 What is Risk?

The term risk originates from the Italian term ‘riskare’ (or risicare), which means
‘to dare’. Risk refers to the uncertainty that surrounds future events and outcomes. Uncertainty is not known
what will happen in the future. If there is the greater the uncertainty, there is greater the risk. For each
decision there is a risk-return trade-off. Anytime there is a possibility of loss (risk), there should also be an
opportunity for profit.

Definition:

Risk can be defined as “the possibility of loss or an unfavourable outcome associated with an
action”.
(Loss: Any negative consequence or adverse effect, financial)

Risk is defined as “the chance of something happening that will have a negative impact on
objectives”.

 Sources of Risk in Business Investment?

If we talk only about return on investment without talking about the risk on
investment, it will not be sensible (done in accordance with wisdom). Return on investment and business
risk always move together and at any stage of our business life cycle, our return may turn into loss. So it is
really important to know about all the sources of risk that may impact our business. There are certain sources
of risks that make financial asset quite risky.

1. Interest rate Risk

2. Market Risk
3. Inflation Risk
4. Business Risk
5. Financial Risk
6. Liquidity Risk
7. Exchange rate Risk
8. Country Risk

1. Interest Rate Risk: The variability in returns of a security which result from changes in the level of
interest rates is referred to as interest rate risk. Generally securities are inversely affected by such
changes. This means that the price of security moves inversely to the interest rate provided, other
things being equal.
This type of risk is most apparent in the bond market because bonds are issued at
specific interest rates. Generally, a rise in interest rates will cause a decline in market prices of existing
bonds, while a decline in interest rates tends to cause bond prices to rise.
For example, you buy a 10-year bond today with a 6% annual yield. If interest
rates rise, a new 10-year bond may be issued with an 8% annual yield. The price of your bond drops
because investors aren’t willing to pay full value for a bond that yields less than the current rate of
interest.

i. Price risk: Price risk arises due to the possibility that the price of the shares, commodity,
investment, etc. may decline or fall in the future.
ii. Reinvestment rate risk: Reinvestment rate risk results from fact that the interest or
dividend earned from an investment can' t be reinvested with the same rate of return as it
was acquiring earlier.

For example, an investor constructs a portfolio of bond at a time when prevailing

yields are running around 5%. Among his bond purchases, the investor buys a 5-year Rs.100,000
treasury note, with the expectation of receiving Rs.5,000 a year in annual income.
In the course of that five-year period, however, prevailing rates on this particular
bond class fall to 2%. The good news is that the bondholder receives all scheduled 5% interest
 payments, as agreed, and at maturity receives full Rs.100,000 of principal, also as agreed. So what's
the problem?
The problem is that if now the investor buys another bond in the same class, he'll no
longer receive 5% interest payments. The investor has to put the cash back to work at the lower
rates. Now, that same Rs.100,000 generates only Rs.2,000 each year rather the Rs.5,000 annual
payments he received on the earlier note.

2. Market Risk: The variability in returns of a security which result from changes in the prices of
financial instruments is referred to as market risk. It arises due to rise or fall in the trading price of
listed shares or securities in the stock market. Market risk can be classified as Directional
Risk and Non - Directional Risk.

i. Directional risk: Directional risks are those risks where the loss arises from an exposure
(experience) to the particular assets of a market. For e.g. an investor holding some shares
experience a loss when the market price of those shares falls down.
ii. Non- directional risk: Non- Directional risk arises where the method of trading is not
consistently followed by the trader. For eg. The dealer will buy and sell the share
simultaneously to mitigate (diminish) the risk.

3. Inflation Risk: Inflation risk is also known as Purchasing power risk, this risk arises from the decline in
value of securities cash flow due to inflation, which is measured in terms of purchasing power.

The risk that the rate of inflation will exceeds the rate of return on an investment. For
example, if the rate of inflation is 5% over a year and the rate of return is 3%, then the investor has
effectively taken a loss even though he/she has made a profit in absolute terms. Inflation risk applies
especially to fixed-return securities as there is no possibility that the rate of return will increase to
surpass inflation. The types of inflationary risk are listed below:

i. Demand inflation risk: Demand inflation risk arises due to increase in price, which result from
an excess of demand over supply. It occurs when supply fails to cope with (manage) the
demand and hence cannot expand anymore. (In other words, demand inflation occurs when
production factors are under maximum utilization.)
ii. Cost inflation risk: Cost inflation risk arises due to sustained (constant) increase in the prices of
goods and services. It is actually caused by higher production cost. A high cost of production
inflates (increases) the final price of finished goods consumed by people.
4. Business Risk: Business risk is also known as liquidity risk. This type of risk arises out of
inability to execute transactions. Liquidity risk can be classified into Asset Liquidity Risk and Funding
Liquidity Risk.

i. Asset liquidity risk: Asset liquidity risk is due to losses arising from an inability to
sell assets at. For e.g. Assets sold at a lesser value than their book value.
ii. Funding liquidity risk: Funding liquidity risk exists for not having an access to the
sufficient- funds to make a payment on time. For e.g. When commitments made to
customers are not fulfilled as discussed in the SLA (service level agreements).