In the context of stock investments, risk can be broadly divided into two major
categories:
I. Systematic Risk
II. Unsystematic Risk - Diversifiable Risk
Systematic Risk
Systematic risk affects all the stocks in the market in general. In other words,
the possibility exists that the financial markets will drop in value and create
a ripple effect in your portfolio. While one cannot avoid this risk, by careful
selection of stocks in various industries this risk can be minimized to a great
extent. We will discuss risk reduction in a portfolio context in the next chapter.
The contributing factors to systematic risk include:
Interest Rate Risk: Interest rates are an important tool for the monetary
policy of a country and hence have tremendous impact on economic growth, which
is also reflected in stock prices. With lowering of interest rates, economic
growth is triggered thus translating in higher earnings prospects for the
companies. Also, risk free rate is an important input in any asset valuation
model and a decrease in risk free interest rates reduces the discount rate
for asset valuation thus increasing the Fair Market Value. An increase in
interest rates can typically result in depressed stock prices across the board.
Currency Risk: Refers to possible fluctuations in currency exchange rates
with currencies in rest of the world.
Inflationary Risk: The possibility that general price levels will go up
in the market. We clearly want an interest rate that will not fall short of
the inflation rate during the period of the investment. Otherwise we will
not retain the purchasing power of our principal. For example, if we invest
SR. 100,000 for a year at an interest rate of 8% and during this period the
inflation rate turns out at 10%, we will need SR. 110,000 to purchase something
that cost SR. 100,000 a year ago but we will only have SR. 108,000 from our
investment i.e., we would have suffered a loss in our purchasing power by
the end of the year. An increase in inflation would also push interest rates
higher because the interest rates have two components: i) Real Interest Rate
ii) Inflation.
Political Risk: The possible political vulnerabilities can affect the business
and investment. Political risk, also called country risk, is the uncertainty
of returns caused by the possibility of major change in the political or economic
environment of a country. Individuals who invest in countries that have unstable
political economic system must add a country risk premium when determining
their required rate of return.
Recession Risk: The possibility of economic downturn.
Unsystematic Risk
Unsystematic or diversifiable risk is specific to an individual stock, firm
or industry. The risk is inherent to the nature of business in the particular
industry.
Examples of such risk include:
Default Risk: This is the risk that the issuer of a security, stock or
bond, because of prolonged poor financial performance, can be forced to default
on its commitments. In such a case, bond or share holders are paid only after
the liquidation of assets. The point to remember is that businesses can run
into trouble and a likelihood of default can emerge during the life of a business.
Business Risk: Business risk is the uncertainty of income flows caused by
the nature of firm's business. The less certain the income flows of the firm,
the less certain the income flows to the investors. Therefore, the investors
will demand a risk premium that is based on the uncertainty caused by the
basic business of the firm.
Liquidity Risk: Liquidity risk is uncertainty introduced by the secondary
market for an investment. When an investor acquires an asset, he or she expects
that the investment will mature (as with the bond) or that it will be saleable
to someone else. In either case, the investor expects to be able to convert
the security into cash and use the proceeds for current consumption or other
investments. The more difficult it is to make this conversion, the greater
the liquidity risk.
The good news about unsystematic risk is that it can be minimized or may be
eliminated by building a diversified investment portfolio.
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