of Modern Portfolio Theory that enable you as an investor to actually quantify the risk existing in the investment you are contemplating.

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