Compiled by Parshva Shah
What is Risk:
Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk measures the uncertainty that a businessman is willing to take to realize a gain from his/her business. Risk is the probability that actual results will differ from expected results.
Types of Risk
Systematic risk occurs due to macroeconomic factors. It is also called market risk or non-diversifiable or volatility risk as it is beyond the control of a specific company or individual and hence, can’t be diversified.
Systematic risk impacts the entire industry rather than a single company or security.
Types of Systematic Risk
Market risk is caused by the herd mentality of investors, i.e., the tendency of investors to follow the direction of the market. If the market is declining, then even the share prices of good-performing companies fall. Market risk constitutes almost two-thirds of total systematic risk.
Interest Rate Risk
Interest rate risk arises due to changes in market interest rates. In the stock market, this primarily affects fixed income securities because bond prices are inversely related to the market interest rate. In fact, interest rate risks include two opposite components: Price Risk and Reinvestment Risk. Both of these risks work in opposite directions. Price risk is associated with changes in the price of a security due to changes in interest rate. Reinvestment risk is associated with reinvesting interest/ dividend income.
Purchasing Power Risk (or Inflation Risk)
Purchasing power risk arises due to inflation. Inflation is the persistent and sustained increase in the general price level. Inflation erodes the purchasing power of money. Therefore, if an investor’s income does not increase in times of rising inflation, then the investor is actually getting lower income in real terms. Fixed income securities are subject to a high level of purchasing power risk because income from such securities is fixed in nominal terms.
Exchange Rate Risk
In a globalized economy, most companies have exposure to foreign currency. Exchange rate risk is the uncertainty associated with changes in the value of foreign currencies. Therefore, this type of risk affects only the securities of companies with foreign exchange transactions or exposures such as export companies, MNCs, or companies that use imported raw materials or products.
Calculation of Systematic Risk (β)
Systematic risk can be captured by the sensitivity of a security’s return with respect to the overall market return. This sensitivity can be calculated by the β (beta) coefficient. The β coefficient is calculated by regressing a security’s return on market return. The estimated equation is given below:
The value of β can be calculated using the following formula:
The value of β can be calculated using the following formula:
Unsystematic risk is unique to a given business or industry. It is also known as specific risk, non-systematic risk, residual risk, or diversifiable risk.
Unsystematic risk is caused due to internal factors; it can be avoided and controlled. Unsystematic risk can be minimised by diversification in the sense of an investment portfolio.
Unsystematic risk can be described as the uncertainty inherent in a company or industry investment. Examples of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, or a product recall.
While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks. For instance, an investor in healthcare stocks may be aware that a major shift in health policy is on the horizon, but may not fully know the particulars of the new laws and how companies and consumers will respond.
Types of Unsystematic Risk
Both internal and external issues may cause business risk. Internal risks are tied to operational efficiencies, such as management failing to take out a patent to protect a new product would be an internal risk, as it may result in the loss of competitive advantage. The Food and Drug Administration (FDA) banning a specific drug that a company sell is an example of external business risk.
Financial risk relates to the capital structure of a company. A company needs to have an optimal level of debt and equity to continue to grow and meet its financial obligations. A weak capital structure may lead to inconsistent earnings and cash flow that could prevent a company from trading.
Operational risks can result from unforeseen or negligent events, such as a breakdown in the supply chain or a critical error being overlooked in the manufacturing process. A security breach could expose confidential information about customers or other types of key proprietary data to criminals.
A strategic risk may occur if a business gets stuck selling goods or services in a dying industry without a solid plan to evolve the company’s offerings. A company may also encounter this risk by entering into a flawed partnership with another firm or competitor that hurts their future prospects for growth.
Legal and Regulatory Risk
Legal and regulatory risk is the risk that a change in laws or regulations will hurt a business. These changes can increase operational costs or introduce legal hurdles. More drastic legal or regulation changes can even stop a business from operating altogether. Other types of legal risk can include errors in agreements or violations of laws.
Unsystematic Risk vs. Systematic Risk
Unsystematic risk is related to a specific industry, segment, or security, while Systematic risk is the loss associated with the entire market or the segment.
- Unsystematic risk is due to internal factors and can be controlled or reduced. Systematic risk, on the other hand, is uncontrollable.
- Unsystematic risk affects a specific company’s stock, while systematic risks impact almost all securities in the market.
- We can remove unsystematic risk using diversification. However, one can control systematic risks using only hedging and asset allocation methods.
We must have heard about the different types of risk which are mentioned above. In our day-to-day activities, managers generally forget about the systematic and unsystematic risk. So, to be aware about the above risk of business, you should have a regular exercise control or good business consultant to highlight you about the business risk.