You are on page 1of 7

RISK

INTRODUCTION
Financial risk is often defined as the unexpected variability or volatility of returns and
thus includes both potential worse-than-expected as well as better-than-expected
returns. References to negative risk below should be read as applying to positive
impacts or opportunity (e.g., for "loss" read "loss or gain") unless the context
precludes this interpretation. In finance, risk is synonymous with downside risk and is
intimately related to the shortfall or the difference between the actual return and the
expected return (when the actual return is less).

In finance, risk is the probability that an investment's actual return will be different
than expected. This includes the possibility of losing some or all of the original
investment. Some regard a calculation of the standard deviation of the historical
returns or average returns of a specific investment as providing some historical
measure of risk; see modern portfolio theory. Financial risk may be market-
dependent, determined by numerous market factors, or operational, resulting from
fraudulent behavior (e.g. Bernard Madoff). Recent studies suggest that testosterone
level plays a major role in risk taking during financial decisions.

A fundamental idea in finance is the relationship between risk and return (see modern
portfolio theory). The greater the potential return one might seek, the greater the risk
that one generally assumes. A free market reflects this principle in the pricing of an
instrument: strong demand for a safer instrument drives its price higher (and its return
proportionately lower), while weak demand for a riskier instrument drives its price
lower (and its potential return thereby higher).

Risk is incorporated into so many different disciplines from insurance to engineering


to portfolio theory that it should come as no surprise that it is defined in different
ways by each one. It is worth looking at some of the distinctions:
a. Risk versus Probability
While some definitions of risk focus only on the probability of an event occurring,
more comprehensive definitions incorporate both the probability of the event
occurring and the consequences of the event. Thus, the probability of a severe
earthquake may be very small but the consequences are so catastrophic that it
would be categorized as a high-risk event.
b. Risk versus Threat:
In some disciplines, a contrast is drawn between risk and a threat. A threat is a
low probability event with very large negative consequences, where analysts may
be unable to assess the probability. A risk, on the other hand, is defined to be a
higher probability event, where there is enough information to make assessments
of both the probability and the consequences.
c. All outcomes versus Negative outcomes:
Some definitions of risk tend to focus only on the downside scenarios, whereas
others are more expansive and consider all variability as risk. The engineering
definition of risk is defined as the product of the probability of an event occurring,
that is viewed as undesirable, and an assessment of the expected harm from the
event occurring.

TYPES OF RISK
There a number of differing types of risk that can affect your investments. While
some of these risks can be reduced through a number of avenues - some of them
simply have to be accepted and planned for in any investment decision. On a macro
(large scale) level there are two main types of risk, these are systematic risk and
unsystematic risk.

Macro Risk Levels

• Systematic risk is the risk that cannot be reduced or predicted in any manner
and it is almost impossible to predict or protect yourself against this type of
risk. Examples of this type of risk include interest rate increases or
government legislation changes. The smartest way to account for this risk, is
to simply acknowledge that this type of risk will occur and plan for your
investment to be affected by it.
• Unsystematic risk is risk that is specific to an assets features and can usually
be eliminated through a process called diversification (refer below). Examples
of this type of risk include employee strikes or management decision changes.

Micro Risk Levels

While the above risk types are the macro scale levels of risk, there are also some
more important micro (small scale) types of risks that are important when talking
about the valuation of a stock or bond. These include:

• Business Risk - The uncertainty of income caused by the nature of a


companies business measured by a ratio of operating earnings (income flows
of the firm). This means that the less certain you are about the income flows
of a firm, the less certain the income will flow back to you as an investor. The
sources of business risk mainly arises from a companies products/services,
ownership support, industry environment, market position, management
quality etc. An example of business risk could include a rubbish company
that typically would experience stable income and growth over time and
would have a low business risk compared to a steel company whereby sales
and earnings fluctuate according to need for steel products and typically
would have a higher business risk.
• Liquidity Risk – The uncertainty introduced by the secondary market for a
company to meet its future short term financial obligations. When an investor
purchases a security, they expect that at some future period they will be able
to sell this security at a profit and redeem this value as cash for consumption -
this is the liquidity of an investment, its ability to be redeemable for cash at a
future date. Generally, as we move up the asset allocation table - the liquidity
risk of an investment increases.
• Financial Risk - Financial risk is the risk borne by equity holders (refer
Shares section) due to a firms use of debt. If the company raises capital by
borrowing money, it must pay back this money at some future date plus the
financing charges (interest etc charged for borrowing the money). This
increases the degree of uncertainty about the company because it must have
enough income to pay back this amount at some time in the future.
• Exchange Rate Risk - The uncertainty of returns for investors that acquire
foreign investments and wish to convert them back to their home currency.
This is particularly important for investors that have a large amount of over-
seas investment and wish to sell and convert their profit to their home
currency. If exchange rate risk is high - even though a substantial profit may
have been made overseas, the value of the home currency may be less than the
overseas currency and may erode a significant amount of the investments
earnings. That is, the more volatile an exchange rate between the home and
investment currency, the greater the risk of differing currency value eroding
the investments value.
• Country Risk - This is also termed political risk, because it is the risk of
investing funds in another country whereby a major change in the political or
economic environment could occur. This could devalue your investment and
reduce its overall return. This type of risk is usually restricted to emerging or
developing countries that do not have stable economic or political arenas.
• Market Risk - The price fluctuations or volatility increases and decreases in
the day-to-day market. This type of risk mainly applies to both stocks and
options and tends to perform well in a bull (increasing) market and poorly in a
bear (decreasing) market (see bull vs bear). Generally with stock market risks,
the more volatility within the market, the more probability there is that your
investment will increase or decrease.

SOURCES OF RISK

1. CREDIT RISK
The risk of a trading partner not fulfilling his obligations in full on due date or at
any time thereafter is a risk that affects all aspects of business. Among the risks
that face financial institutions, credit risk is the one with which we are most
familiar. It is also the risk to which supervisors of financial institutions pay the
closest attention because it has been the risk most likely to cause a bank to fail.

With traditional instruments such as loans, bonds or currency trading, the amount
which the counterparty is obliged to repay is the full or principal amount of the
instrument. For these instruments, the amount at risk equals the principal amount.
Derivatives are different - because they derive their value from an underlying
asset or index, their credit risk is not equal to the principal amount of the trade,
but rather to the cost of replacing the contract if the counterparty defaults. This
replacement value fluctuates over time and is made up of current replacement and
potential replacement costs.

SETTLEMENT RISK

Settlement risk is the risk that a settlement in a transfer system does not take place
as expected. Generally, this happens because one party defaults on its clearing
obligations to one or more counterparties. As such, settlement risk comprises both
credit and liquidity risks. The former arises when a counterparty cannot meet an
obligation for full value on due date and thereafter because it is insolvent.
Liquidity risk refers to the risk that a counterparty will not settle for full value at
due date but could do so at some unspecified time thereafter; causing the party
which did not receive its expected payment to finance the shortfall at short notice.
Sometimes a counterparty may withhold payment even if it is not insolvent
(causing the original party to scramble around for funds), so liquidity risk can be
present without being accompanied by credit risk.
MARKET RISK

Market risk is usually measured as the potential gain/loss in a position/portfolio


that is associated with a price movement of a given probability over a specified
time horizon. This is typically known as value-at-risk (VAR). An institution with
a 10-day VAR of $100 million at 99% confidence will suffer a loss in excess of
$100 million in one fortnightly period out of 20, and then only if it is unable to
take any action to mitigate its loss.

2. OPERATIONAL RISK
IT summarises the findings of an operational risk working group of the Basle
Committee. Several common themes emerged from their discussions with 30
banks. The most major were that virtually all banks assign primary responsibility
for managing operational risk to the business line head, most banks were only in
the early stages of developing an operational risk measurement and monitoring
framework, and unlike market and credit risk, the risk factors that go into the
measurement of operational risk are largely internal to a bank.

5. LIQUIDITY RISK

Liquidity (funding) risk played a major part in the collapse of Barings - indeed it
was because Barings could not pay the margin calls of Leeson's futures positions
on the Singapore International Monetary Exchange and the Osaka Stock
Exchange that the 200-year old British bank collapsed. The liquidity demands
made by Leeson were enormous - at the end of December 1994, the cumulative
funding of Barings Futures (Singapore) by Barings London and Tokyo stood at
US$354 million. In the first two months of 1995, this figure increased by $835
million to $1.2 billion. The fact that London dispatched $835 million to Singapore
in a period of two months without asking any questions and without examining
the implications on the firm's liquidity and capital base borders on the ridiculous,
even impossible. But it did happen and the Barings case study shows that
operational and liquidity risks can be the ruin of a venerated institution.
6. LEGAL RISK

Other enforceability (legal) risks relate to documentation, the capacity of parties


such as government entities and building societies to enter into transactions (ultra
vires), collateral arrangements in bankruptcy and the legality of derivative
transactions. The enforceability and netting risks of nine countries are analysed in
Appendix 2, which accompanied the 1993 G-30 report. The nine countries are:
Australia, Brazil, Canada, England, France, Germany, Japan, Singapore and
United States. Appendix 2 is available from the G-30.