CONCEPT AND TYPES OF RISK - Accounts and Finance for Managers

  • The variability of the actual return from the expected return which is associated with the investment / asset known as risk of the investment.
  • Variability of return means that the Deviation in between actual return and expected return which is in other words as variance i.e., the measure of statistics.
  • Greater the variability means that Riskier the security/ investment.
  • Lesser the variability means that More certain the returns, nothing but Least risky e.g. Treasury Bills, Savings Deposit.

The risk can be further classified into six different categories

  • Interest rate risk
  • lInflation risk
  • Financial risk
  • Market risk
  • Business risk and
  • Liquidity risk

Interest Rate Risk

  • It is risk – variability in a security's return resulting from the changes in the level of interest rates.
  • Security prices - inverse relationship with
    • Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50 points to 6 points; change in the rate of interest - change in the prime lending rate of the banks - Due to Rs. 14,000 cr. amount to be deposited in the Reserve Bank of India by the Banks - to curtail the Inflation

Impact on the Security Prices

  • If the rate of interest increases then the price of the existing securities will come down due to more attraction on the new instruments due to lesser demand on the existing securities more particularly during the periods of inflationary period
  • If the rate of interest decreases means that the price of the existing securities will go up due to lesser attraction on the new investment avenues which are found to be greater demand for new securities during the periods of deflationary period.

Market Risk

  • It refers to variability of returns due to fluctuations in the securities market which is more particularly to equities market due to the effect from the wars, depressions etc.
  • E.g., Greater/lesser investments by the mutual funds, banks, Foreign institutional investors and so on due to entry into or out of the market reflects the market - index is the market risk.

Inflation Risk

  • Rise in inflation leads to Reduction in the purchasing power which influences only few people to invest due to
  • Interest Rate Risk which is nothing but the variability of return of the investment due to oscillation of interest rates due to deflationary and inflationary pressures.

Business Risk

Risk of doing business in a particular industry / environment is known as business risk. Business risk is nothing but Operational risk which arises only due to the presence of the fixed cost of operations. The Higher the fixed cost of operations requires the firm to have Greater BEP to avoid the firm to incur losses. It is normally transferred to the investors who invest in the business or company, the major reason is that EBIT of the firm is subject to the fixed cost of operations.

Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preference share capital. More the application of fixed charge of financial will lead to Greater the financial Risk which is nothing but the Trading on Equity.

Liquidity Risk

  • This is the risk pertaining to the secondary Market, in which the securities can be Bought and sold quickly and without any concession in the price.

Liquidity risk reflects only due to the quality of benefits with reference to certainty of return to receive after some period which is normally revealed in terms of quality of benefits. The more the certainty of benefits leads to lesser the liquidity risk and vice versa.
The government & Treasury bills are bearing greater certainty to receive the benefits which have least probabilities to fail, denominates that is Lesser Liquidity Risk.
The Equity shares of the companies are bearing the Greater Liquidity Risk is subject to the quality of benefits, due to the declaration of dividends, which is subject to the availability of earnings i.e., EBIT, EAT, EPS and DPS; which are nothing but the determinants of Demand and supply them in the market among the investors.

Measurement of Risk

Measurement of Risk

The first one is that sensitivity analysis taken for discussion. It considers all possible outcomes/return estimates in evaluating risk to study the deviation of the expected returns which is nothing but the Sense of Variability among return estimates.

It is being studied through the classification of the span of the investments into following categories viz pessimistic, most likely and optimistic. The above set of classifications are on the basis of cycle of the industry or product which it belongs or markets the product.

The next one is to highlight the risk component through the sensitivity analysis

Measurement-of-Risk

The risk is nothing but the difference in between the optimistic and pessimistic returns, in other words range of the returns. The range of the returns is nothing but the difference in between highest and lowest returns which normally arise during the periods of boom and recession. The greater the range refers to the greater the amount of risk and vice versa. From this table we identify that Asset B is found to be more risky than the asset A, the reason is higher rang in the case of Asset B unlike Asset A; which highlights the difference in between the returns of optimistic and pessimistic. This method is found to be a crude method in studying the risk of the securities.

To nullify the bottlenecks associated with the sensitivity analysis, probability distribution is considered for the discussion of risk to study more in detail than the earlier sensitivity analysis. The probabilities are assigned to reveal the possibilities of occurrence of the event which ranges in between 1-100% of occurring.
If it is certain to occur means that P= 1
If is not certain to occur means that Q = 1

Based on the probabilities, the expected return of the investment could be found out through the multiplication of the respective returns of the horizon which in relevance with possibility of occurrences.
Expected rate of return of the security is as follows :- it is weighted average of all possible returns multiplied by the respective probabilities.
Probabilities of various Outcomes during the various seasons are known as weights
K × P

The risk can be determined through the statistical measure of dispersion of returns of an Risk and expected value of return of the security.

  • Risk is the Standard deviation of returns from the mean/expected value of return
  • Square root of squared deviations of the individual expected returns
    (å(K–K)2 × P)1/2

Standard Deviation:

  • Greater the standard deviation - Greater the risk
  • Does not consider the variability of return to the expected value
  • This may be misleading - if they differ in the size of expected values

In order to replace the bottlenecks associated with the standard deviation in studying the risk of the security, the co-variation is suggested to study the risk of the security

  • It is a measure of dispersion / measure of risk per unit of expected return
  • It converts the standard deviation of expected values into relative values to enable comparison of risks with assets having different expected values.
Coefficient of variation=
S.D
Mean



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