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RISK AND ITS DIFFERENT SOURCES
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Investors invest for anticipated future returns, but these returns can rarely be predicted precisely. There may be difference between expected return and realized return and the latter may deviate from the former. This deviation is nothing but risk. In other words, the chance that the actual return from an investment would be different from its expected return is referred to as risk.

The risk of an investment is related to the uncertainty associated with outcomes from an investment. For instance, a fixed deposit with a commercial bank is risk-less whereas investment in equity shares where the return may be as high as 100% in a year or may be even negative, is considered riskier. Similarly, treasury bills maturing in short period have no practical risk because there seems to be no chance that the government will not be able to fulfill its commitment to redeem these bills on the due date. The government bonds are known as risk-free investments while other investments are risky investments.

All investors, in general, would prefer investments with highest possible return but for getting this return, he has to pay price in terms of accepting higher risk. Investors are rational and prefer less-risky investments. They are risk-averse in the sense that they don’t assume risk for its own sake but they will not incur any level of risk unless there is an expectation of adequate compensation for undertaking that risk. Investors thus, select the level of risk that they are ready to assume.

It is imperative for an investor to understand how does the risk arise. In order to understand this, one can ask questions like – What makes investments a risky proposition? What are different factors or sources where the investments assume risk? There can be different sources that can contribute to variation in returns from an investment. Let us discuss these one by one:

  • Market Risk – Market prices of investments, particularly equity shares may fluctuate widely within a short span of time even when there is no change in the earnings of the company. Reasons for this can be varied. There can be different social, political, economic reasons which may affect prices. Market psychology is another factor that can have an impact. In bull phases, market prices of all shares tend to increase whereas in bear phases, market prices tend to decline. In such situations, the market prices can be far from the fundamental value. Hence, one can say the market risk refers to variability in returns due to change in market price of the investment.
  • Interest-rate Risk – If the risk-free rate of interest rises or falls, rate of interest on other bond securities also rises or falls. Security (bonds & debentures) prices have an inverse relationship with the level of interest rates. Changes in the level of interest rates hence, directly affects the prices of bonds and debentures and also indirectly affect prices of equity shares.
  • Inflation Risk (Purchasing Power Risk) – This can be said as uncertainty of purchasing power of cash flows to be received out of an investment. It shows the impact of inflation or deflation on the investment. When inflation increases, the interest rates also tend to increase; the reason being that the investors want an additional premium for inflation risk (resulting in decrease in purchasing power).

If an investor makes an investment, there is an opportunity cost involved. In other words, the investor is foregoing an opportunity to buy some goods and services during the investment period. If, during this period, the prices of goods & services go up, the investor loses in terms of purchasing power. The inflation risk thus, arises because of uncertainty of purchasing power of the amount to be received out of investment in the future.

  • Business Risk – It refers to the variability in income of the firms and expected dividend there from, resulting from any adverse operating conditions. For instance, if the earnings or dividends are expected to increase by 10% but the actual increase comes out to be only 6%, then this variation in actual vs expected is business risk.
  • Financial Risk – This is the degree of leverage or debt financing used by a firm in its capital structure. Higher the degree of debt financing, greater will be the financial risk as there is a fixed charge involved in terms of interest payments, which may bring more variability in the earnings available for equity shareholders.

 

We shall discuss more on this in a different article.

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