Corporate Finance

64  Corporate Finance

between the mean monthly return and standard deviation as would be suggested by the risk premium
hypothesis. Some of the risk investors assume is specific to the individual stocks in their portfolio. For
example, a company’s earnings may come down due to a strike. On the other hand, because stock prices and
returns move in tandem to some extent, even investors holding widely diversified portfolios are exposed
to the risk inherent in the overall performance of the stock market. So the security’s total risk can be divided
into unsystematic risk, the portion specific to the company or a small group of assets, which can be diversi-
fied away, and systematic risk, the non-diversifiable portion that is related to the movement of the stock
market.

Total risk = Unsystematic risk + Systematic risk

Examples of unsystematic risk factors are: a lower cost, foreign competitor unexpectedly enter a company’s
product market or labor unrest disrupting production in the company. Examples of systematic risk factors
are: increase in long-term interest rates, RBI stepping up its restrictive monetary policy.

MEASURING PORTFOLIO RISK

The risk of a portfolio of securities is not the sum of variances of returns of individual securities. To demonstrate
risk in a portfolio context, consider a primitive economy where there are only two firms—one makes umbrellas
and the other, suntan lotion. Suppose the returns from these two stocks follow a cyclical pattern, as is
illustrated here:

Return

Umbrella Suntan lotion

The return from holding shares of both companies is the weighted average of returns from the two stocks.

Rp= ∑

=

n

i

RX ii

1

(5)

where

Xi = proportion of money invested in asset i, and

Ri = expected return of asset i.