M. Com. Financial Engineering

TYPES OF RISK

Unfortunately, the concept of risk is not a simple concept in finance.

There are many different types of risk identified and some types are relatively more or relatively less

important in different situations and applications. In some theoretical models of economic or financial

processes, for example, some types of risks or even all risk may be entirely eliminated.

For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is

ever-present and must be identified and dealt with.

TYPES OF RISK

There are a number of different types of risk the been identified. It is

important to remember, however, that all types of risks exhibit the same

positive risk-return relationship. Some of the most important types of risk are defined in this presentation

POSITIVE RISK-RETURN RELATIONSHIP

The risk of non-payment.Measurement of it is not easy.

Many things can influence an issuer's default risk and in varying degrees.• poor or falling cash flow from operations ,

• rising interest rates , or

• changes in the nature of the marketplace

DEFAULT RISK

The uncertainty associated with the effects of changes in market interest rates.

There are two types of interest rate risk identified;

price risk and

reinvestment rate risk.

The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in

price for a given change in interest rates.

Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value,

we have the following relationships

INTEREST RATE RISK

The uncertainty associated with the impact that changing interest rates have on available rates of return when

reinvesting cash flows received from an earlier investment. It is a direct or positive relationship.

For example, consider a Company XYZ bond with a 10% yield to maturity (YTM). In order for an investor to actually

receive the expected yield to maturity, she must reinvest the coupon payments she receives at a 10% rate. This is not

always possible. If the investor could only reinvest at 4% (say, because market returns fell after the bonds were

issued), the investor's actual return on the bond investment would be lower than expected.

REINVESTMENT RATE RISK

Also called systematic risk or non-diversifiable risk, relevant risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets. Diversifiable risk is the risk of something going wrong on the company

or industry level, such as mismanagement, labour strikes, production of undesirable products, etc.

Relevant risk + Diversifiable risk = Total risk

Example:

Relevant risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It is unavoidable in all risky investments. Relevant risk can

also be thought of as the opportunity cost of putting money at risk.

For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of Deposit.

Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index.

If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky

equity investment.

RELEVANT RISK

The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels

and rates of return in the economy.

This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present

value of future cash flows.

The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also

true.

PRICE RISK

The uncertainty associated with the ability to sell an asset on short notice without loss of value.

A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers

and sellers in the market.

An illiquid asset is hard to sell because there are few interested buyers. This type of risk is important in some

project investment decisions but is discussed extensively in Investment courses.

LIQUIDITY RISK

The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due

to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value.

Two general theories explain inflation.

The first, the demand-pull theory, says that prices increase when demand for goods and services exceeds their supply.

The second, the cost-push theory, says that companies create inflation when they raise their prices to cover higher supply prices

and maintain profit margins.

INFLATION RISK (PURCHASING POWER RISK)

Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are

exposed to and cannot be diversified away.

Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. This

type of risk is discussed extensively in Investment courses.

MARKET RISK

The uncertainty associated with the returns generated from investing in an individual firm’s common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding

of a well diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is

discussed extensively in Investment courses.

FIRM SPECIFIC RISK

Economic risk is the chance that macroeconomic conditions like exchange rates, government regulation, or political stability will

affect an investment, usually one in a foreign country.

How It Works/Example:

For example, let's assume American Company XYZ invests $1,000,000 in a manufacturing plant in the Congo. Aside from the

business risk associated with making the plant profitable, Company XYZ is exposed to economic risk.

The political environment could shift quickly, perhaps prompting the Congolese government to seize the plant or significantly change

laws that affect Company XYZ's ability to operate the plant.

Likewise, hyperinflation could make it impossible to pay workers, or exchange rate circumstances could make it unprofitable to move

profits out of the country.

ECONOMIC RISK

Downside risk is the probability that an asset will fall in price. It is also the measure of the possible loss from that decline.

How It Works/Example:

Let's assume an investor owns 1,000 shares of Company XYZ and she's paid $100,000 to own that stock. Because the stock price

could theoretically fall to zero under the right economic conditions, the downside risk of the investment is 100% or

$100,000.

Hedging is an attempt to limit the downside risk of an investment. In our example, the investor might purchase a put

option on the shares, meaning that she has the right to force the counterparty to buy the Company XYZ shares for a certain price. That way, the investor can obtain at least a minimum amount for

the shares and thus limit her downside risk.

DOWNSIDE RISK

In the advanced capital budgeting topics, the total risk associated with an investment project.

Also referred to as stand-alone project risk.

In advanced capital budgeting, project risk is partitioned into systematic and un-systematic project risk.

PROJECT RISK

The uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of

earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt

financing. This risk is often discussed within the context of the Capital Structure topics.

FINANCIAL RISK

The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings

before interest and taxes (EBIT).

Since this earnings measure has not had financing expenses removed, it reflect the risk associated with

business operations rather than methods of debt financing.

BUSINESS RISK

Uncertainty that is associated with potential changes in the foreign exchange value of a currency.

There are two major types:

translation risk and

transaction risks.

For example, let's assume XYZ Company is a Canadian company and pays interest and principal on a $1,000 bond with a 5%

coupon in Canadian dollars.

If the exchange rate at the time of purchase is 1:1, then the 5% coupon payment is equal to $50 Canadian, and because of the

exchange rate, it is also equal to US$50. Now let's assume a year from now the exchange rate is 1:0.85. Now the bond's 5% coupon

payment, which is still $50 Canadian, is worth only US$42.50.

FOREIGN EXCHANGE RISKS

Uncertainty associated with the translation of foreign currency denominated accounting statements into the home

currency.

TRANSLATION RISKS

Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign

currency values.

TRANSACTIONS RISKS

While there are many different types of specific risk, we said earlier that in the most general sense, risk is the

possibility of experiencing an outcome that is different from what is expected.

If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk

reflects the variability of returns from some type of financial investment.

TOTAL RISK

Obsolescence risk is the risk that a company's product or service will become obsolete or out of date.

Example:

For example, consider the fax machine. Once a symbol of modern communication, the fax machine was one of the first ways to share information almost instantaneously.

Manufacturers of fax machines, fax paper, fax toner, and fax transmission services faced obsolescence risk with the

advent of increased internet bandwidth, text messaging, PDF technology, and e-mail use. Eventually, the technology became obsolete as fax machine users migrated to cheaper,

faster, more efficient methods.

OBSOLESCENCE RISK

The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible

outcomes about the expected value (or mean).

In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk

and unsystematic risk).

Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will

discuss these concepts in more detail

MEASURES OF TOTAL RISK