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:

 BUSINESS RISK:

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.

FINANCIAL RISK:

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.

 Many investors tend to sell old bonds paying lower rates in the past. They prefer to buy new because the new bonds offering a higher rate of interest are now attractive to them. As a result, the value of the old bond declines. The opposite happens when the market interest rate declines. In this case, the old bond remains attractive as it is paying a rate of interest since the past that is higher than the current market interest rate.
Theré is two aspects of interest rate risk: maturity risk and reinvestment risk. Maturity risk is common for long-term securities, which arises if the interest rate increases. Reinvestment risk is associated with short-term securities, which results due to the decline in the market interest rate. If you invest in long-term fixed-income securities, for example, your investment is tied up for a longer period of time at a promised fixed rate of interest.
If the market interest rate increases, you cannot have the opportunity to use your funds at a current higher rate of interest, which you would otherwise have if your investments were for the short-term. Thus, the value of long-term securities declines with the increase in the market interest rate. This is called maturity risk and is common for long-term securities. On the other hand, if you invest for the short-term, you face reinvestment rate risk which arises due to the decline in the market interest rate.
For example, suppose you invested for one year at an interest rate of 7 percent. After one year, your investment matures, But if the interest rate, when your investment matures, declines to 5 percent, you are compelled to reinvest your money at the new lower market interest rate. If instead, you would have invested for the long-term, you would be able to lock in a higher interest rate. Thus, short-term investments are exposed to reinvestment risk.

LIQUIDITY RISK:

Liquidity risk is associated with the marketability of securities.  Highly marketable securities are those which can be sold quickly at a reasonable price. On the other hand, it is difficult to sell less marketable securities quickly. Investors might have to offer larger price discounts to sell less liquid securities quickly. Thus, liquidity risk refers to the risk of being unable to sell securities quickly at a reasonable price.
The securities issued by a government are considered to be highly liquid. Similarly, the securities issued by large and well-established firms have the broad and active market so that they are easily marketable. Conversely, the securities issued by small and new firms may be less liquid.

MARKET RISK:

The value of an investment may be adversely affected because of some market forces independent of a firm. For example, political events, socio-economic changes, legislative changes, changes in government’s fiscal and monetary policy, changes in customers’ tastes and preferences, changes in technology, nature of market competition, and so forth, are some of the market forces which cause the rate of return on investment to vary adversely.
The risk that the value of an investment is adversely affected due to the changes in these factors is called market risk. The factors that cause market risk cannot be controlled by an individual firm or investor. For example, changes brought about by political events in a country have a greater impact on the country’s business environment which affect all firms and investors operating in the economy

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