Risk and Classification of Risk

Risk and Classification of Risk

at 4:31:00 PM ✪ 1 comment

Definition of Risk:

In basic sense, risk is the chance of financial loss. Risk is present whenever future events are not completely predictable.

Risk is the variability of return associated with a given asset.

Risk is the outcomes that actual outcomes may differ from those expected.

 

The probability, that an actual return on an investment will be lower than the expected return. The source of such disappointment is the failure of dividends (interest) and/or the security’s price to materialize as expected.

For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and,
when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

Different types of Risk/Element of Risk:  

Forces that contribute to variations in return, price or dividend (interest)- constitute elements of risk.

A) Unsystematic risk/Internal element:

1.      Business risk

2.      Financial risk

B) Systematic Risk/External element:

1. Market Risk

2. Interest Rate Risk

3. Purchasing power risk

Systematic risk + Unsystematic risk = Total risk

A)  Unsystematic risk/ Diversifiable risk:

Unsystematic risk is the portion of total risk that is unique to a firm or industry. For example, management capability, consumer preference, and labor strikes cause unsystematic variability of returns in a firm. These risks are internal to a firm and effect one firm, controllable to a large degree and can be eliminated by well diversification.

1.   Business risk: Business risk is the variability of EBIT (Earnings Before Interest & Tax). In the other words business risk is the chance that the firm will be unable to cover its operating cost.

Sources of business risk:

       I.   Change in the consumer taste and preferences,

    II.   Change in technology

 III.   Change in the income

 IV.   Variability of price, demand

    V.   Variability of cost of production

 VI.   Operating leverage.

2.Financial Risk: Financial risk is the variability of EPS (Earning Per Share). Financial risk is the uncertainty about the future returns to a firms common stock owners resulting from the use of debt and preferred stock. It is the risk associated with the way in which a company finances its activities. We generally gauge financial risk by looking at the capital structure of a firm. The presence of such fixed interest payment due to debt and fixed dividend payments on preferred stock. Financial risk is avoidable to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk.

Sources of Financial risk:

       I.   Interest on debt

    II.   Dividend on preferred stock.

B)   Systematic risk/ un-diversifiable risk:

Systematic risk is due to risk factors that affect the overall-such as changes in the national economy, tax reform by the govt., political and sociological changes.

 Those elements that are external to the firm cannot be controlled and affect large numbers of securities are called sources of systematic risk/ un-diversifiable risk/ market risk.

1. Market risk: Market risk is the chance that the value of an investment decline because of the market factors that are independent of investment (Such as political, economic and social events).

It is not uncommon that stock prices are falling from time to time while company’s earnings are rising and vice versa. The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investor’s attitude toward equities in general or toward certain types or groups of securities in particular.

Variability/change in return of common stocks that are due to basic sweeping changes in investor’s expectation is referred to as market risk. Market risk is caused by investor’s reaction to tangible events such as political, economic, social as well as intangible events-emotional instability of the investors.

Example: Which party (Awami League or BNP) will be elected in the nest election? On the victory of the party market will fluctuate. It may increase or decrease the price of share on the subject of any party failure or victory. If the culprit of share market are punished share price will increase or vise versa.

2. Interest rate risk: Interest rate risk refers to the uncertainty of future market values and of the size of the future income, caused by the fluctuations in the general level of interest rate.

Interest rate risk is the chance that the value of an investment will adversely be affected due to the change in the interest rate. Most investment loss value when the interest rate rises and increase in value when it falls.

Direct effect of interest rate risk:

1.      Increase in the level of interest rate will cause security prices to fall across a wide span of investment vehicle.

2.      Falling interest rate precipitate price make ups on outstanding securities.-Jordan.

Indirect effect of interest rate risk:

1.      Lower interest rate will attract the investors to take the margin loan on the other hand; higher interest rate will decrease the demand of margin loan.

 

2.      Higher interest rate may lead to decrease/lower stock prices because the investors (who take margin loan) will not take loan or take fewer loans and invest fewer amounts in the market than before. As a result, demand for share/securities will decrease and price also decrease because of low demand. Lower interest rate may lead to increase/higher stock price.

3.      Those firm have a maximum amount of borrowed/ loan fund, they will find that more of their income goes towards paying interest on borrowed fund due to higher interest rate. This may lead to lower earnings/EPS, lower dividend and finally share price will fall.

High interest rate >High amount of interest paid > Decrease EPS> Dividend will decrease>demand for share fall> finally decrease share price. 

3. Purchasing power risk: Purchasing power risk is the chance that changing price level caused by inflation or deflation in the economy will adversely affects the firm or investments cash flows and values.

Typically firms or investments with cash flows that move with general price level have a low purchasing power risk and those with cash flows that do not move with general price level have high purchasing power risk.

C) Some Other Types of Risk:

1. Liquidity risk: Liquidity means easily and quickly convertible into cash without or with little price appreciation. Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss.

Liquidity risk is of two types:

1. Market liquidity risk and
2. Funding liquidity risk.

Before this, we will know about market liquidity and funding liquidity.

                    i.            Market liquidity: A security has good market liquidity if it is easy to trade in the market.

                  ii.            Funding liquidity: A bank or investor has good funding liquidity if it has enough available funding from its own capital or from loans.

1. Market liquidity risk: Market liquidity risk is the risk that the market liquidity worsens when you need to trade, e.g. lack of reasonable price and lack of buyers of stock.
2. Funding liquidity risk: Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind.

2. Default Risk: Default risk is the possibility that the issuer of debt will not pay the contractual interest or principal as scheduled. The greater the uncertainty, as to the borrower’s ability to meet these payments, the greater is the premium. High bond ratings reflect low default risk and low bond ratings reflect high default risk.
 
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