Risk and its Types

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Meaning of Risk

  • It means the probability of having an adverse or low return as compared to expected return. All investment activities are subject to risk. Even, a safe investment like treasury bills, post office deposits are also not free from risk.
  • The investment environment also has risk. Speculators are risk seekers and would rather invest in securities that give high returns though the certainty around such returns are very minimal.

Types of Risk

SYSTEMATIC RISK

Systematic risk is also known as market risk or undiversifiable risk. This type of risk cannot be eliminated by diversifying assets. Systematic risk indicates how a particular investment in a diversified portfolio contributes to the overall risk of a company’s financial investing.

It arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This type of risk cannot be reduced through diversification. It is also known as market risk

An example of systematic risk occurs when the entire economy goes down due to factors across all sectors and not just when the stock market goes down. Daily fluctuations of stock prices are another example of systematic risk. As long as one does the investment, he gets influenced with these factors-these are the universal factors and these influence the performance of all the investment avenues. Because some get affected hardly and others softly, it is non-diversifiable.

These are as follows:

  1. Inflation Risk – Inflation possess loss of purchasing power due to which real gains from investment are very very low as compared to monetary gains. Inflation effect the price of shares as well as debentures. Due to rising inflation, the returns expected by the investor tend to increase and they discount future earnings at a higher discount rate, which pulls the prices further down.
  2. Interest Rate Risk – Interest rate in an economy tends to fluctuate either on account of regulatory framework or due to market forces. If the general interest rate pushes up the investors expected rate of return from investment, due to which prevailing share prices becomes unattractive. Another effect of increased in expected rate of return is that, low yield debentures or bonds becomes unattractive at prevailing price due to which prices of this also falls down.
  3. Political risk – Performance of industries and stock market depends on country’s political scenario. Political uncertainty adversely affects share prices it was clear evident in 2004 after the Lok Sabha elections when Sonia Gandhi was likely to help the government at the centre and some of the political parties objected this political Chaos created uncertainty and the market collapsed badly the stock index crashed by about 750 points in one single day causing loss of crores of Rupees.
  4. Market riskPrice of securities (shares, stocks and debentures) depend quite upon the activities of operations of speculations in the market. In the past when UTI used to account for a major portion of the daily traded volume in the stock market the buying and selling activities of the brokers on behalf of UTI used to significantly impact the share price.

The world of investment can never be made free from the element of risk and one has to bear certain risk because it is a part of the game of investment. Every investor has to be a systematic risk. Some have the technique to manage it smartly but other than it difficult to cope up with it. However, non-systematic risk can be minimised through proper diversification or well planned investment activities.

  1. Changing government policies – The changing policies of a government can definitely affect the movement of the share price. This becomes evident during the Yearly budget announcement by the finance minister. Whenever the government announces a change is taxation, licensing, quota restriction and foreign trade policy sector and this in turn affects the profitability of industry then the share price for declining trend a favourite arousement has positive effect and vice versa.
  2. Natural calamities – In the past when Gujarat was hit by flood and Cyclone resource of this disaster that immediately observed in the stock market in the form of declining share prices.Prices of almost all the shares declared irrespective of the fundamental soundness.This happened because in the fear of loss for industrial houses at large
  3. Scams and malpractices – Scams like the Mundhra scam, Harshad Mehta scam,CRB scam,Ketan Parekh at their times have effected share price of almost all the companies. Scams can also create a Cycle of Fear in the mind of investor and they start sending every kind of share whether good or bad.

This creates excess supply in the market and market price decline the stock market is always divided by the force of demand and supply when demand and supply or not in equilibrium then certainly distorted prices prevail in the market

  1. Monsoon winter – Indian economy is an agrarian economy enhance the performance of an industry is dependent on the monsoon to a great extent a significant portion of the cross development product comes from agriculture a bad monsoon has an adverse effect of the share price of all the companies.
  2. Industrial performance – Share price depends largely on the profits declared by the companies. Investors have always given more way to high profits .Every year when the economic survey project is present in there is a likelihood the share prices get affected depending on the industrial growth assessment as shown in the survey report.

UNSYSTEMATIC RISK.

Unsystematic risk is also known as specific risk, residual risk or diversifiable risk. Pearson Higher Education reveals this is a portion of a company’s overall risk that can be eliminated by including this risk in a diversified portfolio of assets. One example of an unsystematic risk occurs when a strike affects a company or a sector of a portfolio.

The following are non-systematic risks:

  • Business Risks
  • Financial Risks
  • Risk due to Specific Policies
  • Disputes

Business risk

Business risk gets created due to the operations of company or business or company might not be able to sell its product due to imperfections in its operating activities. As a result, the company might incur losses which certainly has an adverse effect on the share price of such company.Business risk originates due to operating leverage and wrong planning about the operations of a company. It can be measured with the help of degree of operating leverage.

Financial risk

Financial risk occur due to wrong financial planning. A company having high degree of debt certainty has higher financial leverage, which has an adverse effect on the earnings of the company. The unfavourable effect of price financial leverage is observed at the time of declining EBIT with sometimes might erode the capital of the company too.Hence companies with high financial leverage are considered as a risky and vice versa.

Risk due to industries Specific policies

Sometimes government policies are against a particular industry due to which the performance of profitability of the company of such industry gets badly affected this creates a negative effect on the share prices of such companies this policies may include removal of subsidies concessions or imposing a ban on a product or raw material.

Disputes

Share prices of few companies get affected adversely as and when there is a situation of industrial dispute, labour management unrest, lockout or strike. Even the dispute among the promoters or owners have a bad impact of the share price. The dispute between Ambani brothers at affected the share price of Reliance India Limited (RIL) and when the dispute was settle the prices of RIL went up. Disputes about the ‘WILL’ in the Birla family also affected the share price.

DIFFERENCES OF SYSTEMATIC RISK AND UNSYSTEMATIC RISK

There are differences between the systematic and unsystematic risk though they are risk. These differences are given below:

Systematic risk.

Unsystematic risk

1.Systematic Risk arises on account of the economy with uncertainties and the tendency of individual securities to move together with the change in the market

1.Unsystematic risk is that part of risk which arises out from the uncertainties and which are unique to individual securities and can be diversifiable

2.Directly related to economic system of a country.

2. Directly not related with economic system, rather it is more about business or company related

3.Systematic risk is also known as non-diversifiable risk

3. Unsystematic risk is also known as diversifiable risk.

4.We cannot reduce this type of risk individually

4. This type of risk can be reduced

5.Negatively correlated investment cannot eliminate the risk

5. It is possible to eliminate risk by forming portfolio of negatively correlated investment.

6.Beta is measure of systematic risk

6. Unsystematic risk is the function of macroeconomic factors related with business.

7.Basically investor do not try to work with systematic risk.

7. Investor always try to reduce this type of risk through better managing their investment.

Examples:

Change in market interest rate.

Increase in inflation

Change in oil price

Unemployment rate

8.Examples:

Increase in business operational cost.

Workers strike in a factory.

Employee turnover

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