Types & Sources Of Risks - Investment Decisions, Business Economics & Finance | Business Economics & Finance - B Com PDF Download

RISK:

It is not sensible to talk about investment returns without talking about risk, because

investment decisions involve a trade-off between the two--return and risk are opposite

sides of the same coin. Investors must constantly be aware of the risk they are assuming,

know what it can do to their investment decisions, and be prepared for the consequences.

Investors should be "willing to purchase  particular asset if the expected return is, adequate to compensate for the risk, but they must understand that their expectation about the asset's return may not materialize. If not, the realized return will differ from the expected return. In fact, realized returns on securities show considerable variability sometimes they are larger than expected, and other times they are smaller than expected, or even negative. Although investors may receive their expected returns on risky securities on a long-run average basis, they often fail to do so on a short-run basis.

SOURCES OF RISK:

What makes a financial asset risky? Traditionally, investors have talked about several

sources of total risk, such as interest rate risk and market risk, which are explained

below, because these terms are used so widely, Following this discussion, we will define the

modern portfolio sources of risk, which will be used later when we discuss portfolio and

capital market theory.

1. Interest Rate Risk:

The variability in a security's return resulting from changes in the level of interest rates is

referred to as interest rate risk. Such changes generally affect securities inversely; that is,

other things being equal, security prices move inversely to interest rates. Interest rate risk

affects bonds more directly than common stocks, but it affects both and is a very important

consideration for most investors.

2. Market Risk:

The variability in returns resulting from fluctuations in the overall market that is, the

aggregate stock market is referred to as market risk. All securities are exposed to market

risk, although it affects primarily common stocks.

Market risk includes a wide range of factors exogenous to securities themselves, including

recessions, wars, structural changes in the economy, and changes in consumer preferences

3. Inflation Risk:

A factor affecting all securities is purchasing power risk, or the chance that the purchasing

power of invested dollars will decline/With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because enders demand additional inflation premiums to compensate for the loss of purchasing power.

Investment Analysis & Portfolio Management (FIN630) VU

4. Business Risk:

The risk of doing business in a particular industry or environment is called business risk.

For example, AT&T, the traditional telephone powerhouse, faces major changes today in

the rapidly changing telecommunications industry.

5. Financial Risk:

Financial risk is associated with the use of debt financing by companies. The larger the

proportion of assets financed by debt (as opposed to equity), the larger the variability in the

returns, other things being equal. Financial risk involves the concept of financial leverage,

which is explained in managerial finance courses.

6. Liquidity Risk:

Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered to be liquid. The more uncertainty about the time element arid the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small over-the-counter (OTC) stock may have substantial liquidity risk.

7. Exchange Rate Risk:

All investors who invest internationally in today's increasingly global investment arena face the prospect of uncertainty in the returns after they-convert the foreign gains back to their own currency Unlike the past when most U.S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations.

Exchange rate risk is sometimes called currency risk.

For example, a U.S. investor who buys a German stock denominated in marks must

ultimately convert the returns from this stock back to dollars. If the exchange rate has

moved against the investor, losses from these" exchange rate' movements can partially or

totally negate the original return earned.

8. Country Risk:

Country risk, also referred to as political risk, is an important risk for investors today

probably more important now than in the past. With mote investors investing

internationally, both directly and indirectly, the political, and therefore economic, stability

and viability of a country's economy need to be considered. The United States arguably has

the lowest country, risk, and other countries can be judged on a-relative basis using the

United States as a benchmark. Examples - of countries that needed careful monitoring in the 1990s because of country risk included the, former Soviet Union ^and Yugoslavia, China, Hong Kong, and Smith Africa. In the-early part of the twenty-first century, several countries in South America, Turkey, Russia, and Hong Kong, among others, require careful attention.

TYPES OF RISK:

Thus far, our discussion has concerned the total risk of an asset, which is one important

consideration in investment analysis. However, modern investment analysis categorizes the traditional sources of risk identified previously as .causing variability in returns into two 

Investment Analysis & Portfolio Management (FIN630) VU

general types: those that are pervasive in nature, such as market risk or interest rate risk, and those that are specific to a particular security issue, such as business or financial risk.

Therefore, we must consider these two categories of total risk.

Dividing total risk into its two components, a general (market) component and a

specific (issuer) component, we have systematic risk and nonsystematic risk, which are

additive:

Total risk = General risk + Specific risk

= Market risk + Issuer risk

= Systematic risk + Nonsystematic risk

Systematic (Market) Risk:

Risk attributable to broad macro factors affecting all securities

Systematic Risk is an investor can construct a diversified portfolio and eliminate pan of the total risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the market risk. Variability in a security's total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk.

Virtually all securities have some systematic risk, whether bonds or stocks, because

systematic risk directly encompasses the interest rate, market, and inflation risks. The

investor cannot escape this part of the risk, because no matter how well he or she

diversifies, the risk of the overall market cannot be avoided. If the stock market declines

sharply, most stocks will be adversely affected; if it rises strongly, as in the last few months

of 1982, most stocks will appreciate in value. These movements occur regardless of what

any single investor does. Clearly, market risk is critical to all investors.

Nonsystematic (Non-market) Risk:

Risk attributable to factors unique to the security

Nonsystematic Risk is the variability in a security's total returns not related to overall

market variability is called the nonsystematic (non-market) risk. This risk 1s unique to a

particular security and is associated with such factors as business and financial risk as well

as liquidity risk. Although all securities tend to have some nonsystematic risk, it is generally connected with common stocks