FINANCIAL RISK MANAGEMENT

What Is Risk?
The potential loss an asset or a portfolio is likely to suffer due to a variety of reasons is called as risk. OR Risk is the chance (or probability) of a deviation from an anticipated outcome. It is not limited to consideration of losses, but looks at the extent and probability of all of the deviations. It is a function of objectives. Without an objective or intended outcome, there is only uncertainty. OR Risk provides the basis for opportunity. The terms risk and exposure have subtle differences in their meaning. Risk refers to the probability of loss while exposure is the possibility of loss, although they are often used interchangeably. Risk arises as a result of exposure. Exposure to financial markets affects most organizations, either directly or indirectly. When an organization has financial market exposure, there is a possibility of loss but also an opportunity for gain or profit. Financial market exposure may provide strategic or competitive benefits. Risk is the likelihood of losses resulting from events such as changes in market prices. Events with a low probability of occurring, but that may result in a high loss, are particularly troublesome because they are often not anticipated. Put another way, risk is the probable variability of returns. Since it is not always possible or desirable to eliminate risk, understanding it is an important step in determining how to manage it. Identifying exposures and risks forms the basis for an appropriate financial risk management strategy.

Financial Risk
Financial risk is an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default.

Classification of Risk
Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different situations and applications. In some theoretical models of economic or financial processes, for example, some types of risks or even all risk may be entirely eliminated. For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is ever-present and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. Some of the most important types of risk are defined below.

RISKS
FINANCIAL RISK NON FINANCIAL RISK
OPERATING RISK

CREDIT RISK

MARKET RISK
SYSTEMATIC RISK
INTEREST RATE RISK LIQUIDITY RISK

TRANSACTION RISK

POLITICAL RISK HUMAN RISK TECHNOLOGY RISK

PORTFOLIO RISK FOREX RISK

1. CREDIT RISK
Risk that the counterparty will fail to perform or meet the obligation on the agreed terms.
OR

Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly or indirectly use or rely on repo, forward commitment, or derivative instruments. TYPES OF CREDIT RISKS Transaction Risk Risk relating to specific trade transactions, sectors or groups. Portfolio Risk Risk arising from lending to sectors non related to the core competencies of the Bank / concentrated credits to a particular sector / lending to a few big borrowers.

2. MARKET RISK
Market risk is the risk to a banks financial condition that could result from adverse movements in market price. TYPES OF MARKET RISK Interest Rate Risk Risk felt, when changes in the interest rate structure put pressure on the net interest margin of the Bank. OR Uncertainty associated with the effects of changes in market interest rates. OR The value of rate-sensitive assets depends directly or indirectly on the interest rate (or the discount rate) used to present-value the cash flows. Interest rate risk is the risk arising from changes in the rate of interest of borrowed or invested (including lent) money.

Sources of Interest Rate Risk There are several sources of interest rate risk identified; which are as follows: (A) Price Risk The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Price Risk the interest rate used to give the present value of future cash flows. Bond price = C [(1 + i)t 1] / i(1 + i)t + 100/(1 + i)t where C is the coupon, i is the prevailing interest rate and t is the maturity of the bond. Asset prices fall when interest rates rise and vice versa. Sensitivity increases with maturity. Zero coupon bonds (strips) have the highest sensitivity to a rate change, since all of the value is reflected in the terminal cash flow.

(B) Reinvestment Rate Risk The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. This type of interest rate risk is also covered extensively in the Bank Management courses.

Reinvestment Risk the interest rate used to give the future value of, or compound, cash flows into the future. The risk arises when maturing cash flows (e.g., coupons or payments) need to be recycled into new investments or new borrowings. The future value of reinvested cash flows increases as interest rates increase.

(C) Prepayment Risk Sometimes known as call risk arises if the borrower has the right to repay the debt prior to contract maturity. The opportunity arises for the borrower if he can refinance at lower rates. Thus, the risk rises as the rates fall. if the option is in the money, the value of the future cash flow is capped at the present value of the coupon plus the penalty for exercising the call.

(D) Extension Risk Arises when the borrower has an (yet unexercised) option to modify the cash flows. In a mortgage-backed security, for example, where repayment of interest and principal are supported by mortgages on property, the borrower often has an option to prepay, sometimes subject to a penalty. For a portfolio of such assets, there is going to be an expected number of such payments, but the actual number may be more or fewer. Extension does not refer to a lengthening of the term in the same way that prepayment shortens it. Rather, the expected number of prepayments is less, thus effectively extending the expected term.

Term Structure Of Interest Rate

The term structure of interest rates is often shown graphically in what is known as a yield curve. The observed shape and form is not stationary over time the curve changes in response to new information and the changing views of market participant. There is the classic upward slope, implying a premium (contango); a downward slope, implying discount (backwardation); flat; or humped.

Traditional Term Structure Theories 1.The Expectations Theory proposes that the shape of the yield curve is determined by market participants view on the future course of short-term interest rates and the demand for securities of a particular maturity. The theory states that the expected return on a security of whatever maturity is the same for the same holding period. That is, investors expect to earn the same return from holding a two-year security for one year as would be obtainable from holding a one-year security for one year. (1 + 0rn) = [(1 + 0r1) (1 + E0(1r2)) (1 + E0(2r3) (1 + E0(n-1rn) ]1/n Long-term interest rates are determined by short-term interest rates and the degree to which short-term rates are correlated across time.

2. The Liquidity Preference Theory proposes that investors require a maturity risk premium as compensation for holding longer maturity investments. The liquidity premiums over the expected rates would be increasing, but the underlying expected rates are not necessarily increasing (could be flat or humped). Under this theory, the short-term rates derived from the yield curve will overstate the short-term rate when the curve is upward sloping, and understate when the curve is inverted.

3.The Market Segmentation Theory proposes that market participants have a preferred maturity range in which they like to borrow or lend. The yield curve is therefore a series of maturity-segmented markets. If these preferences are tied to underlying assets or liabilities, the participants will be less and less willing to substitute as they move away from their preferred range (habitat).

A Modern Term Structure Theory

Changes in short-term interest rates are characterized by two components: The first is a deterministic process that brings the rate back to its central tendency at a given rate per period.

The second is a random variable taken from a normal distribution with a mean of zero and a standard deviation of one. The deterministic component is required to account for the observed mean reversion of interest rates; the stochastic element provides for the unpredictable changes in rates.

Analyzing the Yield Curve

The spot rates or zero-coupon rates derived from the yield curve provide the interest rates for valuing future cash flows. The nominal interest rate can be decomposed into two elements: a real interest rate and an inflation premium. (1 + rnominal) = (1 + rreal) x (1 + expected inflation) If investors expect to earn a real rate of 4 percent and inflation is anticipated to be 3 percent, then we would expect a nominal rate = (1.04) x (1.03) = 7.12%

We can characterize the change in shape of the yield curve, as expectations about inflation change, as a parallel shift (all maturities change by the same amount) or as a rotational shift (yield curve pivots around a particular maturity point). Both shifts can occur simultaneously, leading to twisting effects.

Liquidity Risk Risk arising due to the potential for liabilities to drain from the Bank at a faster rate than assets. OR Liquidity risks are mitigated by financial intermediation, where middlemen are prepared to buy or sell with the intention reselling or repurchasing. OR The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few

interested buyers. This type of risk is important in some project investment decisions OR This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk: Asset liquidity - An asset cannot be sold due to lack of liquidity in the market essentially a sub-set of market risk. This can be accounted for by:

Widening bid-offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities:

Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic

Liquidity is all about working with efficiency The ability and speed with which markets react to news is an indication of their efficiency. If short-term price movements could be predicted on the basis of price patterns or other market indications, they would be acted upon by all participants. Thus, movements become effectively random. Longer-term prices can be related to variables such as economic growth. The Efficient Markets Hypothesis does not suggest that price randomness is senseless; rather, it is the result of competition among rational investors seeking superior returns.

EMH postulates three levels:

Weak-form: participants cannot make abnormal returns by analyzing previous price behavior Semi-strong form: extends the weak form to include publicly-available information Strong-form: extends semi-strong form to include all information, whether available publicly or not

A market is transparent when it is possible to observe the behavior of other participants.The extent to which the market incorporates new information to generate asset prices bears upon the value of those prices for decisionmaking.

Methods of Intermediation
Acceptance: carrying out a transaction for a client and also guaranteeing that the client will perform under the terms of the agreement, as where a bank guarantees a documentary credit. Broking: acting as an agent to find the other side for a transaction. Dealing (market making): being willing to act as a buyer or seller, according to the need of the client.

Market risk
This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices: Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change. Interest rate risk is the risk that interest rates or the implied volatility will change. Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency. Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change.

Operational risk
Reputational risk

Legal risk IT risk

Diversification
Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification. The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it,[7] but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel.[8] However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that Index Funds have been developed that invest in equities in proportion to the weighting they have in some well known index such as the FTSE. However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes. A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the Late-2000s recession when assets that had previously had small or even negative correlations[9] suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way [10] Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. The is also the risk that as an investor or fund manager diversifies their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations. [edit]Hedging Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium.

Issues in financial risk management

By H. Jamal Zubairi | From InpaperMagzine | 18th October, 2010

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This article focuses on issues pertaining to risk management in the context of financial assets which give rise to variability or deviation in the expected return. Financial assets represent claims to ownership/cash/income as in the case of share certificates, or debt instruments like bonds, term finance certificates (TFCs) and government securities. The evidence of ownership or creditorship is now increasingly available only as an electronic entry to an account on a computer system. People are generally said to be risk averse. But is it possible to find an investment which is completely free from risk? The answer is a firm no! Why? Because a completely risk free investment would be one which would repay at a future date, an amount equivalent in purchasing power to that represented by the amount originally invested. For this to happen, two necessary conditions should be complied: (i) The promised amount is actually paid i.e. there is no chance of default; (ii).an additional amount is also paid, if required, to compensate for decline in purchasing power, measured in terms of the price index of the consumption basket of the investor. When the issuer of security is a sovereign government empowered to print currency, condition No (i) can usually be met but no issuer of a security would perhaps ever be able to offer anything close to what condition No. (ii) represents. Investment options and risks: Individual investors have the following investment options available: short to medium-term and long-term government securities; various short to long-term deposit schemes, COIs etc offered by commercial banks and non-banking financial institutions (NBFI`s); stock market shares; long and short-term finance certificates; real estate; gold, silver and precious stones and foreign currencies. How can an investor minimise the investment risk? The main option currently appears to be diversification of investments because hedging devices like derivatives are not available in our markets. Moreover, derivatives like options and futures are considered to be un-Islamic. Diversification however, is not very effective in the case of small investors with limited funds. Thus the need to be satisfied with a relatively low return by investing a certain percentage (depending on their appetite for risk) of their funds in low risk government securities. Institutional investors can do the same and generally their average return on investment should be higher than that of the individual investors, given their greater ability to take risk.

In the short run, diversification appears to be the main risk minimisation tool, with an important income smoothening role being played by the government securities. How ever, in the long run, effective regulatory intervention to minimise the manipulation component of the risk would be the key, followed by development of debt instruments conforming to the Shariah. Secondary market for debt instruments: Presently about 685 companies are listed on the Karachi Stock Exchange. However, the secondary market for shares is far more developed than the market for debt instruments, with less than five per cent of listed companies currently having debt securities listed on the Karachi Stock Exchange. The listed debt securities are term finance certificates (TFCs) and Sukuks (Islamic bonds), which are equivalent to bonds traded worldwide on security exchanges. It is pertinent to examine the inhibiting factors for issuance of debt securities by companies. After all, there can be no secondary debt market development without the primary market first being firmly in saddle. The matter can be examined both from the prospective holders (buyers) of TFCs and from the issuers viewpoint. The two main categories of buyers of TFCs are individual investors and institutional investors. Individual investors belonging to the segment of retired salaried employees generally do not have a significant capacity to face the risk of default. Thus, they have traditionally favoured the National Savings Schemes. The monthly income scheme and special saving certificates (offering six monthly returns with a three-year maturity) are popular for providing regular near risk free income. The Defence Savings Certificates, with maturities up to ten years give an option for long-term capital appreciation for people who can afford to set aside some amount for the long term but are not willing to take the risk of default. The rate of return on these schemes has not been able to keep pace with the rate of inflation. The government would like to restrict the cost of borrowing. Realising that the risk taking ability of a majority of individual investor is low, the government perhaps does not foresee a significant fall in deposits into its saving schemes, despite the lowering of returns. This has really hit the individual investor hard, particularly the retired salaried class. This category of people would be keen to invest at least a portion of their funds in TFCs, if the promised yield is even 2-3 percentage points more than government schemes. This class is the least likely to subject, even a part of their life time savings, to the volatility of our stock exchanges. Private limited and public limited companies would also be interested to varying degrees in picking up TFCs. This is the type of investment, which can serve to smoothen the fluctuations in a company`s earnings. The extent of interest of any company in such investments would of course depend upon its cash flow pattern, liquidity and reserves position, its stage of

development i.e. whether it has vertical or horizontal growth opportunities still available or its products or services are at the maturity stage, the tax implications of its earnings on TFCs etc. Apparently, the companies generally would be interested in investing some portion of their earnings in debt instruments like TFCs and with a higher capacity to take risks as compared to individual investors. However, they have to be reasonably sure that the secondary market is sufficiently developed to give them comfort on the liquidity aspect of the investments. This is important because while the individual investor would also be interested in assured return and liquidity, the corporate investor would place a much higher premium on liquidity. For instance, no company having a seasonal requirement of funds, say for purchase of raw material, would like to be in a situation where it has investments in hand which it cannot quickly convert into cash at the time of need. From the TFC issuing company`s viewpoint, the following matters need to be considered: * Will it be easier to get a loan from the banking system or to issue a TFC? * Would the effective cost of funds be lower if TFC financing is resorted to rather than going for a loan from a bank or a consortium of banks? * Should the company go for rating of their TFC issue? What if it gets a poor rating? * If the TFC issue is under-subscribed, what implications will it hold for continuance of the company as a going concern? * Is the government supportive in promoting the growth of TFCs or is it applying brakes to restrict their issuance? During the first six months of 1998, a number TFC issues were under active processing and the chances of development of secondary markets appeared bright, with the major brokerage houses gearing themselves to play the role of market makers and reputed foreign banks as well local DFIs teaming up to underwrite their public issues. However, the feverish activity going on at that time suddenly came to a grinding halt when the government decided to withdraw the tax exemption facility on income from TFCs, previously applicable to corporate TFC investors. Another limiting factor was that for companies with good standing, who had the opportunity to raise funds through the banking system, the TFC option did not entail a significant advantage in terms of the effective borrowing cost after accounting for the public floatation costs, rating cost, private placement and underwriting commissions etc. The same would more or less hold true today.

What prompted government`s action which virtually killed the TFCs market? Perhaps the government apprehended that if the TFCs market developed too fast, the individual investor might tilt towards it and thereby the government may lose a substantial part of its major source of public debt i.e. investment in its national savings schemes. It also appears that the underwriting institutions were unable to generate sufficient public interest in the TFCs. Perhaps the public also perceived the default risk to be high, given the history of bank loan defaults. Foreign investment in the TFCs has been virtually absent. Apparently due to a high degree of perceived sovereign risk of Pakistan, high default risk, as well as foreign exchange risk of rupee denominated TFCs. Presently, it seems that the debt securities market would not pick up much until the Sukuk market picks up momentum. However, an enabling regulatory framework, though necessary, will not be sufficient to provide a fillip to the debt market. It is also essential that the economy should pick up and generate requirement for long term debt funds. Risk management practices : In order to have an idea about how the brokerage houses play their risk management role, relative to their own risk and that of their clients, a questionnaire was circulated amongst 26 registered corporate members of the Karachi Stock Exchange. Only nine responses were received but still they have been helpful in understanding, how the brokerage houses view risk, the risks they handle and what technologies they employ. The main operating income of brokerage houses is through commission they earn on buying/selling on behalf of their clients. Usually they do not buy/sell on their own account but whenever they do, the earnings or losses would be classified as `other income / (loss)`. In other words, exposing their own funds to stock market risk is not the usual operating activity of the brokerage houses Risk management by brokerage houses can be divided into the following main parts: * Default risk i.e. the risk that a client fails to settle payment against a transaction undertaken by the brokerage house on its behalf, on the backing of a margin account * Investment risk of clients Discussions with brokerage house executives reveal that brokerage houses do not generally ask for margin deposits from institutional clients, as chances of default are not considered significant. However, in the case of small clients or individuals, brokerage houses do operate on margins. Based on the judgment of risk involved, such clients are required to maintain a minimum margin, with the brokerage house. This normally ranges between 2530 per cent of the

amount of total exposure taken by the brokerage house, on behalf of a client. In effect the margin percentage reflects the brokerage houses` assessment of the maximum price erosion during the normal settlement period of one week. Should default occur, the brokerage house has the option to sell the shares at the reduced market price and use the margin to cover its loss. In the case of investment risk of its client, the risk has to be borne entirely by the clients because it is their funds which have been invested. However, as investment advisors, it is the moral and professional obligation of brokerage houses to give the best possible advice and help manage the clients` risk. Thus, although the brokerage house is not directly exposed to investment risk, it faces the risk of losing reputation and clients, should its advice turn out to be wrong too often. From the responses received to the questionnaire circulated amongst brokerage houses, it is gathered that a majority of them are using sophisticated customised computer software. Only one out of nine respondents has indicated that they do not use any computer software for risk management purposes. Computer software is used both for monitoring the margin maintenance of clients and for undertaking technical/fundamental analyses of specific companies and sectors. As for risk minimisation options used by the brokerage houses, it was not at all surprising that all the respondents believe in diversification and advise their clients to diversify their investments across companies, as well as across industrial sectors. However, it was surprising that only one of the respondents has indicated hedging as a tool being used for minimising investment risk. Apparently most of the brokerage houses believe that there are no hedging instruments currently available in the financial system. Six out of nine respondents say that no hedging instruments exist. However, three of the respondents regard TFCs as a hedging instrument from the point of view of capital preservation and providing a minimum stable income component to a balanced portfolio. These respondents have mentioned one or more out of following as hedging instruments, besides TFCs: (the use of these instruments remains very limited, however). National Saving Certificates, high return deposit accounts, Certificates of Investments (COIs), foreign currency accounts, treasury bills and Pakistan Investment Bonds (PIBs).

Liquidity risk

The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses.

Inflation Risk (Purchasing Power Risk) The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. Market risk Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. This type of risk is discussed extensively in Investment courses.

Firm specific risk The uncertainty associated with the returns generated from investing in an individual firms common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding of a well diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is discussed extensively in Investment courses.

Project risk In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as stand-alone project risk. In advanced capital budgeting, project risk is partitioned into systematic and unsystematic project risk.

Financial risk The uncertainty brought about by the choice of a firms financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics.

Business risk The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflect the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses.

Foreign Exchange Risks Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. Translation Risks Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses. Transactions Risks Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Total Risk
While there are many different types of specific risk, we said earlier that in the most general sense, risk is the possibility of experiencing an outcome that is different from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment.

Measures of Total Risk The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will discuss these concepts in more detail.

Risk And Diversification

1. 2. 3. 4. 5. 6.
Introduction What Is Risk? Different Types of Risk The Risk-Reward Tradeoff Diversifying Your Portfolio Conclusion

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Different Types of Risk

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Let's take a look at the two basic types of risk:

Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk. (We will discuss diversification later in this tutorial).

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds.

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to bejunk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade, and which bonds are junk. (To read more, see Junk Bonds: Everything You Need To Know, What Is A Corporate Credit Rating and Corporate Bonds: An Introduction To Credit Risk.)

Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (For related reading, see What Is An Emerging Market Economy?)

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreignexchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some

Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To learn more, read How Interest Rates Affect The Stock Market.)

Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.