RISKRisk is the part of every human endeavor. From themoment we get up in the morning, drive or take publictransportation to get to school or to work until we getback into our beds (and perhaps even afterwards), weare exposed to risks of different degrees. What makesthe study of risk fascinating is that while some of thisrisk bearing may not be completely voluntary, we seekout some risk on our own (speeding on the highwaysor gambling, for instance) and enjoy them.
RISKThe phenomenon of risk is closely related to the concept ofuncertainty which human lives face routinely. What is notknown today becomes uncertainty, and if this state affects us inan unfavorable way, we often conclude this outcome ofuncertainty as a loss and the potential of uncertainty to behavein such a way as risk.
RISKHolton (2004) argues that two ingredients are needed forrisk to exist. The first one is uncertainty about thepotential outcome from an experiment, and the other is thatthe outcomes have to matter in terms of providing utility.In other words, a person jumping out of an airplanewithout a parachute faces no risk since he is certain to die(no uncertainty)
RISKRisk is incorporated into so many different disciplines from insurance toengineering to portfolio management that it should come as no surprise that it isdefined in different ways by each one. It is worth looking at some of thedistinctions: Risk versus probability – Whereas some definitions of risk focus only on the probability of an event occurring, more comprehensive definitions incorporate both the probability of the event occurring and the consequences of the event. Thus, the probability of a severe earthquake may be small, but the consequences are so catastrophic that it would be categorized as a high-risk event. Risk versus threat – In some disciplines, a contrast is drawn between risk and a threat. A threat is a low-probability event with large negative consequences, where analysts may be unable to assess the probability. A risk, on the other hand, is defined to be a higher probability event, where there is enough information to assess both the probability and the consequences.
RISK All outcomes versus negative outcomes – Some definitions of risk tend to focus only on the downside scenario, whereas others are more expansive and consider all variability as risk. The engineering definition of risk defined as the product of the probability of an event occurring, that is viewed as undesirable, and an assessment of the expected harm form the event occurring. Risk = Probability of an accident * Consequence in lost money/deaths.In contrast, risk is finance is defined in terms of variability of actual returns oninvestment around an expected return, even when those returns representpositive outcomes. Building on the last distinction, we should consider broaderdefinitions of risk that capture both the positive and negative outcomes.
• The values of firm’s assets, liabilities and operating income vary continually in response to changes in a flurry of economic and financial variables such as exchange rates, interest rates, inflation rates.• These uncertainties are known as macro-economic environmental risks.
• Moreover, uncertainties related to its operating business such as interruptions in raw material supply, labour troubles, success or failure of a new product or technology and so forth have an impact on the firm’s performance. These can be grouped under the heading as core business risks
• core business risks: Firm Specific• macro-economic environmental risks : Economy related
SYSTEMATIC RISKIt is also termed as non-diversifiable risk because it cannot be avoided SYSTEMATIC RISK Inflation Risk Interest Rate Risk Political Risk Market Risk Risk Due To Government Policies Natural Calamities Scams/Malpractices Monsoon Industrial Growth And Output International Events War-like Situation/ Internal Peace
SYSTEMATIC RISK Inflation RiskIt causes loss of purchasing power, due to which real gains frominvestment are very low as compared to monetary gains. Inflationaffects the price of shares as well as debentures. Due to risinginflation, the returns expected by the investors tend to increase andthey discount future earnings at a higher discount rate, which pullsthe prices further down. Inflation also influences the real yield frombonds, which happens to be much lower than the normal interestrate. The declining rate affects the market price of the bondsadversely. However, companies have started issuingdebentures/bonds, which provide for protection against risinginterest rate, e.g. flotation rate debentures, index linkeddebentures/bonds, etc.
SYSTEMATIC RISK Interest Rate RiskInterest rate in an economy tends to fluctuate either on account of regularityframework or due to market forces. If the general interest rate rise then it pushesup the investors’ expected rate of return from investment, due to whichprevailing share prices become unattractive. Another effect of increased expectedrate of return is that, low yield debentures or bonds become unattractive at theprevailing price due to which prices of these also tumble down. Thus interestrate also accounts for a major part of the systematic risk for investmentactivities. Recently, a frequent change in the interest rates by RBI affected thestock market. RBI change the bank rate , CRR, repo and reverse repo rates veryfrequently this change resulted in the change in the expectation of return byinvestors followed by a frequent change in the share prices on the stock market.
SYSTEMATIC RISK Political RiskPerformance of industries and stock market depends on a country’s politicalscenario. Political uncertainty adversely affects share prices. Market RiskPrice of securities (shares, stocks and debentures) depend quite upon theactivities of operators/speculators in the market. The risk that because generalmarket pressures will cause the value of an investment to fluctuate, it may benecessary to liquidate a position during a down period in the cycle. Market riskis highest for securities with above-average price volatility and lowest for stablesecurities such as Treasury bills. Market risk is of little consequence to a personwho purchases securities with the intention of holding them for long periods. Market Risk is the risk of losses due to movements in financial market variables. These may be interest rates, foreign exchange rates, security prices, etc. Thus market risk is the risk of fluctuations in portfolio value because of movements in such variables.
SYSTEMATIC RISK Changing Government Policiesthe changing policies of a government can definitely affect the movement ofshare prices. Whenever the government announces a change intaxation, licensing, quota restrictions and foreign trade policies etc. and this inturn, affects the profitability of industry, then the share price show a decliningtrend. A favorable announcement has a positive impact and vice versa. Natural CalamitiesDisasters, tsunamis, floods etc. may affect the stock market badly. This mayhappen because of fear of loss for industrial houses at large.
SYSTEMATIC RISK Monsoon WeatherIndian economy is an agrarian economy and hence the performance of anindustry is dependent on the monsoon to a great extent. A significant portion ofthe Gross Domestic Product (GDP) comes from agriculture. A bad monsoon hasan adverse effect on the share prices of all the companies. Scams and Malpracticesscams a like Satyam scam, Harshad Mehta scam, CRB scam, and many otherscams have not only affect their share prices but also the prices of other companyshares. Scams also create psyche of fear in the minds of investors and they startselling every kind of share whether good or bad. This activity creates excessivesupply in in the market and makes price decline. The stock market is alwaysdriven by the forces of demand and supply. When demand and supply are not inequilibrium, then certainly distorted prices prevail in the market.
SYSTEMATIC RISK Industrial Performanceshare price depend largely on the profits declared by the companies. Investorsalways give more weight to high profits. Every year when the economic surveyreport is presented, there is a possibility that share prices get affected, dependingon the industrial growth assessment as shown in the survey report. International Eventsin the recent years (2008) when recession hit all the economies of the world or thepresent situation of recession (2011) almost hit all the prices of stocks. Terroristattacks on worldwide or other international trade policies etc. also responsiblefor changes in the stock market. War-Like Situation/Internal Peacewhenever there is internal disturbance in the economy; it immediately getsdiscounted in the share prices. Since, everyone wants to sell their shares to meeturgency. Increased selling pressure affects share prices.
UNSYSTEMATIC RISK This kind of risk is due to industry or company-specific factorsThis type of risk can either be reduced or eliminated through diversification. UN-SYSTEMATIC RISK Business Risk Financial Risk Risk Due To Industry-Specific Policies Disputes
UNSYSTEMATIC RISK Business RiskIt gets created due to operation of a company or business. Acompany might not be able to sell its products due to imperfectionsin its operating activities. As a result, the company might incurlosses, which certainly has an adverse effect on share prices of suchcompany. Because risk originates due to operating leverage andwrong planning about the operations of a company. It can bemeasured with the help of degree of operating leverage.
UNSYSTEMATIC RISK Financial risk• Introduction of fixed cost item.It occurs due to wrong financial planning. A company having high degree ofdebt certainly has high financial leverage, which has an adverse effect on theearnings of the company. The unfavorable effect of high financial leverage isobserved at the time of declining EBIT, which sometimes might erode the capitalof the company too. Hence, companies with high financial leverage areconsidered as high risky and vice versa.[A financial risk arises as a result of uncertainties in the financial marketswhich are manifested by changes in the value of market parameters likeinterest rates, stock prices, and the price of currencies…]
SYSTEMATIC RISK Risk Due To Industry-Specific Policiessometimes government policies are against a particular industry, due to whichthe performance/profitability of the company of such industry gets badlyaffected. This creates a negative effect on the share price of such companies.These policies may include removal of subsidy, concessions or imposing hightaxes or a ban on a product/raw material.
UNSYSTEMATIC RISK Disputesshare prices of few companies get effected adversely as and whenthere is a situation of industrial dispute, labour management unrest,lockout or strike. Even the disputes among the promoters or ownershave a bad effect on the share prices.