Risk arises where there is a probability of variation between expectations and realizations with regard to an investment. Hence, it is arises from the variability in returns.
An investment whose returns are fairly stable is considered to be low-risk investment. Whereas an investment whose returns fluctuate significantly is considered to be a highly risky investment.
Further, Govt. securities whose returns are fairly stable and which are free from default are considered to possess low risk. whereas equity shares whose returns are likely to fluctuate widely around their mean are considered risky investment.
Moreover, the essence of risk in an investment is the variation in its returns. This variation in returns is caused by a number of factors. These factors which produce variations in the returns from an investment constitute different types of risk.
Types of risk
Lets consider the risk of holding equity securities. The elements of risk may be classified into two groups are as follows:
1. Systematic and
2. Unsystematic
1. Systematic Risk
It comprises of factors that are external to the company i.e. macro in nature. And this affects large number of securities simultaneously. This are mostly uncontrollable in nature.
Further, due to dynamic nature of an economy, the changes occur in the economic, political and social conditions constantly. These changes have an influence on the performance of companies and thereby on their stock prices but in varying degrees.
For example, economic and political instability adversely affects all industries and companies. When an economy moves into recession, corporate profits will shift downwards, and stock prices of most companies may decline.
Systematic risk can further subdivided into following :
- Interest rate
- Purchasing power and
- Market
Lets understand subdivision of systematic risk.
1. Interest rate:
This arises due to variability in the interest rates from time to time and its impact on security prices. Further, a change in the interest rates establishes an inverse relationship with the price of a security. Price of a securities tends to move inversely with change in rate of interest. Moreover, long term securities show greater variability in the price with respect to interest rate changes than short term securities.
2. Purchasing power:
It is also known as inflation risk, as it also emanates from the very fact that inflation affects the purchasing power adversely. Nominal return contains both the real return component and an inflation premium in a transaction involving risk of the above type to compensate for inflation over an investment holding period.
Further, This is more in inflationary conditions especially in respect of bonds and fixed income securities. It is not desirable to invest in such securities during inflationary periods.
It is however , less in flexible income securities like equity shares or common stock. Where rise in dividend income off-sets increase in the rate of inflation and provides advantages of capital gain.
3. Market :
This type of systematic risk that affects prices of a share that moves up or down consistently for some time periods in line with other share in the market.
Further, A general rise in share prices is referred to as a bullish trend. Whereas a general fall in share prices is referred to as a bearish trend. In other words, the share market moves between the bullish phase and the bearish phase.
2. Unsystematic Risk
Sometimes the return from a security of any company may vary because of certain factors particular to this company. The variability in returns of the security on account of these factors i.e. micro in nature is known as unsystematic . Further, it should be noted that this is in addition to systematic affecting all companies.
Unsystematic risk can further be subdivided into:
- Business and
- Financial
Business :
This emanates variability in the operating profits of a company. Higher the variability in the operating profits of a company , higher is the business risk . And this can be measured using operating leverage.
Financial:
It is arises due to presence of debt in the capital structure of the company . It is also known as leveraged risk and expressed in terms of debt-equity ratio.
Further, excess of debt vis-a-vis equity in the capital structure indicates that the company is highly geared and hence , has higher financial risk.
Although a leveraged company’s earnings per share may be more but dependence on borrowings exposes it to the risk of winding-up for its inability to honour its commitments towards lenders/creditors.
This is known as leveraged or financial risk of which investors should be aware of and portfolio managers should be very careful.
