Want to know the different types of risk associated with the investing? Scroll on to know what!
Take off: Risk in holding securities is generally associated with possibility that realized returns will be less than the returns that were anticipated. Forces that throw in to variations in return price or dividend constitute elements of risk. Every company has its own risk that varies with different organizations. So, we can find companies with low risks which usually are big established companies, with a good market value for their shares, and companies with a big risk factor or companies that never paid their dividends, that belong to a rickety economic area and their shares are worth less. In other words the option of an adverse end outcome is referred to as the “Risk”. Risk cannot be eliminated perhaps could be minimized. Risk can be explained as the expression of the possibility that the actual income will differ from the expected income.
Types of Risk
Inflation Risk: It is better titled the unexpected risk or the purchasing power risk. There is a certain degree of uncertainty regarding the amount of the goods and services that can be bought at the same price at a future date. Rational investors should include in their estimate the expected return for purchasing-power risk, in the form of an expected annual percentage change in prices. If a cost-of living index begins the year at 100 and ends at 103, we say that
The Inflation rate is 3 percent [(103*100)/100]. If from the second to the third year, the index changes from 103 to 109, the rate is about 5.8 percent [109-103/103]. If annual changes in the consumer price index of other measure of purchasing power have been averaging steadily around 3.5 percent and prices will apparently spurt ahead by 4.5 percent over the next year hence the required rates of return will adjust upward. This process will affect government and corporate bonds as well as common stocks. Market, purchasing-power and interest-rate risk are the principle sources of systematic risk in securities.
Interest Rate Risk: It refers to the effects of changes in the prevailing market rates of interest on the bond values. When the interest rates rise, the bond values fall. Hence there is inverse relationship between the interest rate and bond value.
Liquidity risk: Liquidity generally means the quantum of cash readily available. The risk associated with the sale of fixed income securities that must be made at a price lesser than the fair market value because of the lack of liquidity for a particular issue is called the liquidity risk. Treasury bonds are the perfect example of liquid securities that can be easily changed to cash. On the other hand of the liquidity gamut, a unique expensive home or an automobile may be quite intricate to process cash immediately. By and large the investors prefer higher liquidity to a lesser one. Decrease in security’s liquidity will decrease its price as the requisite yield will be higher.
Reinvestment Risk: The process of second investment for any sake is called the reinvestment. When the market rates fall there is a force to reinvest the cash flows at a lower rate thus reducing the returns of the investors.
Suppose say for example: The market rates falls by 10% and the cash flows received from the fixed income securities is Rs. X. Reinvesting the X amount of cash flow at a lower rate say (10-x) % is the process of reinvestment at a lower rate.
Credit risk: Credit period is generally defined as the time granted by the creditor for the repayment of the dues. The risk of credit worthiness is that the firm may lose its value of credit thus increasing the required return thereby decreasing the security value.
Exchange rate risk: Exchange rate is defined as the rate at which a country’s medium is swapped against the currency of the other country so involved. This risk arises from the uncertainty about the value of the exchange medium that flows to an investor in his home country. Thus a US treasury bill may be considered less risky to a US based investor, the same T-Bill to an Indian investor will be reduced by a depreciation of the US Dollar’s relative to Rupees (INR).
Example the value of an US dollar to an Indian rupee is Rs.40. Say the value of the T-bill amounts to Rs.2500. The risk associated with the exchange rate is the depreciation in the value of the US dollar to its initial market value of the bill.
Financial Risk: Financial risk is associated with the way in which a company finances its activities. We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money of debt in the capital structure creates fixed payment in the form of interest that must be sustained by the firm. Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk. By engaging in debt financing, the firm changes the characteristic of the earnings stream available to the common-stock holders. Specifically, the reliance on debt financing, called financial leverage, has at three important effects on common-stock holders. Debt financing (1) increases the variability of their returns, (2) affects their expectations concerning their returns, and (3) increases their risk of being ruined.
Take off: Risk in holding securities is generally associated with possibility that realized returns will be less than the returns that were anticipated. Forces that throw in to variations in return price or dividend constitute elements of risk. Every company has its own risk that varies with different organizations. So, we can find companies with low risks which usually are big established companies, with a good market value for their shares, and companies with a big risk factor or companies that never paid their dividends, that belong to a rickety economic area and their shares are worth less. In other words the option of an adverse end outcome is referred to as the “Risk”. Risk cannot be eliminated perhaps could be minimized. Risk can be explained as the expression of the possibility that the actual income will differ from the expected income.
Types of Risk
Inflation Risk: It is better titled the unexpected risk or the purchasing power risk. There is a certain degree of uncertainty regarding the amount of the goods and services that can be bought at the same price at a future date. Rational investors should include in their estimate the expected return for purchasing-power risk, in the form of an expected annual percentage change in prices. If a cost-of living index begins the year at 100 and ends at 103, we say that
The Inflation rate is 3 percent [(103*100)/100]. If from the second to the third year, the index changes from 103 to 109, the rate is about 5.8 percent [109-103/103]. If annual changes in the consumer price index of other measure of purchasing power have been averaging steadily around 3.5 percent and prices will apparently spurt ahead by 4.5 percent over the next year hence the required rates of return will adjust upward. This process will affect government and corporate bonds as well as common stocks. Market, purchasing-power and interest-rate risk are the principle sources of systematic risk in securities.
Interest Rate Risk: It refers to the effects of changes in the prevailing market rates of interest on the bond values. When the interest rates rise, the bond values fall. Hence there is inverse relationship between the interest rate and bond value.
Liquidity risk: Liquidity generally means the quantum of cash readily available. The risk associated with the sale of fixed income securities that must be made at a price lesser than the fair market value because of the lack of liquidity for a particular issue is called the liquidity risk. Treasury bonds are the perfect example of liquid securities that can be easily changed to cash. On the other hand of the liquidity gamut, a unique expensive home or an automobile may be quite intricate to process cash immediately. By and large the investors prefer higher liquidity to a lesser one. Decrease in security’s liquidity will decrease its price as the requisite yield will be higher.
Reinvestment Risk: The process of second investment for any sake is called the reinvestment. When the market rates fall there is a force to reinvest the cash flows at a lower rate thus reducing the returns of the investors.
Suppose say for example: The market rates falls by 10% and the cash flows received from the fixed income securities is Rs. X. Reinvesting the X amount of cash flow at a lower rate say (10-x) % is the process of reinvestment at a lower rate.
Credit risk: Credit period is generally defined as the time granted by the creditor for the repayment of the dues. The risk of credit worthiness is that the firm may lose its value of credit thus increasing the required return thereby decreasing the security value.
Exchange rate risk: Exchange rate is defined as the rate at which a country’s medium is swapped against the currency of the other country so involved. This risk arises from the uncertainty about the value of the exchange medium that flows to an investor in his home country. Thus a US treasury bill may be considered less risky to a US based investor, the same T-Bill to an Indian investor will be reduced by a depreciation of the US Dollar’s relative to Rupees (INR).
Example the value of an US dollar to an Indian rupee is Rs.40. Say the value of the T-bill amounts to Rs.2500. The risk associated with the exchange rate is the depreciation in the value of the US dollar to its initial market value of the bill.
Financial Risk: Financial risk is associated with the way in which a company finances its activities. We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money of debt in the capital structure creates fixed payment in the form of interest that must be sustained by the firm. Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk. By engaging in debt financing, the firm changes the characteristic of the earnings stream available to the common-stock holders. Specifically, the reliance on debt financing, called financial leverage, has at three important effects on common-stock holders. Debt financing (1) increases the variability of their returns, (2) affects their expectations concerning their returns, and (3) increases their risk of being ruined.
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