RISK MANAGEMENT : CONCEPT, SOURCES & TYPES OF RISK

RISK MANAGEMENT : CONCEPT, SOURCES & TYPES OF RISK

Risk in holding securities is genrally associated with possibility that realized returns will be less than the returns that were expected. Forces that contribute to variations in return price or dividend/interest constitute elements of risk. Some influences are external to the firm, cannot be controlled, and affect large numbers of securites. Other influences are internal to the firm and are controllable to a large degree.
In investments, those forces that are uncontrollabe, external and borad in their effect
are called sources of systematic risk. Conversely, controllable internal factors somewhat peculiar toindustries and/or firms are refereed to as sources of unsystematic risk.


Systematic Risk

Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are sources of systematic risk.
Their effect is to cause prices of nearly all individual common stocks and/or all indivdidual bonds to move together in the same manner. For example, if the economy is moving toward a recession and corporate profits shift downward, stock prices may decline across a broad front.
On the average, 50 percent of the variation in a stock’s price can be explained by variation in the market index. In other words, about one-half the total risk in an average common stock is systematic risk. Systematic risk includes:

Market Risk
Maket risk is caused by investor reaction to tangible as well as intangible events. Expectaitions of lower corporate profits in general may cause the larger body of common to fall in price.
The basis for the reaction is a set of real, tangible events political, social, or economic.
Intangible events are related to market psychology
Interest-Rate Risk
Interest-rate risk refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates.
Purchasing-Power Risk
Market risk and interest-rate risk can be definded in terms of uncertainties as to the amount of current dollars to be received by an investor. Purchasing-power risk is the uncertainityof the purchasing power of the amounts to be received. In more everyday terms, purchasing-power risk refers to the impact of inclation or deflation on an investment.

Unsystematic Risk

Unsystematic risk is the portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securites markets in general. Factors such as management capability, consumder preferences, and labor strikes can cause unsystematic variability of returns for a company’s stock. Because these factors affect one industry and/or one firm, they must be examined separately for each company.
Unsystematic risk includes:
Business Risk
Business risk is a function of the operating conditions faced by a firm Business risk can bedivided into two broad categories: external and internal.
Internal business risk is largely asociated with the efficiency with which a firm conducts its operations with in the broader operating environment imposed upon it. Each firm has its own set of internal risks, and the degree to which it is successful in coping with them is reflectedin operating efficienty.
External business riskis the result of operating conditions imposes upon the firm by circumstances beyond its control. Each frim also faces its own set of external risks, depending upon the specific operating environmental factors with which it must deal.

Financial Risk
Financial risk is associated with the way in which a company finaces its activities. We usually gauge finacial risk by looking at the capital structure of a firm. The presence of borrowed
money of debt in the capital structure creates fixed payment in the form of interest that must be sustained by the firm..
Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk. By engaging in debt financing, the firm changes the characteristic of the earnings stream available to the common-stock holders.
Speciafically, the reliance on debt financing, called financial leverage, has at three important effects on common-stock holders. Debt financing
(1) increases the variability of their returns,
(2) affects their expectations concerning their returns,and
(3) increases their risk of being ruined.

Can we Reduce the Risk Exposure?

Every investor wants to guard himself from the risk. This can be done by understanding the nature of the risk and careful planning.

Market Risk Protection
(a.)The investor has to study the price behaviour of the stock. Usually history repeats itself even though it is not in perfect form. The stock that shows a growth pattern may continue
to do so for some more period.
(b.) The standard deviation and beta are available for the stocks that are included in the indices. The National Stock Exchange News bulletin provides this information.
Looking at the beta values, the investor can gauge the risk factor and make wise decision according to his risk tolerance.
Further, the investor should be prepared to hold the stock for a period of time to reap the benefits of the rising trends in the market. He should be careful in the timings of the purchase and sale of the stock. He should purchase it at the lower level and should exit at a higher level.

Protection Against Interest Rate Risk
(a.) Often suggested solution for this is to hold the investment sells it in the middle due to fall in the interest rate, the capital invested would experience tolerance.
(b.) The investors can also buy treasury bills and bonds of short maturity. The portfolio manager can invest in the treasury bills and the money can be reinvested in the market to suit the prevailing interest rate.
(c.) Another suggested solution is to invest in bonds with different maturity dates. When the bonds mature in different dates, reinvestment can be done according to the changes in the investment climate. Maturity diversification can yield the best results.

Protection Against Inflation
(a.) The general opinion is that the bonds or debentures with fixed return cannot solve the problem. If the bond yield is 13 to 15 % with low risk factor, they would provide hedge
against the inflation .
(b.) Another way to avoid the risk is to have investment in short-term securities and to avoid long term investment. The rising consumer price index may wipe off the real rate of interest in the long term.
(c.) Investment diversification can also solve this problem to a certain extent. The investor has to diversify his investment in real estates, precious metals, arts and antiques along with
the investment in securities. One cannot assure that different types of investments would provide a perfect hedge against inflation. It can minimise the loss due to the fall in the purchasing power.

Protection Against Business and Financial Risk
(a.) To guard against the business risk, the investor has to analyse the strength and weakness of the industry to which the company belongs. If weakness of the industry is too much of government interference in the way of rules and regulations, it is better to avoid it.
(b.) Analysing the profitability trend of the company is essential. The calculation of standard deviation would yield the variability of the return. If there is inconsistency in the earnings, it is better to avoid it. The investor has to choose a stock of consistent track record.(c.) The financial risk should be minimised by analysing the capital structure of the company. If the debt equity ratio is higher, the investor should have a sense of caution. Along with the capital structure analysis,. he should also take into account of the interest payment. In a boom period, the investor can select a highly levered company but not in a recession