LDM | Risk Management

Background

Change is the essence of life and risk is the integral aspect of living. This holds equally good in the capital market as well. In the context of capital market, risk is the chance that the expected return either may not materialize or may be less than the expected one. Return can be earned from the investment in the shares of a company has two components: the basic one which is the periodic cash flow by way of receiving dividend; and the other which is the appreciation in the price of shares, called the capital gain.

Volatile share market is a market subject to price fluctuations, which increases the risk for the latter type of return. Compared to the dividend, market price is the more crucial factor, which contributes to the success of investment. Therefore, volatility in the price of shares is the most crucial risk associated in the capital market.

Price Volatility

Volatile share market is not always risky for the investors. In the financial market, return can be maximized only at the cost of incurring higher degree of risk. A fall in the market price of shares results in decreasing the profit or increase in the loss to the investors. On the other hand, appreciation in the price of shares may put the investor in a favorable position.

Short-term fluctuation in the price of shares affects the investors who intend to invest in the shares and earn returns in the short span of time. The prospective investors need to find out the degree of price fluctuations in order to access the degree of risk involved in the investment. The degree of fluctuations in the price of shares can be found by computing price volatility index of shares.

Measurement of Price Volatility

Volatility measures the dispersion about a central tendency. There are a number of measures to measure the price volatility of shares. One of the widely accepted measures is the Price Volatility Index (PVI). PVI can be computed by dividing the range of price fluctuations of a share by the average price of the same share. Range is the difference between the highest and lowest price of shares during a particular period and the average price of share is the average of these highest and lowest prices. For example, Nabil Bank’s shares are traded in the market at the highest price of Rs. 1,130 and at lowest price of Rs. 830 in 2018. The PVI of Nabil Bank’s shares becomes 0.31, i.e., {(1,130-830)/(1,130+830)/2}.

PVI can be computed on an annual basis in order to find out long-term price fluctuations. But, in order to find out long-term price fluctuations PVI can be computed on a weekly, monthly or quarterly basis.

PVI of Nepalese Banks

Nepalese share market is volatile and has always been dominated by the banking and finance sector. The market is almost dead in other sector in the exception of few companies. Therefore, PVI of top 10 Banks based on market capitalization in 2018 has been computed and presented in the table in order to analyze price fluctuations of their shares.

A higher PVI is considered to be a risky security. Generally, a PVI with value greater is considered as aggressive security. On the other hand, a PVI with less value is considered as defensive security. NSCB, EBL and NSBI had greater PVI in 2018 whilst  GBIME, NIBL and SANIMA had lower PVI.

Conclusion

While ancient societies used to face the risk just by believing in fate, modern societies endeavors to manage the risk with the help of various risk management tools. Management of risk calls for understanding, measuring and analyzing it. PVI can be a useful tool for the investors to achieve this objective.