Types of Investment Risk
In considering economic and political factors, investors commonly identify five types of investments risks to which their investments are exposed. They are:
Table of Contents
Systematic risk refers to that portion of the total variability in return caused by factors affecting the prices of all securities. It arises due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization’s point of view. Economic, political, and social changes are sources of systematic risk. Thus it is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization.
For instance, nearly all stocks listed on the National Stock Exchange (NSE) move in the same direction as the NSE Index. On average, 50 percent of the variation in a stock’s price can be explained by variation in the market index. In other words, about half of the total risk on an average common stock is systematic risk.
For example, the rupee devaluation in India in August 2013 has affect whole stock market and some sectors like IT was left totally unaffected, similarly, any change in the interest rates affect the whole market through some sectors are more affected then others. This type of risk is called non-diversifiable risk because no amount of diversification can reduce this risk.
Types of Systematic Risk
Systematic Risk is further subdivided into:
- Market Risk (Variation in returns caused by the volatility of stock market)
- Interest Rate Risk (Variation in bond prices due to change in interest rate)
- Purchasing Power Risk (Inflation results in lowering of the purchasing power of money)
Interest Rate Risk
Interest-rate risk refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates. Hence it arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. The interest- rate risk is further classified as price risk and reinvestment rate risk. The meaning of various types of interest-rate risk is discussed below:
- Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may decline or fall in the future.
- Reinvestment rate risk results from fact that the interest or dividend earned from an investment can’t be reinvested with the same rate of return as it was acquiring earlier.
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities in the stock market. The stock prices may fall from time to time while a company’s earnings are rising, and vice versa is not uncommon. The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged.
The causes of this occurrence are varied, but it is mainly due to a change in investors’ attitudes toward shares in general, or toward certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic wide changes in investor expectations is referred to as market risk. The market risk is further classified as absolute risk, relative risk, directional risk, non-directional risk, basis risk and volatility risk.
The meaning of different types of market risk is briefly discussed below:
- Absolute risk is the risk without any content. For e.g., if a coin is tossed, there is fifty percentage chance of getting a head and vice-versa.
- Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a relative risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an organization are of export sales.
- Directional risks are those risks where the loss arises from an exposure to the particular assets of a market. For e.g. an investor holding some shares experience a loss when the market price of those shares falls down.
- Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk.
- Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks which are in offsetting positions in two related but non-identical markets.
- Volatility risk is the risk of a change in the price of securities as a result of changes in the volatility of a risk factor. For e.g. volatility risk applies to the portfolios of derivative instruments, where the volatility of its underlying is a major influence of prices.
Purchasing Power or Inflationary Risk
Market risk and interest-rate risk can be defined in terms of uncertainties as to the amount of current rupees to be received by an investor. Purchasing-power risk is the uncertainty of the purchasing power of the amounts to be received.
In general terms, purchasing-power risk refers to the impact of inflation or deflation on an investment. Therefore it is also known as inflation risk. It is so, since it derive from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
Rational investors should include in their estimate of expected return an allowance for purchasing-power risk, in the form of an expected annual percentage change in prices. The purchasing power or inflationary risk is classified as demand inflation risk and cost inflation risk.
The types of purchasing power or inflationary risk are discussed below.
- Demand inflation risk arises due to increase in price, which result from an excess of demand over supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In other words, demand inflation occurs when production factors are under maximum utilization.
- Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually caused by higher production cost. A high cost of production inflates the final price of finished goods consumed by people.
Unsystematic or diversifiable risk is the portion of total risks that is unique to a firm or industry. Therefore it arises due to the influence of internal factors prevailing within an organization. Factors like management capability, labor unions, product category, research and development, pricing, marketing strategy, consumer preferences and raw material scarcity causes unsystematic variability of returns in a firm.
Unsystematic factors are largely independent of factors affecting securities markets in general. Such factors are normally controllable from an organization’s point of view. Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
Types of Unsystematic Risk
Unsystematic Risk is further subdivided into:
- Business Risk (Variability in Operating Income caused by Operating Conditions)
- Financial Risk (Variability in EPS due to the presence of debt in Capital Structure)
- Operational risk (Business process risks arising due to human errors)
Business risk arises due to the operating conditions faced by a firm and the variability these conditions instill into operating income and expected income. The degree of variation from the expected trend would measure business risk.
Business risk can be divided into two broad categories: external and internal.
- Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it. Each firm has its own set of internal risks, and the degree to which it is successful in coping with them is reflected in operating efficiently.
- External business risk is the result of operating conditions imposes upon the firm by circumstances beyond its control. Each firm also faces its own set of external risks, depending upon the specific operating environmental factors with which it must deal. The external factors, from cost of money to defence-budget cuts to higher tariffs to a down swing in the business cycle, are some of the external factors.
Financial or Credit Risk
Financial risk is also known as credit risk. This risk arises due to change in the capital structure of the organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects and they are owned funds (share capital), borrowed funds (loan funds, debentures) and retained earnings (reserve and surplus).
The financial or credit risk is further classified into following types.
- Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises from a potential change seen in the exchange rate of one country’s currency in relation to another country’s currency and vice-versa.
For e.g. investors or businesses face an exchange rate risk either when they have assets or operations across national borders, or if they have loans or borrowings in a foreign currency.
- Recovery rate risk is an often neglected aspect of a credit risk analysis. The recovery rate is normally needed to be evaluated. For e.g. the expected recovery rate of the funds tendered (given) as a loan to the customers by banks, non-banking financial companies (NBFC), etc.
- Sovereign risk is the risk associated with the government. In such a risk, government is unable to meet its loan obligations, reneging (to break a promise) on loans it guarantees, etc.
- Settlement risk is the risk when counterparty does not deliver a security or its value in cash as per the agreement of trade or business.
Operational risks are the business process risks failing due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems. The operational risk is further classified as model risk, people risk, legal risk and political risk.
The types of operational risk are depicted and explained below:
- Model risk is the risk involved in using various models to value financial securities. It is due to probability of loss resulting from the weaknesses in the financial model used in assessing and managing a risk.
- People risk arises when people do not follow the organization’s procedures, practices and/or rules. That is, they deviate from their expected behaviour.
- Legal risk arises when parties are not lawfully competent to enter an agreement among themselves. Furthermore, this relates to regulatory risk, where a transaction could conflict with a government policy or particular legislation (law) might be amended in the future with retrospective effect.
- Political risk is the risk that occurs due to changes in government policies. Such changes may have an unfavourable impact on an investor. This risk is especially prevalent in the third-world countries.
Risk is the potential for variability in returns. Total variability in returns of a security represents the total risk of that security. Hence,
Total Risk = Systematic Risk + Unsystematic Risk
Factors influencing risk:
- The length of the maturity period affects risk. The longer maturity periods impart greater risk to investments.
- The credit-worthiness of the issuer of securities also influences the risk of the securities. The ability of the borrower to make periodical interest payments and pay back the principal amount may create risk.
- The nature of the instrument or security also determines the risk. The government securities and fixed deposits with banks tend to be least risky while corporate debt instruments like debentures tend to be riskier than government bonds whereas ownership instruments like equity shares tend to be the riskiest
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