Types of risk

M. Com. Financial Engineering
TYPES OF RISK

Unfortunately, the concept of risk is not a simple concept in
finance.
There are many different types of risk identified and some types
are relatively more or relatively less important in different
situations and applications. In some theoretical models of
economic or financial processes, for example, some types of risks
or even all risk may be entirely eliminated.
For the practitioner operating in the real world, however, risk can
never be entirely eliminated. It is ever-present and must be
identified and dealt with.
TYPES OF RISK

There are a number of different types of risk the
been identified. It is important to remember,
however, that all types of risks exhibit the same
positive risk-return relationship.
Some of the most important types of risk are
defined in this presentation
POSITIVE RISK-RETURN
RELATIONSHIP

The risk of non-payment.
Measurement of it is not easy.
Many things can influence an issuer's default risk and in
varying degrees.
• poor or falling cash flow from operations ,
• rising interest rates , or
• changes in the nature of the marketplace
DEFAULT RISK

The uncertainty associated with the effects of changes in market interest rates.
There are two types of interest rate risk identified;
price risk and
reinvestment rate risk.
The price risk is sometimes referred to as maturity risk since the greater the
maturity of an investment, the greater the change in price for a given change
in interest rates.
Both types of interest rate risks are important in banking and are addressed
extensively in Bank Management classes.
Since interest rates directly affect discount rates and present values of future
cash flows represent underlying economic value, we have the following
relationships
INTEREST RATE RISK

The uncertainty associated with the impact that changing interest rates have
on available rates of return when reinvesting cash flows received from an
earlier investment. It is a direct or positive relationship.
For example, consider a Company XYZ bond with a 10% yield to maturity
(YTM). In order for an investor to actually receive the expected yield to
maturity, she must reinvest the coupon payments she receives at a 10% rate.
This is not always possible. If the investor could only reinvest at 4% (say,
because market returns fell after the bonds were issued), the investor's actual
return on the bond investment would be lower than expected.
REINVESTMENT RATE RISK

Also called systematic risk or non-diversifiable risk, relevant risk is the fluctuation of
returns caused by the macroeconomic factors that affect all risky assets. Diversifiable risk
is the risk of something going wrong on the company or industry level, such as
mismanagement, labour strikes, production of undesirable products, etc.
Relevant risk + Diversifiable risk = Total risk
Example:
Relevant risk is comprised of the “unknown unknowns” that occur as a result of everyday
life. It is unavoidable in all risky investments. Relevant risk can also be thought of as the
opportunity cost of putting money at risk.
For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of Deposit.
Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index.
If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are
demanding 9% to move their money from a risk-free investment to a risky equity investment.
RELEVANT RISK

The uncertainty associated with potential changes in the price of an asset
caused by changes in interest rate levels and rates of return in the economy.
This risk occurs because changes in interest rates affect changes in discount
rates which, in turn, affect the present value of future cash flows.
The relationship is an inverse relationship. If interest rates (and discount
rates) rise, prices fall. The reverse is also true.
PRICE RISK

The uncertainty associated with the ability to sell an asset on short notice
without loss of value.
A highly liquid asset can be sold for fair value on short notice. This is because
there are many interested buyers and sellers in the market.
An illiquid asset is hard to sell because there are few interested buyers. This
type of risk is important in some project investment decisions but is discussed
extensively in Investment courses.
LIQUIDITY RISK

The loss of purchasing power due to the effects of inflation. When inflation
is present, the currency loses it's value due to the rising price level in the
economy. The higher the inflation rate, the faster the money loses its value.
Two general theories explain inflation.
The first, the demand-pull theory, says that prices increase when demand for goods and
services exceeds their supply.
The second, the cost-push theory, says that companies create inflation when they raise
their prices to cover higher supply prices and maintain profit margins.
INFLATION RISK (PURCHASING
POWER RISK)

Within the context of the Capital Asset Pricing Model (CAPM), the economy
wide uncertainty that all assets are exposed to and cannot be diversified away.
Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk
of the market portfolio. This type of risk is discussed extensively in
Investment courses.
MARKET RISK

The uncertainty associated with the returns generated from investing in an
individual firm’s common stock. Within the context of the Capital Asset
Pricing Model (CAPM), this is the investment risk that is eliminated through
the holding of a well diversified portfolio. Often referred to as un-systematic
risk or diversifiable risk. This type of risk is discussed extensively in
Investment courses.
FIRM SPECIFIC RISK

Economic risk is the chance that macroeconomic conditions like exchange
rates, government regulation, or political stability will affect an investment,
usually one in a foreign country.
How It Works/Example:
For example, let's assume American Company XYZ invests $1,000,000 in a
manufacturing plant in the Congo. Aside from the business risk associated
with making the plant profitable, Company XYZ is exposed to economic risk.
The political environment could shift quickly, perhaps prompting the
Congolese government to seize the plant or significantly change laws that
affect Company XYZ's ability to operate the plant.
Likewise, hyperinflation could make it impossible to pay workers, or exchange
rate circumstances could make it unprofitable to move profits out of the
country.
ECONOMIC RISK

Downside risk is the probability that an asset will fall in price. It is also the
measure of the possible loss from that decline.
How It Works/Example:
Let's assume an investor owns 1,000 shares of Company XYZ and she's
paid $100,000 to own that stock. Because the stock price could theoretically
fall to zero under the right economic conditions, the downside risk of the
investment is 100% or $100,000.
Hedging is an attempt to limit the downside risk of an investment. In our
example, the investor might purchase a put option on the shares, meaning
that she has the right to force the counterparty to buy the Company XYZ
shares for a certain price. That way, the investor can obtain at least a
minimum amount for the shares and thus limit her downside risk.
DOWNSIDE RISK

In the advanced capital budgeting topics, the total risk associated with an
investment project.
Also referred to as stand-alone project risk.
In advanced capital budgeting, project risk is partitioned into systematic and
un-systematic project risk.
PROJECT RISK

The uncertainty brought about by the choice of a firm’s financing methods
and reflected in the variability of earnings before taxes (EBT), a measure of
earnings that has been adjusted for and is influenced by the cost of debt
financing. This risk is often discussed within the context of the Capital
Structure topics.
FINANCIAL RISK

The uncertainty associated with a business firm's operating environment and
reflected in the variability of earnings before interest and taxes (EBIT).
Since this earnings measure has not had financing expenses removed, it reflect
the risk associated with business operations rather than methods of debt
financing.
BUSINESS RISK

Uncertainty that is associated with potential changes in the foreign exchange
value of a currency.
There are two major types:
translation risk and
transaction risks.
For example, let's assume XYZ Company is a Canadian company and pays
interest and principal on a $1,000 bond with a 5% coupon in Canadian dollars.
If the exchange rate at the time of purchase is 1:1, then the 5% coupon
payment is equal to $50 Canadian, and because of the exchange rate, it is also
equal to US$50. Now let's assume a year from now the exchange rate is 1:0.85.
Now the bond's 5% coupon payment, which is still $50 Canadian, is worth
only US$42.50.
FOREIGN EXCHANGE RISKS

Uncertainty associated with the translation of foreign currency denominated
accounting statements into the home currency.
TRANSLATION RISKS

Uncertainty associated with the home currency values of transactions that
may be affected by changes in foreign currency values.
TRANSACTIONS RISKS

While there are many different types of specific risk, we said earlier that in the
most general sense, risk is the possibility of experiencing an outcome that is
different from what is expected.
If we focus on this definition of risk, we can define what is referred to as
total risk. In financial terms, this total risk reflects the variability of returns
from some type of financial investment.
TOTAL RISK

Obsolescence risk is the risk that a company's product or service will become
obsolete or out of date.
Example:
For example, consider the fax machine. Once a symbol of modern
communication, the fax machine was one of the first ways to share
information almost instantaneously. Manufacturers of fax machines, fax paper,
fax toner, and fax transmission services faced obsolescence risk with the
advent of increased internet bandwidth, text messaging, PDF technology, and
e-mail use. Eventually, the technology became obsolete as fax machine users
migrated to cheaper, faster, more efficient methods.
OBSOLESCENCE RISK

The standard deviation is often referred to as a "measure of total risk"
because it captures the variation of possible outcomes about the expected
value (or mean).
In financial asset pricing theory there is a pricing model (Capital Asset Pricing
Model or CAPM) that separates this "total risk" into two different types of
risk (systematic risk and unsystematic risk).
Another related measure of total risk is the "coefficient of variation" which is
calculated as the standard deviation divided by the expected value. The
following notes will discuss these concepts in more detail
MEASURES OF TOTAL RISK

Types of risk

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Types of risk