CHAPTER 1 - THE NATURE OF RISK

Introduction To Risk

It is not sensible to talk about investment returns without talking about risk because investment
decisions involve a trade-off between the two. Investors must constantly be aware of the risk
they are assuming, understand how their investment decisions can be impacted, and be prepared
for the consequences.

Risk can be defined as the chance that the actual outcome from an investment will differ from
the expected outcome.

Specifically, most investors are concerned that the actual outcome will be less than the expected
outcome, so the more variable the possible outcomes that can occur, the greater the risk.

Components of risk

Risk has three components. These components need to be considered separately when
determining on how to manage the risk

Risk Components are:

1. The event that could occur – the risk,

2. The probability that the event will occur – the likelihood,
3. The impact or consequence of the event if it occurs – the penalty (the price you pay).

Differences between financial and non-financial risk

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Financial risk is an umbrella term for any risk associated with any form of financing. Typically,
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).

Non-financial risk should be on comparative basis. Non-monetory would refer to anything that is
not monetary or that which cannot be associated or viewed in money terms. A risk is anything
that if it occurs, the resultant consequences thereof will be to the detriment of the benefactor.
Therefore a non-financial risk is that which if it happens there won't be any monetory
consequence.

Sources of Financial Risk

1. Financial risks arising from an organization’s exposure to changes in market prices, such as
interest rates, exchange rates, and commodity prices.
2. Financial risks arising from the actions of, and transactions with, other organizations such as
vendors, customers and counterparties in derivatives transactions.
3. Financial risk resulting from internal actions or failures of the organization, particularly
people, processes and system.

Categories of Financial Risk

1. Credit risk is an investor's risk of loss arising from a borrower who does not make payments
as promised. Such an event is called a default.
Another term for credit risk is default risk.
Investor losses include lost principal and interest, decreased cash flow, and increased
collection costs, which arise in a number of circumstances:
 A consumer does not make a payment due on a mortgage loan, credit card, line of credit,
or other loan
 A business does not make a payment due on a mortgage, credit card, line of credit, or
other loan
 A business or consumer does not pay a trade invoice when due

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  A business does not pay an employee's earned wages when due
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due
 An insolvent insurance company does not pay a policy obligation
 An insolvent bank won't return funds to a depositor
 A government grants bankruptcy protection to an insolvent consumer or business

2. Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading
portfolio, will decrease due to the change in value of the market risk factors. The four
standard market risk factors are stock prices, interest rates, foreign exchange rates,
and commodity prices. The associated market risk are:

 Equity risk, the risk that stock prices and/or the implied volatility will change.
 Interest rate risk, the risk that interest rates and/or the implied volatility will
change.
 Currency risk, the risk that foreign exchange rates and/or the implied volatility will
change.
 Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or
implied volatility will change.

3. Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the
market to prevent a loss (or make the required profit). Or risk that a bank will have to sell
assets at a loss to meet cash demands, for example, depositors' demands for funds. Liquidity
risk is generally explained as a ratio comparing available liquidity to the demand for funds.

4. Operational risk is, as the name suggests, a risk arising from execution of a company's
business functions. It is a very broad concept which focuses on the risks arising from the
people, systems and processes through which a company operates. It also includes other
categories such as fraud risks, legal risks, physical or environmental risks.

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5. Volatility risk in financial markets is the likelihood of fluctuations in the exchange rate of
currencies. Therefore, it is a probability measure of the threat that an exchange rate
movement poses to an investor's portfolio in a foreign currency. The volatility of the
exchange rate is measured as standard deviation over a dataset of exchange rate movements.
A far more sophisticated extension of this model is the Value at Risk method, which helps to
determine the actual risk exposure to a portfolio of several currencies.
 Consequences of currency volatility
 Reduces volume of international trade
 Reduces long term capital flows
 Increases speculation
 Increases resources absorbed in risk management
 Economic policy making becomes difficult

6. Settlement risk can be the risk associated with default at settlement and any timing
differences in settlement between the two parties. This type of risk can lead to principal risk.
Or the risk that one party will fail to deliver the terms of a contract with another party at the
time of settlement.

7. Political risk refers to risks faced by international investors. Most political risk is of a
regulatory nature. It refers to risks such as expropriation/nationalization, imposition of
exchange controls that disallow foreigners to withdraw their funds, the imposition of
unfavorable tax or ownership requirements etc. Political risk therefore refers to the
diminution in the value of a foreign held asset as a result of unfavorable regulatory change
overseas.

Risk and return tradeoff

There is a positive relationship between risk and return ie high risk is associated with high return
and low risk is followed by low return. The rationale for such a relationship is that an investor
who wants a high return will motivated to assume higher risks associated with the desired return.
This relationship can be shown using the following graph:

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 Return ER
Option Futures
Mutual fund
Return on PS CS
Risk less Convertible securities
Investment CD
Rf Bonds
Tbills

Risk
From the graph, the line shows that a person who assumes higher risk can expect a higher return.

Sources of risk

Risk is affected by internal and external factors.

1. External factors are uncontrollable and broadly affect the investment. Examples are changes
in the economic, politic and consumer preferences. They are also known as systematic risk.
(Also known as market risk)

2. Internal factors are controllable and are caused by the internal environment of a firm or those
affecting a particular industry. Examples are labor strike and mismanagement. Another name
for internal risk is unsystematic risk. (Also known as non market risk)

Systematic Risk/ External Risk/Uncontrollable Risk/Market Risk

There are several types of systematic risk:

1. Purchasing power risk/ Inflation risk

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 When inflation rate increases, the amount of principal and income received will not provide
the same purchasing power as its original value. This risk affects individuals who buy long-
term fixed income securities and those who holds surplus funds bank.

2. Market risk
The decrease in the value of the principal invested caused by changes in prices of securities
resulting from real events such as political, sociological and economic factors and due to
psychological factors such as rumors, speeches by important people etc.

3. Interest rate risk

It is the loss of the principal value because of the change in the prevailing interest rate paid
on the newly issued securities. For example, interest on long-term investment remains the
same although the interest rates, in the market rise and fall due to the demand and supply of
money.

4. Liquidity risk
The risk of not being able to liquidate an investment conveniently and at a reasonable price is
called liquidity risk. In general, investment vehicles traded in thin markets, where demand
and supply are small, tend to be less liquid than those traded in broad market.

5. Exchange rate or currency risk

Exchange rate or currency risk is the variability of returns caused by currency fluctuations.
Return received from investment abroad may reduce in value due to weak currency
exchange.

Unsystematic Risk/Internal Risk/Controllable Risk/Non market Risk

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It comprises:

1. Business risk
It is related to the efficiency of the management in handling the business (internal) and also
how it responds to factors outside its control (external) such as the general business cycle.
This type of risk will affect the general operation of the company such as increase in the
operating cost, thus reducing the operating profit.

2. Financial risk
It is associated with the method through which the company plans its financial structure. A
company that borrows to finance its operation carries high financial risk because it has to
bear high interest expense, which will affect its net profit. Low net profit will result in low
earnings per share (EPS).

Investor’s Preference Level of Risk

The degree to which investors are willing to commit funds to stocks depends on risk aversion.
Investors are risk averse in the sense that, if the risk premium were zero, people would not be
willing to invest any money in stocks.

1. Risk averse – investors is an individual who, when given a choice between two investments
with equal expected returns, will always choose the investment with the lowest variance.

2. Risk neutral/risk indifferent – investors who are indifferent between two investments having
an equal returns but different variance.

3. Risk seeking/risk taking – investor is one who will actually choose the riskier of two
investments offering the same expected payoff.

Three Broad Altenatives For Managing Risk

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1. Do nothing, and actively, or passively by default, accept all risk.
2. Hedge a portion or exposures by determining which exposures can and should be hedged.
3. Hedged all exposures possible.