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Risk

Stock market has generated larger


returns than other forms of investments.
However, as with other ventures with
high
returns,
stocks
are
risky
investments. Movements in stock prices
mirror actual and expected business
activity. As a result, stocks are sensitive
to investor expectations and prevailing
economic
conditions.
Generally,
changes in economic conditions have
almost immediate effects on the value
of a stock which may depreciate gains.

Risk is the potential that a chosen


action or activity (including the choice of
inaction) will lead to a loss (an
undesirable outcome).
This implies that a choice having an
influence on the outcome exists (or
existed).
Potential losses themselves may also be
called "risks".
Almost any Human Endeavour carries
some risk, but some are much more risky
than others.

Exposure to the possibility of loss, injury, or


other adverse or unwelcome circumstance;
a chance or situation involving such a
possibility
Economic risks - lower incomes or higher
expenditures than expected.
The causes - hike in the price of raw
materials, delay in construction of a new
operating facility, disruptions in a production
process, emergence of a serious competitor
on the market, the loss of key personnel, the
change of a political regime, or natural
disasters

Risk is the quantifiable likelihood of loss or less


than expected returns.
Factors to be considered for Investment
Return, Risk, Liquidity & Tax Efficiency
Return, liquidity & tax efficiency are
measurable.
Return of an investment has been in the past,
How liquid is it
Amount of tax can be saved if you invest.
Risk is subjective, cannot immediately
allocate a number to it.

Systemic risk - the risk of collapse of an entire


financial system or entire market, as opposed
to risk associated with any one individual
entity, group or component of a system.
It is financial system instability, potentially
disastrous, caused or exacerbated (intensified)
by idiosyncratic (particular) events or
conditions in financial intermediaries.
It is risks imposed by interlinkages and
interdependencies in a system or market,
where the failure of a single entity or cluster of
entities can cause a cascading(dropping)
failure, which could potentially bankrupt or
bring down the entire system or market.

Acascading failureis a failure in a


system of interconnected parts in
which the failure of a part can trigger
the failure of successive parts.
Systemic risk should not be confused
with market or price risk as it is
specific to the item being bought or
sold and the effects of market risk
are isolated to the entities dealing in
that specific item. This kind of risk
can be mitigated by hedging.

In finance,riskhas no one definition,


Some theorists have defined quite
general methods to assess risk as an
expected after-the-fact level of regret.
Such methods are successful in limiting
interest rate risk in financial markets.
Financial markets are proving to be
ground for general methods of risk
assessment. In particular, it is not always
obvious if such financial instruments are
used for hedging or speculation.

Hedging - purchasing/selling a
financial instrument specifically to
reduce or cancel out the risk in
another investment
Speculation - increasing measurable
risk and exposing the investor to
catastrophic (disastrous) loss in
pursuit of very high windfalls (bonus)
that increase expected value.

A fundamental idea in finance is the


relationship between risk and return.
The greater the return, the greater the
risk.
A free market reflects this principle in the
pricing of an instrument:
strong demand for a safer instrument
drives its price higher and its return
proportionately lower, while weak
demand for a riskier instrument drives its
price lower and its potential return
thereby higher.

Systematic Risk
The risk inherent tothe entire market or entire
market segment. Also known as "undiversifiablerisk" or "market risk."
Interest
rates,
recession
and
wars
all
representsources of systematic risk because they
affect the entire market and cannot be avoided
through diversification.
This type of risk affects a broad range of securities.
Unsystematic risk affects a very specific group of
securities or an individual security.
Systematic risk can be mitigated only by being
hedged. Even a portfolio of well-diversified assets
cannot escape all risk.

Systematic risk results from forces


outside of a firm's control; also called
nondiversifiable or noncontrollable risk.
Purchasing power, interest rate, and
market risks fall into this category.
This type of risk is assessed relative to
the risk of a diversified portfolio of
securities, or the market portfolio.
It is measured by the beta () used in
the CAPITAL ASSET PRICING MODEL
(CAPM).

In considering economic and political


factors, investors commonly identify five
kinds of hazards to which their
investments are exposed. The following
tables show components of risk:
(A) SYSTEMATIC RISK:
Market Risk
Interest Rate Risk
Purchasing power Risk
(B) UNSYSTEMATIC RISK:
Business Risk
Financial Risk

(A) Systematic Risk:


Systematic risk is the portion of total variability in return
caused by factors affecting the prices of all securities.
Economic, Political & Sociological charges are sources of
systematic risk. Their effect is to cause prices of nearly
all individual common stocks or security to move
together in the same manner. E.g.; if economy is moving
towards recession & corporate profits shift downward,
stock prices may decline across a broad front. Nearly all
stocks listed on the BSE / NSE move in the same direction
as the BSE / NSE index.
Systematic risk is also called non-diversified risk. It is
unavoidable. Variability in securities total return is
directly associated with overall movements in general
market or economy is called systematic risk. Systematic
risk covers Market Risk, Interest Rate Risk & Purchasing
Power Risk

1. Market Risk:
Market risk is referred to as stock / security variability
due to changes in investors reaction towards tangible
& intangible events
It 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 psychological basis.
Real Events, comprising of political, social or Economic
reason. Intangible Events are related to psychology of
investors or say emotional intangibility of investors.
The initial decline or rise in market price will create
emotional instability of investors & cause a fear of loss
or create an undue confidence, relating possibility of
profit. The reaction to loss will reduce selling &
purchasing prices down & the reaction to gain will
bring in the activity of active buying of securities.

2. Interest Rate Risk:


The price of all securities rise or fall depending on the
change in interest rate
Interest rate risk is difference between expected
interest rates & the current market interest rate. The
markets will have different interest rate fluctuations,
according to market situation, supply/demand
position of cash or credit.
The degree of interest rate risk is related to length of
time to maturity of security. If the maturity period is
long market value of the security may fluctuate
widely. Market activity & investor perceptions change
with change in interest rates & interest rates also
depend upon the nature of instruments such as
bonds, debentures, loans & maturity period, credit
worthiness of the security issues.

3. Purchasing Power Risk:


also known as inflation risk. It arises out of change in
prices of goods & services & technically it covers both
inflation & deflation period. This risk is more relevant in
case of fixed income securities; shares are regarded as
hedge against inflation. There is always a chance that
purchasing power of invested money will decline or real
return will decline due to inflation.
Behaviour of purchasing power risk can in some way be
compared to interest rate risk. They have systematic
influence on prices of both stocks & bonds. If the
consumer price index in a country shows a constant
increase of 4% & suddenly jump to 5% in the next.
Year, the required rate of return will have to be
adjusted with upward revision. Such a change in
process will affect government securities, corporate
bonds & common stocks.

(B) Unsystematic Risk:


Risk arising out of uncertainty surrounding
particular firm or industry due to factors
like labour strike, consumer preference &
management policies called Unsystematic
Risk. These uncertainties directly affect
financing & operating environment of firm.
Unsystematic risk is also called
Diversifiable risk. It is avoidable.
Unsystematic risk can be minimized or
eliminated through diversification of
security holding. Unsystematic risk covers
Business risk and Financial risk

1. Business Risk:
Business risk arises due to uncertainty of return
which depend upon the nature of business. It relates
to variability of business, sales, income, expenses &
profits. It depends upon market conditions for the
product mix, input supplies, strength of competitor
etc. Business risk may be classified into two kind viz.
Internal Risk and External risk.
Internal risk is related to operating efficiency of
firm. This is manageable by the firm. Interest
Business risk leads to fall in revenue & profit of the
companies.
External risk refers to policies of government or
strategic of competitors or unforeseen situation in
market. This risk may not be controlled & corrected
by the firm.

2. Financial Risk:
It is associated with the way in which a company finances its
activities. Generally, financial risk is related to capital
structure of a firm. Presence of borrowed money or debt in
capital structure creates fixed payments in the form of
interest that must be sustained by the firm. Presence of these
interest commitments fixed interest payments due to debt
or fixed dividend payments on preference share causes
amount of retained earning availability for equity share
dividends to be more variable than if no interest payments
were required. Financial risk is avoidable risk to the extent
that management has the freedom to decline to borrow or not
to borrow funds. A firm with no debt financing has no financial
risk. One positive point for using debt instruments is that it
provides a low cost source of funds to a company at the same
time providing financial leverage for the equity shareholders
& as long as the earning of company are higher than cost of
borrowed funds, the earning per share of equity share are
increased.

Above chart-A represent the relationship


between risk and return. The slop of the
market line indicates the return per unit of
risk required by all investors highly riskaverse investors would have a steeper
line, and Yields on apparently similar may
differ. Difference in price, and therefore
yield, reflect the markets assessment of
the issuing companys standing and of the
risk elements in the particular stocks. A
high yield in relation to the market in
general shows an above average risk
element. This is shown in the Char-B

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