Risk
Risk is usually understood as “exposure to a danger or hazard”. In Financial Risk Management or in investment decisions, risk is defined as the possibility that what is actually earned as return could be different from what is expected to be earned. For example, consider an investor who buys equity shares after hearing about the huge returns made by other investors. He expects to earn at least 50% return within 2 years. But if equity markets decline during that period, the investor could end up with negative returns instead. This deviation between actual and expected returns is the risk in his investment.
If the return from an investment remains unchanged over time, there would be no risk. But there is no investment of that kind in the real world. Even returns on government saving products change. For example, consider the Public Provident Fund (PPF), which is a 15-year deposit in which investors have to put in money at least once every year. This investment is considered to be government- guaranteed and its returns are viewed as being very safe. The rate of return on PPF was 12% in the year 2000. Consider the changes ever since:
- Reduced to 11% in January 2000
- Reduced to 9.5% in March 2001
- Reduced to 9 % in March 2002
- Reduced to 8% in March 2003
An investor, who began to invest in 1999, hoping to earn 12% return, would have found that by March 2003, the rate had come down to 8%. The unexpected change to investment return that impacts the investor’s financial plans is the risk investors have to deal with.
Deviations from expected outcomes can be positive or negative: both are considered to be risky. However, it is human nature to focus on negative deviations- or situations when actual returns fall below the expected level.
All investments are subject to risk, but the type and extent of risk are different. Thus, it is important to understand the common types of risk and evaluate investments with respect to them. Understanding the risk will help an investor decide the impact it will have on their financial situation and how to deal with it. The risk that an individual will be willing to take is specific to their situation in life. Some risks will require strategic portfolio changes to be made, such as extent of diversification in the portfolio. Other risks may be managed tactically, for example making temporary changes in asset allocation to deal with a risk.
Types of Risk
There are several common types of risk to which investments can be exposed.
Inflation Risk
Inflation risk represents the risk that the money received on an investment may be worth less when adjusted for inflation. Inflation risk is also known as purchasing power risk. It is a risk that arises from the decline in value of security’s future cash flows, whether in the form of periodic pay-outs such as interest and dividend or the redemption value at the time of sale, due to the falling purchasing power of money.
Consider an example. Asha has invested a lump sum in bank fixed deposits that yields her about Rs.5000 per month. This is adequate to cover the cost of her household provisions. Suppose that inflation rises by 10%, meaning that there is a general rise in prices of goods by about 10%. Then Rs.5000 will no longer be enough to cover Asha’s monthly provisions costs, she would need 10% more, or Rs.5500. The purchasing power of her cashflows has declined. Asha’s options would be to either cut back on her expenses to fit it within the Rs.5000 available to her, or reallocate her investments to earn higher returns. Her investment, though in a safe bank deposit, has been exposed to inflation risk.
Inflation risk is highest in fixed return instruments, such as bonds, deposits and debentures, where investors are paid a fixed periodic interest and returned the principal amount at maturity. Both interest payments and principal repayments are amounts fixed in absolute terms. Suppose a bond pays a coupon of 8% while the inflation rate is 7%, then the real rate of return is just 1%. If inflation goes up to 9%, the bond may return a negative real rate of return. Thus, even if there is no risk of default on payment of interest or return of principal, the real value of the investment has been eroded because of inflation.
Inflation risk has a particularly adverse impact on retired persons, whose income flows tend to be fixed in absolute terms. Tactical allocations that help generate higher returns will help manage the effect of inflation. For example, the investor may consider investing a portion of the debt portfolio in shorter term maturities to benefit from rising interest rates in response to inflation, or the investor may consider some exposure to an inflation-hedging asset class such as equity or commodities.
Default Risk
Default risk or credit risk refers to the probability that borrowers will not be able to meet their commitment on paying interest and/or principal as scheduled. Debt instruments are subject to default risk as they have pre-committed pay outs. The ability of the issuer of the debt instrument to service the debt may change over time and this creates default risk for the investor.
The sovereign government as a borrower and institutions associated with the government have no credit risk as they have the means to raise funds through taxation, international loans and even print notes as a last resort, to repay loans. All other borrowers have some degree of credit or default risk associated with them. This is measured using the credit rating assigned to a debt instrument.
Credit rating is an alpha-numeric symbol that expresses the credit rating agencies assessment of the ability and intention of the borrower to meet the obligations arising from the debt. SEBI has standardized the symbols used by credit rating agencies. Symbols such as AAA, A1 indicate the highest degree of credit worthiness while D represents default status. Credit rating is not a static parameter and is liable to change every time there is a change in the fundamentals of the company that will affect its ability to meet its obligations. The rating may therefore be downgraded to reflect a greater perceived default risk or upgraded to indicate lower risk. The financial situation of the issuer is monitored by the credit rating agency till the instrument is redeemed on maturity.
Monitoring the credit quality and exiting a bond whose credit rating is likely to fall to levels where the investor is uncomfortable with the risk, is the way to handle the credit risk in a bond. However, the low liquidity in the bond markets is likely to make it difficult for the investor to sell, especially when there is a likely downgrade. Holding a diversified portfolio of bonds is the best way to protect the investor’s portfolio from the default by one issuer.
Liquidity Risk
Liquidity or marketability refers to the ease with which an investment can be bought or sold in the market. Liquidity risk refers to an absence of liquidity in an investment. Thus, liquidity risk implies that the investor may not be able to sell his investment when desired, or it has to be sold below its intrinsic value, or there are high costs to carrying out transactions. All of this affects the realisable value of the investment.
The market for corporate bonds in India is not liquid, especially for retail investors. Investors who want to sell a bond may not find a ready buyer. Even if there were a buyer, the price may be lower due to the lack of liquidity. Investments in property and art are also subject to liquidity risk, since identifying a buyer and determining the price is a lengthy process in the absence of frequent transactions. Some investments come with a lock-in period during which investors cannot exit the investment.
Investors can manage the liquidity risk by holding a diversified portfolio of securities so that their need for liquidity from their investments is taken care of by the liquid investments in the portfolio and not dependent on the illiquid securities.
Re-investment risk
Re-investment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. The risk is that intermediate cash flows may be reinvested at a lower return as compared to the original investment. The rate at which the re-investment of these periodic cash flows is made will affect the total returns from the investment. The reinvestment rates can be high or low, depending on the levels of interest rate at the time when the coupon income is received. This is the reinvestment risk.
- If Interest rate rises, reinvestment risk reduces or is eliminated
- If Interest rate falls, reinvestment risk increases
Choosing the cumulative option available in most debt investments is a way for investors to protect the investment from re-investment risk. In a marketable security, such as a bond, this may expose the bond to higher price volatility. Bond fund managers use strategies such as laddering the portfolio by holding securities of different maturities to manage these risks.
Business Risk
Business risk is the risk inherent in the operations of a company. It is also known as operating risk, because this risk is caused by factors that affect the operations of the company. Common sources of business risk include cost of raw materials, employee costs, introduction and position of competing products, marketing and distribution costs.
For example, consider a company that manufactures jute bags. Suppose the cost of jute,
which is the key raw material, increases, the company has to face higher operating costs, which it may or may not be able to pass on to its customers through higher selling prices. This is a risk specific to businesses that use jute as an input.
Holding a diversified portfolio of securities so that all investments are not affected by the same business risks is a way to manage this risk.
Exchange Rate Risk
Exchange rate risk is incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment is subject to exchange rate risk.
It must be noted that:
- If domestic currency depreciates (falls in value) against foreign currency, the value of foreign asset increases in terms of domestic currency and the value of domestic assets in terms of foreign currency decreases.
- If domestic currency appreciates (increase in value) against foreign currency, the value of foreign asset decreases in terms of domestic currency and the value of the domestic assets in terms of foreign currency increases.
Consider this example. An NRI based in the US invests $1000 in a bank deposit in India @10% for 1 year when the exchange rate is Rs. 60 per US$. After one year, the rupee depreciates and the exchange rate is Rs. 67 per US$. What is the risk to his investment if he decides to repatriate the money back?
The value of his investment has increased in rupee terms and declined in dollar terms as the rupee has depreciated against the dollar.
Initial Invested amount = US$1000 = Rs.60000
Interest earned = 10% x 60,000 = Rs. 6000
Investment value after one year = 60000+6000 = Rs. 66000
Investment value in dollar terms = 66000/67 = $985
Loss in investment value = $1,000 - $985 = $15
Although the deposit paid a nominal return of 10%, there was a loss in investment value, because the exchange rate depreciated by more than 10%.
Interest Rate Risk
Interest rate risk refers to the risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates.
Bond prices and interest rates have an inverse relationship. This can be explained with an example. An investor invests in a 5-year bond that is issued at Rs.100 face value, and pays an annual interest rate of 8%. Suppose that after one year, the Reserve Bank of India cuts policy interest rates. As a result, all rates in the markets start declining. New 5-year bonds are issued by companies with a similar credit rating at a lower rate of 7.5%. Investors in the old bonds have an advantage over investors in the new bonds, since they are getting an additional 0.5% interest rate. Since investors want to earn the maximum return for a given level of risk, there will be a rush of investors trying to buy up the old bonds. As a result, the market price of the old bond will increase. The price will rise upto a level at which the IRR of the cash flows from the old bond is about 7.5%. This will take place for all bonds until their yields are aligned with the prevailing market rate.
Suppose, instead, that policy rates are increased. New issuers of 5-year debt will be forced to offer higher interest rates of, say, 9%. Now investors in the new bonds will earn more than investors in the old bonds. As a result, holders of the old bonds (which pay only 8% interest) will try to sell off their holdings and try to buy the new bonds. This market reaction will push down the prices of the old bonds upto the level at which the IRR of its cash flows exactly matches the market rate.
The relationship between rates and bond prices can be summed up as:
- If interest rates fall, or are expected to fall, bond prices increase.
- If interest rates rise, or are expected to rise, bond prices decline.
Bond investments are subject to volatility due to interest rate fluctuations. This risk also
extends to debt funds, which primarily holds debt assets.
Market Risk
Market risk refers to the risk of the loss of value in an investment because of adverse price movements in the market. The price of an asset/investment responds to information that impacts the intrinsic value of an investment. For example, an increase in interest rates reduces the value of the cash flows from existing bonds and therefore leads to a fall in the price of bonds (interest rate risk), an appreciation in the currency reduces the earning expectations of export-oriented companies and leads to a fall in price (currency risk). Market risk affects those investments where transactions happen at current applicable prices, such as equity, bonds, gold, real estate, among others. Investments such as deposits or small savings schemes are not marketable securities and the investor gets a pre-defined amount on maturity. They have no market risk; but they also do not gain in value.
Systematic and Unsystematic Risk
Total risk consists of two parts. The part of risk that affects the entire system is known as systematic risk, and the part that can be diversified away is known as unsystematic risk.
Systematic risk or market risk refers to those risks that are applicable to the entire financial market or a wide range of investments. These risks are also known as undiversifiable risks, because they cannot be eliminated through diversification. Systematic risk is caused due to factors that may affect the economy/markets as a whole, such as changes in government policy, external factors, wars or natural calamities. Here are some examples.
- The 2008 financial crisis affected economic growth and led to depressed equity prices across all stocks. The RBIs move to increase interest rates in order to control inflation. This led to a fall in the prices of all bonds during that period.
- The depreciation of the rupee in 2013 increased the costs of imports into the country. It affected the profitability of all companies whose inputs involved imported commodities.
Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks. Inflation risk affects all investments, though its highest impact is on fixed rate instruments. All overseas investments are subject to exchange rate risk. Interest rate and reinvestment risk impact all debt investments.
Unsystematic risk is the risk specific to individual securities or a small class of investments. Hence it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk. Credit risk, business risk, and liquidity risks are unsystematic risks.
Unsystematic risks in a portfolio can be reduced by diversification. This means that the portfolio should hold investments whose risks and returns react differently to the same set of events. For example, when inflation is high and interest rates are increased to counter it, bond prices fall. But periods of inflation are positive for the price of gold.
Covariance and Correlation are statistical terms used to describe the relationship between two investments. Covariance tells you how the two are related, whether positively or negatively. Two investments are said to be positively related when their returns respond the same way to a given condition, i.e. go up or go down together. They are said to be negatively related when they move in opposite directions. A Covariance of 1.32 between two stocks indicates that they have a positive relationship and will move together in the same direction. A covariance of -.0267 indicates a negative relationship and movement in opposite directions.
Correlation gives the degree to which two variables (in this case investment returns) tend to move together, apart from whether they are positively or inversely related. The coefficient of correlation measures the interdependence between the two and ranges from -1 to 1, with -1 indicating perfect negative correlation and 1 indicating perfect positive correlation. In real situations, however, there are no perfect negative or perfect positive correlated assets. There are assets with low correlation with each other that can be combined in a portfolio to manage risk.
The following examples illustrate how an investment can be subject to both systematic and unsystematic risk.
a. Ajay invests in equity shares of an infrastructure company. He believes that the company will do well because of the growing demand for infrastructure, and the company’s strong technical and managerial capabilities. Ajay’s investment is subject to two main risks business risk and market risk. Ajay can reduce his business risk by investing in other companies operating in different sectors. But an economic slowdown would reduce the profitability of all companies. This is the market risk in equity investment that cannot be diversified.
b. Ashima is keen to invest in bonds issues. Her investment is subject to credit risk and interest rate risk. She can reduce credit risk by increasing the proportion of highly-rated bonds in her portfolio. However, if interest rates fall, then prices of all the bonds held by her will decline. This is the interest rate risk which is common to all debt investments.
Thanks for reading. We hope this was informative to you. Read Investment Related more articles.
- Fixed Income Investment. | All you need to know about fixed income instruments.
- Thinking of investing in Mutual Funds? Know about India's best performing Flexi Cap Mutual Funds SIP in 2021.
- Mutual Funds SIP. | All you need to know about Systematic Transactions.
- Post Office Savings Scheme | All you need to know about small saving schemes.
- What precautions you should take before investing in the stock market?
0 Comments