Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Uncertainties could be due to the political, economic and industry factors.
Risk could be systematic in future depending upon its source. Systematic risk is for the market as a whole, while unsystematic risk is specific to an industry or the company individually. The first three risk factors discussed below are systematic in nature and the rest are unsystematic. Political risk could be categorised depending on whether it affects the market as whole, or just a particular industry.
2.2 Types of Investment Risk
Modern investment analysis categorizes the traditional sources of risk causing variability in returns into two 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. The following discussion introduces these terms. Dividing total risk into its two components, a general (market) component and a specific (issuer) component, we have systematic risk and non-systematic risk, which are additive: Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Non-systematic risk
Systematic risk is non-diversifiable risk and is associated with the securities market as well as the economic, sociological, political, and legal considerations of the prices of all securities in the economy. The effect of these factors is to put pressure on all securities in such a way that the price of all stocks will move in the same direction. For example, during a boom period prices of all securities will rise and indicate that the economy is moving towards prosperity. This is based on the forces of demand and supply. It is uncontrollable; it can be reduced but not eliminated because it is an external risk.
Thus 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 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.
It is unique to a firm or industry. It does not affect an average investor. Unsystematic risk is caused by factors like labour strike, irregular disorganized management policies and consumer preferences. These factors are independent of the price mechanism operating in the securities market. The problems of both systematic and unsystematic risk are inherent in industries dealing with basic raw materials as well as in consumer goods industries
2.3 Types of Systematic Risk
The variability in a security's returns resulting from fluctuations in the aggregate market is known as market risk. All securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes and even changes in consumer preferences. The investor's reaction towards tangible and intangible events is the chief cause affecting 'market risk'. The first set, that is the tangible events, has a 'real' basis but the intangible events are based on a 'psychological' basis or reaction to expectations or realities.
Market risk triggers off through real events comprising political, social, economic reasons. The initial decline or 'rise' in market price will create an emotional instability of investors and cause a fear of loss or create an undue confidence, relating possibility of profit. The reaction to loss will culminate in excessive selling and pushing prices down and the reaction to gain will bring in the activity of active buying of securities. However, investors are more reactive towards decline in prices rather than increase in prices.
Market risks cannot be eliminated while financial risks can be reduced. Through diversification also, market risk can be reduced but not eliminated because prices of all stocks move together and any equity stock investor will be faced by the risk of a downwards market and decline in security prices.
Investors can try and eliminate market risk by being conservative in framing their portfolios. They can time their stock purchases and also choose growth stocks only. These methods will reduce their risk to some degree but as explained earlier market risk will not be completely eliminated because falling markets would bring down the prices of all stocks. Obviously the decline in some stock will be more than in others. With a wise combination of stocks on the portfolio, to some extent, the risk will be reduced. While the impact on an individual security varies, experts in investment market feel that all securities are exposed to market risk.
2. 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. The reason for this movement is tied up with the valuation of securities. Interest rate risk affects bonds more directly than common stocks and is a major risk that all bondholders face. As interest rates change, bond prices change in the opposite direction.
Interest rate risk can also be reduced by analyzing the different kinds of securities available for investment. A government bond or a bond issued by the financial institution like IDBI is a risk-less bond. Even if government bonds give a slightly lower rate of interest, in the long-run they are better for a conservative investor because he is assured of his return. Moreover, government bonds are made more attractive by additional advantages of tax benefits. Therefore, one way to avert interest rate risk would be to purchase government securities. Then the price of securities in the private corporate sector will fall and interest rates will increase. This process will create a chain reaction in the securities. This is rarely possible in the real world situation.
The direct effect of increase in the level of interest rates will raise the price of securities. High interest rates usually lead to stock prices because of a diminished demand by speculators who purchase and sell by using borrowed funds and maintaining a margin.
The effect of interest can be different for lending institutions and borrowing institutions. Term lending banks and financial institutions may find it attractive to lend during the prevailing high rates of interest. Consequently, the borrowing institutions and corporate organizations will be paying a high interest amount during the high rates of interest. Therefore, investors should during times of high rate of interest purchase indirect securities of financial institutions and avoid purchasing securities of the corporate sector in order to reduce the rate of risk on securities. This switching over of securities is not practical in the actual practice of making investments. The brokers and speculators can, however, use this as a hedge against possible occurrences of loss.
3. Purchasing Power Risk
Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods and services and technically it covers both inflation and deflation periods. During the last two decades it has been seen that inflationary factors have been continuously affecting the Indian economy. In India, purchasing power risk is associated with inflation and rising prices in the economy.
Inflation in India has been either 'cost push' or 'demand pull'. This type of inflation has been seen when costs of production rise or when there is a demand for products but there is no smooth supply and consequently prices rise. In India, the cost push inflation has led to enormous problems as the rise in prices of raw materials has greatly increased costs of production. The increase in costs of production has shown a rising trend in 'wholesale price index' and 'consumer price index'. A rising trend in price index reflects a price spiral in the economy.
The consumers who wanted to forego their present consumption level to purchase commodities in future found that they could not adjust their budgets because they were faced with rising prices and shortage of funds for allocation according to their preferences. All investors should have an approximate estimate in their minds before investing their funds of the expected return after making an allowance for purchasing power risk. The allowance for rise in prices can be made through a check list of the 'cost of living index'. If a cost of living index has a base 100 and the next year shows 105, the rate of increase in inflation is (105-100) 100 or 5%. If the index rises further in the second year to 108, the rate is (108-105) 105 or 2.8%.
The importance of purchasing power risk can be equated to a simple example. If Z, lends A 100 today, for a promise to be repaid A 110 at the end of the year, the rate of return is 10%. This effect becomes nullified if the prices in the country increase. Assuming that the prices rise from 100 base index to 112 A 110 received at the end of the year has purchasing power value of only 88% of A 110 or 96.80. A rate of 2% should be charged in the beginning (10% + 12% expected inflation) to allow for this.
The behaviour of purchasing power risk can in some ways be compared to interest rate risk. They have a systematic influence on the prices of both stocks and bonds. If the consumer price index in a country shows a constant increase of 4% and suddenly jumps to 5% in the next year the required rates of return will also have to be adjusted with an upward revision. Such a change in process will affect government securities, corporate bonds and equity shares.
2.4 Types of Un Systematic Risk
A. Business Risk:
Every corporate organization has its own objectives and goals and aims at a particular gross profit and operating income and also expects to provide a certain level of dividend income to its shareholders. It also hopes to plough back some profits. Once, it identifies its operating level of earnings, the degree of variation from this operating level would measure business risk. For example, if operating income is expected to be 15% in a year, business risk will be low if the operating income varies between 14% and 16%. If the operating income is as low, as 10% or as high as 18% it would be said that the business risk is high.
Business risk is also associated with risks directly affecting the internal environment of the firm and those of circumstances beyond its control. The former is classified as internal business risk and the latter as external business risk. Within these two broad categories of risk the firm operates.
Internal business risk may be represented by a firm's limiting environment within which it conducts its business. It is the framework within which the firm conducts its business drawing its efficiency largely from the constraints within which it functions. Internal business risk will be of differing degrees in each firm and the degree to which each firm achieves its goals and attainment level is reflected in its operating efficiency.
Each firm also has to deal with specific external factors. Many a time, these factors are beyond the control of a firm as they are responsive to specific operating environmental conditions. External risks of the business are due to many factors. Some of the factors that can be summarized are:
Business cycle: Some industries move automatically with the business cycle, others move countercyclically;
Demographic factors: Such as geographical distribution of population by age, group and race;
Political policies: Change in decisions, toppling of State Governments to some extent affect the working of an industry;
Monetary policy: Reserve Bank of India's policies with regard to monetary and fiscal policies may also affect revenues through an effect on cost as well as availability of funds. When the RBI controls its monetary policies in a way that money asset becomes expensive, people postpone their purchases and the impact of such factors can be seen in retailers' showrooms. As buying activity is restricted, sales slide down;
Environment: The economic environment of the economy also influences the firm and costs and revenues;
Internal Business Risk can be identified through rise and decline of total revenues as indicated in the firm's earnings before interest and taxes. A firm which has high fixed costs has large internal risk because the firm would find it difficult to curtail its expenses during a sluggish market. Even when market conditions improve, a firm with a high fixed cost would be unable to respond to changes in the economy because it would already be burdened with a certain fixed cost factor.
A firm can reduce its internal business risk both by keeping its fixed expenses low and through other means. One of the methods of reducing internal business risk is to diversify its business cycle others will be quite profitable. Internal risk can be reduced to this extent because a decline in revenue from one product line can be offset by an increase in another, leaving total revenue unchanged. Other methods to reduce risk are to cut costs of production through other techniques and skills of management.
B) Financial Risk:
Financial risk in a company is associated with the method through which it plans its financial structure. If the capital structure of a company tends to make earnings unstable, the company may fail financially. How a company raises funds to finance its needs and growth will have an impact on its future earnings and consequently on the stability of earnings. Debt financing provides a low cost source of funds to a company, at the same time providing financial leverage for the equity share holders. As long as the earnings of the company are higher than the cost of borrowed funds, the earnings per share of equity share are increased. Unfortunately, large amounts of debt financing also increases the variability of the returns of the equity share holders and thus increases their risk. It is found that variation in returns for shareholders in levered firms (borrowed funds company) is higher than in un-levered firms. The variance in returns is the financial risk.
Financial risk and business risk are somewhat related. While business risk is concerned with an analysis of the income statement between revenues and earnings before interest and taxes (EBIT), financial risk can be stated as being between earnings before interest and taxes (EBIT) and earnings before taxes (EBT). If the revenue, cost and EBIT of a firm is variable, it implies that there is business risk and in this situation borrowed funds can magnify risk especially in unprofitable years. Debt in modest amounts is desirable. Excessive debt is to be avoided as the long range profitability of the company can be depressed. The company should constantly test its debt to fixed assets, debts to net worth, debts to working capital, and give coverage of interest charges and preferred dividends by net income after taxes. These methods will check imbalance in the firms financing method and help to reduce risk.
C) Management Risk
Management, all said and done, is made up of people who are mortal, fallible and capable of making a mistake or a poor decision. Errors made by the management can harm those who invested in their firms. Forecasting errors is difficult work and may not be worth the effort and, as a result, imparts a needlessly sceptical outlook. An agent-principal relationship exists when the shareholder owners delegate the day-to-day decision-making authority to managers who are hired employees rather than substantial owners. This theory suggests that owners will work harder to maximize the value of the company than employees will. Various researches in the field indicate that investors can reduce their losses to difficult-to-analyse management errors by buying shares in those corporations in which the executives have significant equity investments.
D) Default Risk:
It is that portion of an investment's total risk that results from changes in the financial integrity of the investment. For example, when a company that issues securities moves either further away from bankruptcy or closer to it, these changes in the firm's financial integrity will be reflected in the market price of its securities. The variability of return that investors experience, as a result of changes in the credit worthiness of a firm in which they invested, is their default risk. Almost all the losses suffered by investors as a result of default risk are not the result of actual defaults and/or bankruptcies. Investor losses from default risk usually result from security prices falling as the financial integrity of a corporation's weakness - market prices of the troubled firm's securities will already have declined to near zero. However, this is not always the case - 'creative' accounting practices in firms like Enron, WorldCom, Arthur Anderson and Computer Associates may maintain quoted prices of stock even as the company's net worth gets completely eroded. Thus, the bankruptcy losses would be only a small part of the total losses resulting from the process of financial deterioration.