Risk

RiskPRESENTED BY; ADIL MEHRAJ 100129 MBA (CUK)

Risk is the part of every human endeavor. From the moment we get up in the morning, drive or take public transportation to get to school or to work until we get back into our beds (and perhaps even afterwards), we are exposed to risks of different degrees. What makes the study of risk fascinating is that while some of this risk bearing may not be completely voluntary, we seek out some risk on our own (speeding on the highways or gambling, for instance) and enjoy them.

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The phenomenon of risk is closely related to the concept of uncertainty which human lives face routinely. What is not known today becomes uncertainty, and if this state affects us in an unfavorable way, we often conclude this outcome of uncertainty as a loss and the potential of uncertainty to behave in such a way as risk.

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Holton (2004) argues that two ingredients are needed for risk to exist. The first one is uncertainty about the potential outcome from an experiment, and the other is that the outcomes have to matter in terms of providing utility. In other words, a person jumping out of an airplane without a parachute faces no risk since he is certain to die (no uncertainty)

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

Risk versus probability – Whereas 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 small, but the consequences are so catastrophic that it would be categorized as a high-risk event.

Risk versus threat – In some disciplines, a contrast is drawn between risk and a threat. A threat is a low-probability event with 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 assess both the probability and the consequences.

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All outcomes versus negative outcomes – Some definitions of risk tend to focus only on the downside scenario, whereas others are more expansive and consider all variability as risk. The engineering definition of risk defined as the product of the probability of an event occurring, that is viewed as undesirable, and an assessment of the expected harm form the event occurring.

Risk = Probability of an accident * Consequence in lost money/deaths.

In contrast, risk is finance is defined in terms of variability of actual returns on investment around an expected return, even when those returns represent positive outcomes. Building on the last distinction, we should consider broader definitions of risk that capture both the positive and negative outcomes.

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The Nature and Exposure of Risk

• The values of firm’s assets, liabilities and operating income vary continually in response to changes in a flurry of economic and financial variables such as exchange rates, interest rates, inflation rates. •These uncertainties are known as macro-economic environmental risks.

•Moreover, uncertainties related to its operating business such as interruptions in raw material supply, labour troubles, success or failure of a new product or technology and so forth have an impact on the firm’s performance. These can be grouped under the heading as core business risks


• core business risks: Firm Specific

•macro-economic environmental risks : Economy related


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It is also termed as non-diversifiable risk because it cannot be avoided

SYSTEMATIC RISK

SYSTEMATIC RISKInflation Risk

Interest Rate Risk Political RiskMarket RiskRisk Due To Government

Policies Natural CalamitiesScams/Malpractices

MonsoonIndustrial Growth And OutputInternational EventsWar-like Situation/ Internal Peace

Inflation Risk It causes loss of purchasing power, due to which real gains from investment are very low as compared to monetary gains. Inflation affects the price of shares as well as debentures. Due to rising inflation, the returns expected by the investors tend to increase and they discount future earnings at a higher discount rate, which pulls the prices further down. Inflation also influences the real yield from bonds, which happens to be much lower than the normal interest rate. The declining rate affects the market price of the bonds adversely. However, companies have started issuing debentures/bonds, which provide for protection against rising interest rate, e.g. flotation rate debentures, index linked debentures/bonds, etc.

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Interest Rate Risk Interest rate in an economy tends to fluctuate either on account of regularity framework or due to market forces. If the general interest rate rise then it pushes up the investors’ expected rate of return from investment, due to which prevailing share prices become unattractive. Another effect of increased expected rate of return is that, low yield debentures or bonds become unattractive at the prevailing price due to which prices of these also tumble down. Thus interest rate also accounts for a major part of the systematic risk for investment activities. Recently, a frequent change in the interest rates by RBI affected the stock market. RBI change the bank rate , CRR, repo and reverse repo rates very frequently this change resulted in the change in the expectation of return by investors followed by a frequent change in the share prices on the stock market.

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Political Risk Performance of industries and stock market depends on a country’s political scenario. Political uncertainty adversely affects share prices.

Market Risk Price of securities (shares, stocks and debentures) depend quite upon the activities of operators/speculators in the market. The risk that because general market pressures will cause the value of an investment to fluctuate, it may be necessary to liquidate a position during a down period in the cycle. Market risk is highest for securities with above-average price volatility and lowest for stable securities such as Treasury bills. Market risk is of little consequence to a person who purchases securities with the intention of holding them for long periods.

Market Risk is the risk of losses due to movements in financial market variables. These may be interest rates, foreign exchange rates,

security prices, etc. Thus market risk is the risk of fluctuations in portfolio value because of movements in such variables.

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Changing Government Policies the changing policies of a government can definitely affect the movement of share prices. Whenever the government announces a change in taxation, licensing, quota restrictions and foreign trade policies etc. and this in turn, affects the profitability of industry, then the share price show a declining trend. A favorable announcement has a positive impact and vice versa.

Natural Calamities Disasters, tsunamis, floods etc. may affect the stock market badly. This may happen because of fear of loss for industrial houses at large.

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Monsoon Weather Indian economy is an agrarian economy and hence the performance of an industry is dependent on the monsoon to a great extent. A significant portion of the Gross Domestic Product (GDP) comes from agriculture. A bad monsoon has an adverse effect on the share prices of all the companies.

Scams and Malpractices scams a like Satyam scam, Harshad Mehta scam, CRB scam, and many other scams have not only affect their share prices but also the prices of other company shares. Scams also create psyche of fear in the minds of investors and they start selling every kind of share whether good or bad. This activity creates excessive supply in in the market and makes price decline. The stock market is always driven by the forces of demand and supply. When demand and supply are not in equilibrium, then certainly distorted prices prevail in the market.

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Industrial Performance share price depend largely on the profits declared by the companies. Investors always give more weight to high profits. Every year when the economic survey report is presented, there is a possibility that share prices get affected, depending on the industrial growth assessment as shown in the survey report.

International Events in the recent years (2008) when recession hit all the economies of the world or the present situation of recession (2011) almost hit all the prices of stocks. Terrorist attacks on worldwide or other international trade policies etc. also responsible for changes in the stock market.

War-Like Situation/Internal Peace whenever there is internal disturbance in the economy; it immediately gets discounted in the share prices. Since, everyone wants to sell their shares to meet urgency. Increased selling pressure affects share prices.

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Business Risk

Financial Risk

Risk Due To Industry-Specific Policies

Disputes

This kind of risk is due to industry or company-specific factors This type of risk can either be reduced or eliminated through diversification.

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Business Risk It gets created due to operation of a company or business. A company might not be able to sell its products due to imperfections in its operating activities. As a result, the company might incur losses, which certainly has an adverse effect on share prices of such company. Because 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.

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Financial risk • Introduction of fixed cost item.It occurs due to wrong financial planning. A company having high degree of debt certainly has high financial leverage, which has an adverse effect on the earnings of the company. The unfavorable effect of high financial leverage is observed at the time of declining EBIT, which sometimes might erode the capital of the company too. Hence, companies with high financial leverage are considered as high risky and vice versa.

[A financial risk arises as a result of uncertainties in the financial markets which are manifested by changes in the value of market parameters like interest rates, stock prices, and the price of currencies…]

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Risk Due To Industry-Specific Policies

sometimes government policies are against a particular industry, due to which the performance/profitability of the company of such industry gets badly affected. This creates a negative effect on the share price of such companies. These policies may include removal of subsidy, concessions or imposing high taxes or a ban on a product/raw material.

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Disputes share prices of few companies get effected adversely as and when there is a situation of industrial dispute, labour management unrest, lockout or strike. Even the disputes among the promoters or owners have a bad effect on the share prices.

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