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SANATAN DHARMA COLLEGE
(LAHORE) AMBALA CANTT
Types
Of
Risk
RISK ANALYSIS
What is Risk:-
Everyone is exposed to some type of risk every day- whether it’s
from driving, walking down the street, investing, capital planning or
something else. An investor’s personality, lifestyle, and age are some
of the top factors to consider for individual investment management
and risk purposes. Each investor has a unique risk profile that
determines their willingness and ability to withstand risk. In
general, as investment risks rise, investors expact higher returns to
compensate for taking those risks.
A fundamental idea in finance is the relationship between risk and
return. The greater the amount of risk an investor is willing to take,
the greater the potential return.
Risk is defined in financial terms as the chance that an outcome or
investment’s actual gains will differ from an expected outcome or
return. Risk includes the possibility of losing some or all of an
original investment.
Definition:-
Risk implies future uncertainty about deviation from expected
earnings or expected outcome. Risk measures the uncertainty that
an investor is willing to take to realize a gain from an investment.
Types
of
Risk
Systematic Risk
Unsystematic Risk
Systematic risk is that part of the total risk that is caused by
factors beyond the control of a specific company or individual.
Systematic risk is caused by factors that are external to the
organization. All investments or securities are subject to systematic
risk and, therefore, it ia a non-diversifiable risk. Systematic risk
cannot be diversified away by holding a large number of securities.
It affects the overall market, not just a particular stock or
industry. This type of risk is both unpredictable and impossible to
completely avoid. Systematic risk includes market risk, interest rate
risk, purchasing power risk.
Systematic Risk
Systematic Risk
Market Risk
Interest Rate Risk
Purchasing Power Risk
Market risk is the possibility of an investor experiencing losses due to
factors that affect the overall performance of the financial markets in
which he or she is involved.
Market risk, also called “systematic risk”, cannot be eliminated through
diversification, though it can be hedged against in other ways.
Sources of market risk includes recessions, political turmoil, changes in
interest rates, natural disasters and terrorist attacks. Systematic, or
market risk tends to influence the entire market at the same time.
Market Risk
Types
of
Market
Risk
Absolute
Risk
Non-
Directional
Risk
Relative
Risk
Basis
Risk
Directional
Risk
Volatility
Risk
Absolute Risk is without any content. Absolute risk is the size of your own
risk. Absolute risk reduction is the number of percentage points your own
risk goes down if you do something protective, such as stop drinking
alcohol. The size of your absolute risk reduction depends on what your risk
is to begin with.
For e.g., if a coin is tossed, there is fifty percent chance of getting a head
and vice-versa. Any risk in which there is no possibility of gain, only the
avoidance of loss.
For Example:- if a company’s car is stolen, the company endures a loss, but
if it is not stolen, the company does not make a gain… it is also called
absolute risk.
Absolute Risk
Relative risk is the assessment or evaluation of risk at different levels of
business functions. Relative Risk is the number that tells you how much
something you do, such as maintaining a healthy weight, can change your
risk compared to your risk if you’re very overweight. Relative risk can be
expressed as a percentage decrease or a percentage increase. If
something you do or take doesn’t change your risk, then the relative risk
reduction is 0% (no difference). If something you do or take lowers your
risk by 30% compared to someone who doesn’t take the same step, then
that action reduces your relative risk by 30%.
For example:- a relative risk from a foreign exchange fluctuations may be
higher if the maximum sales accounted by an organization are of export
sales.
Relative Risk
Directional Risks are those risks where the loss arises from an exposure
to the particular assets of a market. For Example :- An investor holding
some shares experience a loss when the market price of those shares falls
down.
Non-Directional Risk arises where the market of trading is not
consistently followed by the trader. For Example :- The dealer will buy
and sell the share simultaneously to mitigate the risk.
Directional Risk
Non-Directional Risk
Basis Risk is due to the possibility of loss arising from imperfectly
matched risks. Basis Risk is the potential risk that arises from
mismatches in a hedged position. Basis risk occurs when a hedge is
imperfect, so that losses in an investment are not exactly offset by the
hedge. Certain investments do not have good hedging instruments,
making basis risk more of a concern than with other assests.
For Example:- In the attempt to hedge against a two-year bond with the
purchase of treasury bill futures, there is a risk the treasury bill and
the bond will not fluctuate identically.
Basis Risk
Volatility Risk is of a change in the price of securities as a result of
changes in the volatility of a risk-factor. The Volatility of a security is
defined as the change in the asset in percentage terms on an annualized
basis. Most investors are cognizant of volatility as it relates to returns
on their portfolio especially if the market is moving lower.
Volatility represents how large an asset’s price swing around the mean
price- it is a statistical measure of its dispersion of returns.
For Example :- It applies to the portfolios of derivative instruments,
where the volatility of its underlying is a major influence of price.
Volatility Risk
The Risk of variations in future market values and the size of income,
caused by fluctuations in the general level of interest rates is referred
to as interest - rate risk. The basic cause of interest rate risk lies in
the fact that, as the rate of interest paid on Indian Government
securities rises or falls, the rates of return demanded on alternative
investment vehicles, such as stocks and bonds issued in the private
sector, rise or fall. In other words, as the cost of money changes for
risk-free securities, the cost of money to risk-prone issuers will also
change.
Interest Rate Risk
Interest - Rate risk arises due to variability in the interest rates from
time to time. It particularly affects debt securities as they carry the
fixed rate of interest.
Interest
Rate
Risk
Price Risk
Reinvestment
Rate Risk
Price Risk arises due to the possibility that the price of the shares;
commodity, investment, etc. may decline or fall in the future. Price Risk
is the risk of a decline in the value of a security or an investment
portfolio excluding a downturn in the market, due to multiple factors.
Investors can employ a number of tools and techniques to hedge price
risk, ranging from relatively conservative decisions (e.g., buying put
options) to more agressive strategies (e.g., short selling).
Price Risk
Reinvestment rate risk results from fact that the interest or dividend
earned from an investment can’t be reinvested with the same rate of
return as it was acquiring earlier.
For Example :- An investor buys a 10-year $100000 treasury note
with an interest rate of 6%. The investor expects to earn $6000 per
year from the security.however, at the end of the term, interest
rates are 4%. If the investor buys another 10-year $100000 treasury
note, they will earn $4000 annually rather than $6000. Also, if
interest rates subsequently increase and they sell the note before its
maturity date, they lose part of the principle.
Reinvestment Risk
Purchasing-Power Risk refers to the uncertainty of the purchasing power
of the money to be received. In simple terms, purchasing-power risk is
the impact of inflation or deflation on an investment. When we think of
investment as the postponement of consumption, we can see that when a
person purchases a stock, he has foregone the opportunity to buy some
goods or services for as long as he owns the stock. If, during the holding
period, prices on desired goods and services rise, the investor actually
loses purchasing power. Rising prices on goods and services are normally
associated with what is referred to as inflation. Falling prices on goods
and services are termed deflation. Both inflation and deflation are
covered in the all-encompassing term purchasing-power risk.
Purchasing Power Risk
Purchasing-Power Risk
Demand Inflation Risk
Cost Inflation Risk
Demand Inflation Risk arises due to increase in price, which result from an
excess of demand over supply. It occurs when supply fails to cope with the
demand and hence cannot expand anymore. In other words, demand
inflation occurs when production factors are under maximum utilization.
For Example :- When there was an outbreak of swine flu in india. Due to
the outbreak of swine flu epidemic in india, the government notified a
warning that people should wear breathing masks to protect them from
the infection. As a result, the demand for masks had risen to a very high
level, but the supply being limited as the producers of the mask had no
anticipation of the swine flu epidemic. Due to the high demand and limited
supply of masks, the prices had risen manifold.
Demand Inflation Risk
Cost Inflation Risk arises due to sustained increase in the prices of goods
and services. It is actually caused by higher productive cost. A high cost
of production inflates the final price of finished goods consumed by
people. The most common cause of cost inflation starts with an increase in
the cost of production, which may be expected or unexpected.
For Example :- The cost of raw materials or inventory used in production
might increase, leading to higher costs.
Cost Inflation Risk
Unsystematic Risk is associated with the Internal risk factors of the
firm. Unsystematic Risk is also known as specific risk, or Diversifiable
risk. An unsystematic Risk arises from any such event the business is not
prepared for and which disrupts the normal functioning of the business.
Unsystematic risk is diversifiable in nature and thus, can be avoided. It is
a fact that you can diversify your portfolio by buying shares of
different companies and also in different geographical locations.
Unsystematic Risk
Unsystematic Risk
Business Risk Financial Risk
Business Risk is related to the internal and external factors of a particular
company. Business Risk is any exposure a company or organization has to
factor that may lower its profits or cause it to go bankrupt.
The sources of business risk are varied but can range from changes in
consumer taste and demand, the state of the overall economy, and
government rules and regulations. While companies may not be able to
completely avoid business risk, they can take steps to mitigate its impact.
For Example:- The CEO of a company may make certain decision that affect
its profits, or the CEO may not accurately anticipate certain events in the
future, causing the business to incur losses or fail.
Business Risk
Financial Risk is also known as credit risk. It arises due to change in the capital
structure of the organization. This type of risk is applied to individual, business,
and government entities and relates to the fact that there is a chance that
stakeholders can lose their money. It actually relates to the capital structure of
an organization. The manner in which a company raises required funds for its
growth has a direct impact on future earnings and stability of a business entity.
The capital structure mainly comprises of three ways by which funds are sourced
for the projects. These are:-
Owned Funds. For e.g. Share capital
Borrowed Funds. For e.g. Loan funds
Retained Earnings. For e.g. Reserve and surplus
Financial Risk
Difference Between systematic and unsystematic Risk
Basis for Comparison Systematic risk Unsystematic risk
Meaning Systematic risk refers to the
hazard which is associated with
the market or market segment as
a whole.
Unsystematic risk refers to the
risk associated with a particular
security, company or industry.
Nature Uncontrollable Controllable
Factors External Factors Internal Factors
Affects Large number of securities in the
market.
Only particular company.
Types Interest Rate Risk, Market Risk
and Purchasing Power Risk.
Business Risk and Financial Risk.
Example Change in inflation, change in oil
price, Unemployment Rate.
Workers strike in the factory,
Employee turnover.
References
https://www.investopedia.com
https://corporatefinanceinstitute.com
https://economictimes.indiatimes.com
Security Analysis And Investment Management :- Dr. B.S. Bodla
Concept of risk

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Concept of risk

  • 1. SANATAN DHARMA COLLEGE (LAHORE) AMBALA CANTT Types Of Risk
  • 2. RISK ANALYSIS What is Risk:- Everyone is exposed to some type of risk every day- whether it’s from driving, walking down the street, investing, capital planning or something else. An investor’s personality, lifestyle, and age are some of the top factors to consider for individual investment management and risk purposes. Each investor has a unique risk profile that determines their willingness and ability to withstand risk. In general, as investment risks rise, investors expact higher returns to compensate for taking those risks.
  • 3. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. Definition:- Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment.
  • 5. Systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and, therefore, it ia a non-diversifiable risk. Systematic risk cannot be diversified away by holding a large number of securities. It affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. Systematic risk includes market risk, interest rate risk, purchasing power risk. Systematic Risk
  • 6. Systematic Risk Market Risk Interest Rate Risk Purchasing Power Risk
  • 7. Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also called “systematic risk”, cannot be eliminated through diversification, though it can be hedged against in other ways. Sources of market risk includes recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks. Systematic, or market risk tends to influence the entire market at the same time. Market Risk
  • 9. Absolute Risk is without any content. Absolute risk is the size of your own risk. Absolute risk reduction is the number of percentage points your own risk goes down if you do something protective, such as stop drinking alcohol. The size of your absolute risk reduction depends on what your risk is to begin with. For e.g., if a coin is tossed, there is fifty percent chance of getting a head and vice-versa. Any risk in which there is no possibility of gain, only the avoidance of loss. For Example:- if a company’s car is stolen, the company endures a loss, but if it is not stolen, the company does not make a gain… it is also called absolute risk. Absolute Risk
  • 10. Relative risk is the assessment or evaluation of risk at different levels of business functions. Relative Risk is the number that tells you how much something you do, such as maintaining a healthy weight, can change your risk compared to your risk if you’re very overweight. Relative risk can be expressed as a percentage decrease or a percentage increase. If something you do or take doesn’t change your risk, then the relative risk reduction is 0% (no difference). If something you do or take lowers your risk by 30% compared to someone who doesn’t take the same step, then that action reduces your relative risk by 30%. For example:- a relative risk from a foreign exchange fluctuations may be higher if the maximum sales accounted by an organization are of export sales. Relative Risk
  • 11. Directional Risks are those risks where the loss arises from an exposure to the particular assets of a market. For Example :- An investor holding some shares experience a loss when the market price of those shares falls down. Non-Directional Risk arises where the market of trading is not consistently followed by the trader. For Example :- The dealer will buy and sell the share simultaneously to mitigate the risk. Directional Risk Non-Directional Risk
  • 12. Basis Risk is due to the possibility of loss arising from imperfectly matched risks. Basis Risk is the potential risk that arises from mismatches in a hedged position. Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset by the hedge. Certain investments do not have good hedging instruments, making basis risk more of a concern than with other assests. For Example:- In the attempt to hedge against a two-year bond with the purchase of treasury bill futures, there is a risk the treasury bill and the bond will not fluctuate identically. Basis Risk
  • 13. Volatility Risk is of a change in the price of securities as a result of changes in the volatility of a risk-factor. The Volatility of a security is defined as the change in the asset in percentage terms on an annualized basis. Most investors are cognizant of volatility as it relates to returns on their portfolio especially if the market is moving lower. Volatility represents how large an asset’s price swing around the mean price- it is a statistical measure of its dispersion of returns. For Example :- It applies to the portfolios of derivative instruments, where the volatility of its underlying is a major influence of price. Volatility Risk
  • 14. The Risk of variations in future market values and the size of income, caused by fluctuations in the general level of interest rates is referred to as interest - rate risk. The basic cause of interest rate risk lies in the fact that, as the rate of interest paid on Indian Government securities rises or falls, the rates of return demanded on alternative investment vehicles, such as stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for risk-free securities, the cost of money to risk-prone issuers will also change. Interest Rate Risk
  • 15. Interest - Rate risk arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. Interest Rate Risk Price Risk Reinvestment Rate Risk
  • 16. Price Risk arises due to the possibility that the price of the shares; commodity, investment, etc. may decline or fall in the future. Price Risk is the risk of a decline in the value of a security or an investment portfolio excluding a downturn in the market, due to multiple factors. Investors can employ a number of tools and techniques to hedge price risk, ranging from relatively conservative decisions (e.g., buying put options) to more agressive strategies (e.g., short selling). Price Risk
  • 17. Reinvestment rate risk results from fact that the interest or dividend earned from an investment can’t be reinvested with the same rate of return as it was acquiring earlier. For Example :- An investor buys a 10-year $100000 treasury note with an interest rate of 6%. The investor expects to earn $6000 per year from the security.however, at the end of the term, interest rates are 4%. If the investor buys another 10-year $100000 treasury note, they will earn $4000 annually rather than $6000. Also, if interest rates subsequently increase and they sell the note before its maturity date, they lose part of the principle. Reinvestment Risk
  • 18. Purchasing-Power Risk refers to the uncertainty of the purchasing power of the money to be received. In simple terms, purchasing-power risk is the impact of inflation or deflation on an investment. When we think of investment as the postponement of consumption, we can see that when a person purchases a stock, he has foregone the opportunity to buy some goods or services for as long as he owns the stock. If, during the holding period, prices on desired goods and services rise, the investor actually loses purchasing power. Rising prices on goods and services are normally associated with what is referred to as inflation. Falling prices on goods and services are termed deflation. Both inflation and deflation are covered in the all-encompassing term purchasing-power risk. Purchasing Power Risk
  • 19. Purchasing-Power Risk Demand Inflation Risk Cost Inflation Risk
  • 20. Demand Inflation Risk arises due to increase in price, which result from an excess of demand over supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In other words, demand inflation occurs when production factors are under maximum utilization. For Example :- When there was an outbreak of swine flu in india. Due to the outbreak of swine flu epidemic in india, the government notified a warning that people should wear breathing masks to protect them from the infection. As a result, the demand for masks had risen to a very high level, but the supply being limited as the producers of the mask had no anticipation of the swine flu epidemic. Due to the high demand and limited supply of masks, the prices had risen manifold. Demand Inflation Risk
  • 21. Cost Inflation Risk arises due to sustained increase in the prices of goods and services. It is actually caused by higher productive cost. A high cost of production inflates the final price of finished goods consumed by people. The most common cause of cost inflation starts with an increase in the cost of production, which may be expected or unexpected. For Example :- The cost of raw materials or inventory used in production might increase, leading to higher costs. Cost Inflation Risk
  • 22. Unsystematic Risk is associated with the Internal risk factors of the firm. Unsystematic Risk is also known as specific risk, or Diversifiable risk. An unsystematic Risk arises from any such event the business is not prepared for and which disrupts the normal functioning of the business. Unsystematic risk is diversifiable in nature and thus, can be avoided. It is a fact that you can diversify your portfolio by buying shares of different companies and also in different geographical locations. Unsystematic Risk
  • 24. Business Risk is related to the internal and external factors of a particular company. Business Risk is any exposure a company or organization has to factor that may lower its profits or cause it to go bankrupt. The sources of business risk are varied but can range from changes in consumer taste and demand, the state of the overall economy, and government rules and regulations. While companies may not be able to completely avoid business risk, they can take steps to mitigate its impact. For Example:- The CEO of a company may make certain decision that affect its profits, or the CEO may not accurately anticipate certain events in the future, causing the business to incur losses or fail. Business Risk
  • 25. Financial Risk is also known as credit risk. It arises due to change in the capital structure of the organization. This type of risk is applied to individual, business, and government entities and relates to the fact that there is a chance that stakeholders can lose their money. It actually relates to the capital structure of an organization. The manner in which a company raises required funds for its growth has a direct impact on future earnings and stability of a business entity. The capital structure mainly comprises of three ways by which funds are sourced for the projects. These are:- Owned Funds. For e.g. Share capital Borrowed Funds. For e.g. Loan funds Retained Earnings. For e.g. Reserve and surplus Financial Risk
  • 26. Difference Between systematic and unsystematic Risk Basis for Comparison Systematic risk Unsystematic risk Meaning Systematic risk refers to the hazard which is associated with the market or market segment as a whole. Unsystematic risk refers to the risk associated with a particular security, company or industry. Nature Uncontrollable Controllable Factors External Factors Internal Factors Affects Large number of securities in the market. Only particular company. Types Interest Rate Risk, Market Risk and Purchasing Power Risk. Business Risk and Financial Risk. Example Change in inflation, change in oil price, Unemployment Rate. Workers strike in the factory, Employee turnover.