The Concept and Measurement of Risk
However, an investment’s performance does not only depend on the level of returns but also on the level of risk associated with it. Therefore, it is necessary to consider investment return and risk together. Risk” is a term carrying different meanings to different parties. For example, a motorcyclist is exposed to the risk of accident, a player is exposed to the risk of losing the game and an investor is exposed to the risk of losing her/his investment or the risk of earning less than what had been expected.
But one common element in all these outcomes is that the risk is undesirable, hence everybody tries to avoid it. The risk is defined as the variability of returns. In other words, it is the chance that an investment will fail to generate the returns as expected.
At the outset, we must récognize that there is a close relationship between expected return and risk. An investor expects a higher return from the risky investment as compared to a less risky investment. If a more risky investment offers the same level of return as a less risky investment, there is no incentive for investors to assume a higher risk.
In this situation, the investor finds no reason to put her/his capital at risk. Instead, she/he prefers to invest in less risky investments offering the same return. Therefore, additional return on risky investment above the less risky investment works as a stimulus to induce investment for assuming a higher risk.
Investment theory assumes that investors are generally risk-averse. A risk-averse investor is one who prefers a higher return for a given level of risk or lower risk for a given level of return. This preference holds true for many investors because there is a positive trade-off between risk and return-higher the risk higher should be the expected return an investment should offer. In this section, we discuss the major sources of risk along with the measurement and assessment of investment risk in the context of a single asset. Finally, we discuss how the return and risk are considered together in making an investment decision.
Sources Of Risk
There are more than one sources of risk that affect the investment return. As we have discussed, the required rate of return is the combination of the risk-free rate and risk premium. The level of risk premium depends on the level of risk associated with an investment. The higher the risk higher will be the risk premium. The risk premium required for investment results from the combined effect of different sources of risk. The major sources of risk are as follows:
Return on investment varies due to the number of factors such as variability In demand, price of the product and cost of Inputs, economic condition, market competition, and so on. These are the inherent attributes in the operation of the business. These attributes cause the variation between realized return and expected return on Investment and in the return over years. Business risk is the variation in the return due to the inherent attributes of the operation of a firm. So, thus ls called operating risk also.
The level of business risk varies across the industry. For example, the business risk experienced in the automobile industry is different from that experienced in the textile industry. However, firms within the same industry are supposed to have similar business risks although risk among the firms varies depending on the managemenť’s efficiency, economies of scale, cost-efficiency, ability to price adjustment, level of fixed operating costs, and so forth.
Firms finance their assets by both equity capital and debt capital. The use of borrowed capital to finance the assets by a firm increases the chances of variability in its return. A firm that uses higher debt has more fixed obligations to pay interest as committed and repay the principal at maturity. Such a firm has more chance to experience financial difficulties because the firm may not generate sufficient cash to pay fixed obligations.
Therefore, a firm using borrowed capital experiences an additional risk that it may be unable to cover fixed obligatory payments. Such risk is known as a financial risk. If a firm only uses equity, the risk to investors is business risk? In addition, if the firm also uses borrowed capital, the additional risk to investors above business risk is the financial risk.
PURCHASING POWER RISK:
Purchasing power risk is the risk caused by a change in the general price level In the economy. This risk is related to inflation. Higher inflation erodes the purchasing power of money. In an inflationary economy, it is possible that the return from an investment is not sufficient even to cover the loss in purchasing power due to inflation. For example suppose we invest at 5 percent return, but the rate of inflation in the economy is 7 percent. In this situation, although we generate 5 percent return on the investment, the purchasing power of our wealth at the end will decrease as compared to the beginning due to higher rate of inflation.
The purchasing power risk varies across the type of investment vehicles. For example, fixed income securities like bonds and preferred stocks are exposed to higher purchasing power risk because they provide a fixed income irrespective of the level of inflation in the economy. Therefore, the holders of bonds and preferred stock experience higher loss if the rate of inflation increases. On the other hand, common stock investment is less exposed to purchasing power risk because the return on common stock investment generally follows the intlationary movement in the economy.
INTEREST RATE RISK:
Interest rate risk arises due the change in market interest rate. It is the risk that the value of an investment may adversely be affected due to the change in interest rate in the market. Such risk is more common to the fixed income securities like bonds and preferred stocks. For example, suppose you are holding a bond issue since last two years that pays you 8 percent annual interest.