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