Posted by The growth in the financial markets has been impacted by major developments in information technology, resulting in automation of trading systems and settlement processes. This has facilitated faster transactions with capital flows across continents. Globalization of economies and free trade has resulted in increased interlinkages. Advent of sophisticated financial instrument has increased risk for the market participants.
Global commodity prices have a direct impact on commodity prices in India. Increase in consumption of food grain coupled with a decrease in production resulted in increased price of essential commodities in 2008. Fluctuations in Gold prices in London markets have a direct impact on the gold prices in India. Similarly, if the US economy is undergoing a recessionary period with negative GDP growth rate, then there is a direct impact on the Information Technology (IT) and Business Process Outsourcing (BPO) industry in India. This is because the IT and BPO industry is dependent on revenues provided by clients in developed markets. This has resulted in increased risk for the shareholder in India. The earnings of the Indian IT companies are impacted by the global economic downturn affecting markets since 2008. This has translated risk across different geographies, countries and continents. Volatility in currency markets has also resulted in increased exposure to risk.
Risk is the extent of uncertainty associated with the outcome of an event. In other words, it is the chance / probability that an investment’s actual return will be different than that which is expected. This includes the possibility of losing some or all of the original investment in a financial product / instrument. For example, assume that you were tossing a Rs. 1 Coin. The chance that the toss of the coin would return a “Head” or “Tail” is supposed to be equal. We cannot say for certain that the toss of the coin would result in a “Head” or a “Tail”. There is a certain amount of risk associated with the uncertainty of the outcome.
In financial market, risk is associated with the extent of uncertainty of asset prices remaining the same. This fluctuation in asset prices is usually referred to as volatility. Risk can be measured by calculating the volatility of asset / portfolio prices.
Understanding Risk and Return
The risk-return tradeoff refers to the fact that potential return rises with an increase in risk.
Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can result higher profits, only if it is subject to the possibility of losing the invested capital. In other words, when a trader or investor seeks higher returns, he may invest in assets / instruments that have potentially higher volatility or risk.
Because of the risk-return tradeoff, an investor should be aware of his/her personal risk tolerance (risk appetite or potential to take risk) when choosing investments for his/her portfolio. Let us assume that risk is the price of achieving returns. If a trader or investor wants to begin high returns, he/she cannot avoid the uncertainty associated with risky assets. The goal instead is to find an appropriate balance – one that generates some profit but still provides reasonable protection for the invested capital. Deciding what amount of risk, you can take while remaining comfortable with your investments is very important.
Example of Risk Return Trade-off: Consider an index fund that gives an average of 12% return in the long run. Alternatively, the return on Government Securities is considered as the risk-free rate because there is no probability of default. If the risk-free rate is currently 8%, this means that with virtually no risk, we can earn at least 8% per annum on the amount invested.
A common question arises: Who wants to earn 8%, when index funds average returns of 12% per annum over a longer time period? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds may not be consistently 12% every year; but on the other hand, may be 10% in the first year, +25% in the second year, etc. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a Government Security. We call this additional return as the “risk premium”, which in the prior mentioned example, is 4% (i.e., 12% – 8%).
Risk tolerance differs from one individual to another. Your decision will depend on your goals, income and personal situation, among other factors.
Inverse Relationship between risk and Return: If an investor invests in assets or securities that have high risk due to price volatility, then then investor would automatically expect a higher return. The reason for this is that investors need to be compensated for taking on additional risk.
For example, a US Treasury bond is considered to be one of the safest investments. When compared to a corporate bond, the treasury bond gives a lower rate of return. The reason for this is that a corporate is more likely to go bankrupt than the US Government. Because the risk of investing in a corporate bond is higher, investors automatically expect a higher rate of return.
Thus, for less risky assets or securities, the returns may be less, but the possibility of default is also usually minimal.
Risk Appetite: There are three types of investors based on the risk-taking capacity or risk appetite, namely.
1- Risk-Averse Investor: A risk averse investor is one who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. A risk-averse investor is not comfortable investing in risk-prone assets. Thus, such an investor stays away from adding high-risk stocks or investments to his portfolio. They do not mind losing out on higher rates of return but consider capital protection as their primary objective. They are happy to obtain lower returns by investing in safer/risk-free instruments.
Investors, who value safety of capital over everything else, usually prefer to invest in government bonds, treasury bills, post office savings deposits, etc. These avenues of investment generally give lower returns.
2- Risk-Taker: As the name suggests, a risk taker is an investor who is willing to take on additional risk for an investment that has a relatively low expected return. This contracts with the typical investor mentality – risk aversion. Risk-Averse investors tend to take on increased risks only if these are warranted by the potential for higher returns.
There is always a risk/return tradeoff in investments. Lower returns are usually associated with investment in assets that have low risk. Higher returns are associated with investments in assets that have risk profile. Usually, investors expect to be compensated for taking on additional risk.
3- Risk-Neutral Investor: A description of an investor who purposefully overlooks risk, when deciding between investments is commonly referred to as a risk-neutral investor. A risk neutral investor is only concerned with an investment’s expected return.
Types of Risk in the Financial System
We have observed that greater is the risk associated with a financial investment, higher should be the returns obtained. Thus, the risk premium or the return obtained over and above the risk-free rate of return should be proportional to the extent of risk. But there are different types of risk in the markets. It is important to understand the different types of risk in order to analyze if the return is commensurate to the extent of risk associated with the investment. Risk in the financial system can be broadly classified as follows:
1- Systematic Risk: In financial markets, those forces that are uncontrollable, external and broad in their effect are usually referred to as sources of systematic risk. Systematic risk refers to that portion of total variability in returns caused by factors affecting the prices of all securities. Economic, political and sociological changes are source of systematic risk. Their overall effect is on the entire equity market. Some of the sources of systematic risk in equity markets are market risk, interest rate risk and purchasing-power risk.
2- Unsystematic Risk: On the other hand, controllable and internal factors which are specific to industries or companies are usually referred to as source of unsystematic risk. It is the portion of the risk that is unique to a firm or industry. They are independent of factors affecting the equity markets in general. Unsystematic factors need to be analyzed for the specific firm. Unsystematic variability of returns may also arise from changing consumer preferences, extent of capability and competence of the top management, labor dispute leading to strike, etc. Such factors are usually unique to a particular company of industry and need to be analyzed separately. Some of the major sources of unsystematic risk includes:
- Business Risk – related to operating environment of the business. For example, increase in raw material costs or production expenses can include high variability in company’s operating profit. This degree of variation of the expected operating profit is the measure of business risk. Once again, the business risk may be due to internal source or external factors.
- Financial Risk – This is associated with the way in which a company finances its activities – for example, mis of debt, equity, etc.
Let us try to understand the different types of systematic and unsystematic risk in financial markets. We shall discuss market risk, credit risk, operational risk, and liquidity risk, which are usually the major sources of concern for banks, financial institutions, corporate in general and equity markets in particular:
Market Risk – The potential for an investor to incur losses due to the fluctuation in prices of assets is usually referred to as Market Risk. Market Risk as indicated above, is also known as systematic risk. This risk results from the characteristic behavior of an entire market or asset class. If for example, there is a decline in rainfall during monsoon season, this can adversely affect not only the rural population, but also urban areas. Farmers depend on monsoon rains for growing crops have less disposable income due to monsoon failure. The prices of essential commodities can increase, leading to a strain in the budget for the middle-class household in urban areas. This can have a potential cascading effect on stock prices, due to lower demand for specific goods – for example, demand for automobiles, consumer goods (durable and non-durable), etc. can be impacted. This will eventually lead to lower share prices due to decreasing earnings.
Asset allocation is generally considered an antidote for market risk, since if the portfolio includes multiple asset classes, it tends to be less vulnerable to a downturn in any one class, supposedly reducing the extent of risk associated with price fluctuations.
Credit Risk – The risk that a loss will be experienced because of a default by the counterparty in a transaction is usually referred to as credit risk. There may be a risk that an issuer of corporate debt securities or a borrower may default on his obligations, or that the payment may not be made on a negotiable instrument – thus, giving rise to credit or counterparty default risk. The system of credit rating has evolved to mitigate this type of risk. Nevertheless, when Lehman Brothers decided to file for bankruptcy protection, this led to a series of defaults across the entire financial system, due to the huge exposure taken by Lehman Brothers in the OTC derivatives markets.
Operational Risk – The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events is usually referred to as Operational risk. Basel II norms have been stipulated for providing risk-based capital for banks. Basel II stipulates the requirement for banks to provide for operational risk within their business operations. This has transformed the perspective with which risk has been assessed. This is all the more important because, operational risk can in turn to market risk and credit risk.
Thus, operating risk may come from mundane sources such as incompetent personnel or miscommunication between a buyer and seller, or it may stem from events beyond a firm’s control, such as terrorism, damage to goods in transport, or even a sudden drop in demand. Because it is not (primarily) financial, it is the most difficult type of risk to quantify. Sometimes, operating risk are predictable, for example, a farmer can prepare for a drought that would harm his/her harvest and therefore profits. On the other hand, risk from an employee’s fraud is often impossible to anticipate. Consultancies often offer operating risk management, identifying and attempting to eliminate it as much as possible.
Liquid Risk – This risk associated with lack of available counterparties to liquidate outstanding positions in securities of any other asset is referred to as “liquidity risk”. Usually, over-the-counter markets have extensive liquidity risk, due to the customized nature of contracts.
