RISK

Every investment is characterisied by return

and risk. In general, it refers to the possibility
of incurring a loss in a financial transaction.
A person making an investment expects to get
some return from the investment in the future.
But, as future is uncertain, so is the future
expected return.
It is this uncertainty associated with the returns
from an investment that introduce risk into an
investment.
Now, the question arise ,what is difference
between expected return and the realised return

The expected return is the uncertain future

return that an investor expects to get from
his investment.
The realised return is the certain return that
an investor has actually obtained from his
investment at the end of the holding
period.
This possibility of variation of the actual
return from the expected return is termed
risk.
There would be no risk, where realisations
correspond to expectations.
Risk arises where there is a possibility of
variation between expectations and
realisations, with regard to the investment.
Thus, risk can be defined in terms of
variability of returns. ”Risk is the potential
for variability in returns.”
An investment whose returns are fairly
stable is considered to be a low-risk
investment, whereas an investment whose
returns fluctuate significantly is considered
to be a high-risk investment.
Equity shares whose returns are likely to
fluctuate widely are considered risky
investment.
Government securities whose returns are
fairly stable are considered to posses low
risk.
The elements of risk may be broadly
classified into two groups.
The first group comprises factors that are
external to the company and affect a large
number of securities simultaneously.
These are mostly uncontrollable in nature.
The second group includes those factors
which are internal to companies and affect
only those particular companies. These are
controllable to a great extent.
The risk produced by the first group of factors
is known as systematic risk, and that
produced by the second group is known as
unsystematic risk.
Systematic risk and unsystematic risk are the
two components of total risk. Thus,
Total risk= Systematic risk + Unsystematic risk
Systematic Risk:
As the society is dynamic, changes occur in the
economic, political and social systems
constantly. These changes have an influence
on the performance of companies and
thereby on their stock prices. But these
changes affect all companies and all
securities 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.
Thus, the impact of economic, political and
social changes is system-wide and that
portion of total variability in security returns
caused by such system-wide factors is
referred to as systematic risk.
Systematic risk is further subdivided into
interest rate risk, market risk and purchasing
power risk.
1. Interest Rate Risk :
Interest rate risk is a type of systematic risk
that particularly affects debt securities like
bonds and debentures.
A bond or debenture normally has a fixed
coupon rate of interest. The issuing
company pays interest to the bond holder
at this coupon rate. A bond is normally
issued with a coupon rate which is equal
to the interest rate prevailing in the market
at the time of issue.
The market interest rate may change but the
coupon rate remains constant till the
maturity of the instrument.
The change in market interest rate relative
to the coupon rate of a bond causes
changes in its market price.
For example, A bond having a face value of
Rs.100 issued with a coupon rate of ten
per cent when the market interest rate is
also ten per cent will have a market price
of Rs.100.If the market interest rate moves
up to 12.5 per cent, no investor will buy
the bond with ten per cent coupon interest
rate unless the holder of the bond reduces
the price to Rs. 80. When the price is
reduced to Rs.80,the purchaser of the
bond gets interest of Rs ten on an
investment of Rs. 80 which is equivalent to
a return of 12.5 per cent which is the same
as the prevailing market interest rate.
Thus we, see that as the market interest rate
moves up in relation to the coupon interest
rate, the market price of the bond declines.
Similarly the market price of the bond would
move up when there is a drop in market
interest rate compared to the coupon rate.
In other words, the market price of bonds
and debenture is inversely related to the
market interest rate.
As a result, the market price of debt
securities fluctuate in response to
variations in interest rates is known as
interest rate risk.
The interest rate variations have an
indirect impact on stock prices also.
Speculators often resort to margin
trading i.e. purchasing stock on
margin using borrowed funds. As
interest rates increase, margin
trading become less attractive .The
lower demand by speculators may
push down stock prices. The
opposite happens when interest
rates fall.
Many companies use borrowed funds to
finance their operation. When interest
rates move up, companies using borrowed
funds have to make higher interest
payment.
This lead to low earnings, dividends and
share price. On the other hand lower
interest rates may push up earnings and
prices. Thus we see that variations in
interest rates may indirectly influence
stock prices. Interest rate risk is a
systematic risk which affects bonds
directly and share indirectly.
2. Market Risk:
a. Market risk is a type of systematic
risk that affects shares.
b. Market price of shares move up or
down consistently for some time periods.
c. A general rise in share prices is
referred to as a bullish trend, whereas
d. A general fall in share price is
referred to as a bearish trend
e. So the share market alternates
between the bullish phase and the bearish
phase.
Jack Clark Francis has defined market risk
as that portion of total variability of return
caused by the alternating forces of bull and
bear markets.
During the bull and bear market more than
80 per cent of the securities prices rise or
fall along with the stock market indices.
The forces that affect the stock market are
tangible and intangible events.
The tangible events are real events such as
earthquake, war, political uncertainty and
fall in the value of the currency.
Intangible events are related to market
psychology.
3. Purchasing Power Risk:
Another type of systematic risk is the
purchasing power risk. It refers to the
variation in investor returns caused by
inflation.
Inflation results in lowering of the purchasing
power of money. When an investor
purchases a security, he foregoes the
opportunity to buy some goods or
services.
In other words, he is postponing his
consumption.
Meaning while, if there is inflation in the
economy, the prices of goods and services
would increase and thereby the investor
actually experiences a decline in the
purchasing power of his investments and
the return from the investment.
For example, Suppose a person lends
Rs.100 today at ten per cent interest. He
would get back Rs.110 after one year. If
during the year, the prices have increased
by eight per cent, Rs 110 received at the
end of the year will have a purchasing
power of only Rs.101.20, i.e.,92 per cent
of Rs.110.
Thus, inflation causes a variation in the
purchasing power of the returns from an
investments. This is known as purchasing
power risk and its impact is uniformly felt
on all securities in the market and as such,
is a systematic risk.