Types of Risk

We recently discussed different sources of risk vis-à-vis market risk, interest rate risk, inflation risk, business risk and financial risk. The first three sources, i.e., market risk, interest rate risk, inflation risk, are external to the firm and cannot be controlled. These are all-pervasive in nature and affect all the firms.

On the other hand, the last two sources, i.e., business and financial risk are internal to a firm and hence, controllable. The risk can thus, be systematic risk and unsystematic risk.

Systematic Risk/ Market Risk/ Non-diversifiable Risk, is the one which arises due to general factors in the market such as money supply, inflation, economic recession, interest rate policy of the government, political factors, credit policy, tax reforms, etc. These are the factors that affect almost all the firms though in varying degrees. This part of the risk arises because every security has a built-in tendency to move in line with the fluctuations in the market. No investor can avoid or eliminate this risk, whatever precautions or diversification may be resorted to.

Another type of risk is the Unsystematic Risk/ Firm-specific Risk/ Diversifiable Risk: This risk is specific to a firm and doesn’t affect the entire market. In other words, it represents fluctuations in returns from an investment due to factors which are specific to a particular firm and not the market as a whole. These factors are same which are responsible for business risk or financial risk. Since, these factors are unique
to a particular firm; these must be examined separately for each firm and for each industry. For example, a fluctuation in the price of crude oil will affect the fortune of petroleum companies but not the textile manufacturing companies. As this risk results from random events that tend to be unique to a firm or a particular industry, it is random in nature. 

Further, unsystematic risk can be reduced through the process of diversification. This we have already discussed in one of our previous write-ups.



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