REPUBLIC OF THE PHILIPPIINES

NORTHERN NEGROS STATE COLLEGE OF SCIENCE AND TECHNOLOGY

OLD SAGAY, SAGAY CITY, NEGROS OCCIDENTAL
ISO 9001:2015
(034)722-4169/www.nonescost.edu.com
____________________________________________________________________________________
Certified

COURSE BAPF 102 : BANKING AND FINANCIAL INSTITUTIONS

MODULE 4 (6HOURS) LESSON 4: Understanding Risk

COURSE
JAZMYLE BANES PAGKATIPUNAN
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Phone No./s +639173190255

This module introduces you to identify, evaluate, analyze, monitor, and mitigate the risks that
threaten the achievement of the organization’s strategic objectives in a disciplined and systematic
way. For you to be able to understand the risks that can apply to different scenarios and some of
the ways to manage them holistically, will help all types of investors and business managers
avoid unnecessary and costly losses.

LEARNING OUTCOMES

At the end of this module you are expected to:

 INTRODUCTION
Define Risk
 Differentiate idiosyncratic and systematic risk
 Identify ways to diversify investments
 Compare and contrast the types of bonds and stocks

MOTIVATION
For 10 points (answer is neatly written, and student must observe proper grammar
in forming sentences) 6points content, 4points form

“Make sure you don't put all your eggs in one basket” - What do you think this
means in your own opinion?
PRESENTATION
Business risk is the exposure of a company or organization that will lower its profits or lead it to fail.
Anything that threatens a company's ability to achieve its financial goals is considered a business risk.
There are many factors that can converge to create business risk. Sometimes it is a company's top
leadership or management that creates situations where a business may be exposed to a greater degree
of risk.

Throughout this module you will be going to learn how to mitigate the overall risks associated with
operating a business; because sometimes the cause of risk is external to a company so it is impossible
for a company to completely shelter itself from risk. Most companies accomplished this through adopting
a risk management strategy

TEACHING POINTS

I. WHAT IS RISK?

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ
from an expected outcome or return. Risk includes the possibility of losing some or all of an original
investment.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance,
standard deviation is a common metric associated with risk. Standard deviation provides a measure of the
volatility of asset prices in comparison to their historical averages in a given time frame.

Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street,
investing, capital planning, or something else. An investor’s personality, lifestyle, and age are some of the
top factors to consider for individual investment management and risk purposes. Each investor has a
unique risk profile that determines their willingness and ability to withstand risk. In general, as investment
risks rise, investors expect higher returns to compensate for taking those risks.

Overall, it is possible and prudent to manage investing risks by understanding the basics of risk and how
it is measured.

II. THE BASIC OF RISK

Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street,
investing, capital planning, or something else. An investor’s personality, lifestyle, and age are some of the
top factors to consider for individual investment management and risk purposes. Each investor has a
unique risk profile that determines their willingness and ability to withstand risk. In general, as investment
risks rise, investors expect higher returns to compensate for taking those risks

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk
an investor is willing to take, the greater the potential return. Risks can come in various ways and
investors need to be compensated for taking on additional risk.

For example, a treasury bond is considered one of the safest investments and when compared to
a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt.
Because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of
return.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance,
standard deviation is a common metric associated with risk. Standard deviation provides a measure of the
volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of
value volatility and therefore a high degree of risk.

Individuals, financial advisors, and companies can all develop risk management strategies to help
manage risks associated with their investments and business activities. Academically, there are several
theories, metrics, and strategies that have been identified to measure, analyze, and manage risks.

III. WHAT IS IDIOSYNCRATIC RISK

Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in
investing in a specific asset, such as a stock.

Idiosyncratic risk is the risk that is peculiar to a specific investment – as opposed to risk that affects the
entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all
investments within a given asset class. Systemic risks include things such as changing interest rates or
inflation.

Idiosyncratic risks are rooted in individual companies (or individual investments). Investors can mitigate
idiosyncratic risks by diversifying their investment portfolios.

a. Common Forms of Idiosyncratic Risk

Every company and its stock face their own inherent risks. Some of the most common types of
idiosyncratic risks include the choices a company’s management makes in relation to operating
strategies, financial policies, and investment strategy. Other forms of regularly recurring idiosyncratic risk
include the general culture and strength of the company from within, and where its operations are based.

b. FACTORS OF IDIOSYNCRATIC RISK

 1. Operating strategies- drive a company’s operations, the part of the business that produces and
distributes goods and services. Operations strategy underlies overall business strategy, and both
are critical for a company to compete in an ever-changing market. With an effective ops strategy,
operations management professionals can optimize the use of resources, people, processes, and
technology.

2. Financial policies- refers to policies related to the regulation, supervision, and oversight of the
financial and payment systems, including markets and institutions, with the view to promoting
financial stability, market efficiency, and client-asset and consumer protection.

3. Corporate culture- refers to the beliefs and behaviors that determine how a company's
employees and management interact and handle outside business transactions. Often, corporate
culture is implied, not expressly defined, and develops organically over time from the cumulative
traits of the people the company hires.

4. Investment strategy- is what guides an investor's decisions based on goals, risk tolerance, and
future needs for capital. Some investment strategies seek rapid growth where an investor focuses
on capital appreciation, or they can follow a low-risk strategy where the focus is on wealth
protection.

IV. SYSTEMATIC RISK

Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also
known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular
stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be
mitigated through diversification, only through hedging or by using the correct asset allocation strategy.

Systematic risk underlies other investment risks, such as industry risk. If an investor has placed too much
emphasis on cybersecurity stocks, for example, it is possible to diversify by investing in a range of stocks
in other sectors, such as healthcare and infrastructure. Systematic risk, however, incorporates interest
rate changes, inflation, recessions, and wars, among other major changes. Shifts in these domains can
affect the entire market and cannot be mitigated by changing positions within a portfolio of public equities.

To help manage systematic risk, investors should ensure that their portfolios include a variety of asset
classes, such as fixed income, cash and real estate, each of which will react differently in the event of a
major systemic change. An increase in interest rates, for example, will make some new-issue bonds more
valuable, while causing some company stocks to decrease in price as investors perceive executive teams
to be cutting back on spending. In the event of an interest rate rise, ensuring that a portfolio incorporates
ample income-generating securities will mitigate the loss of value in some equities.

a. Idiosyncratic Risk vs. Systematic Risk

With idiosyncratic risk, factors that affect assets such as stocks and the companies underlying them make
an impact on a microeconomic level. This means that idiosyncratic risk shows little, if any, correlation to
overall market risk. The most effective way to mitigate or attempt to eliminate idiosyncratic risk is with the
diversification of investments.

Idiosyncratic risk, by its very nature, is unpredictable. Studies show that most of the variation in risk that
individual stocks face over time is created by idiosyncratic risk. If an investor is looking to cut down on the
risk’s potentially drastic impact on his investment portfolio, he can accomplish this through investment
tactics such as diversification and hedging. The diversification strategy involves investing in a variety of
assets with low correlation, i.e., assets that don’t typically move together in the market. The theory behind
diversification is that when one or more assets lose money, the rest of an investor’s non-correlated
investments gain, thus hedging or minimizing his losses.

Systemic risk, on the other hand, involves macroeconomic factors that affect not just one investment, but
the overall market and the economy in general. Adding more assets to a portfolio or diversifying the
assets within it cannot counteract systemic risk.

V. WAYS TO DIVERSIFY INVESTMENTS

a. WHAT IS DIVERSIFICATION?

Diversification is a technique that reduces risk by allocating investments among various financial
instruments, industries, and other categories. It aims to maximize returns by investing in different areas
that would each react differently to the same event. It is a practice of spreading your investments around
so that your exposure to any one type of asset is limited. This practice is designed to help reduce the
volatility of your portfolio over time.

One of the keys to successful investing is learning how to balance your comfort level with risk against
your time horizon. Invest your retirement too conservatively at a young age, and you run the risk that the
growth rate of your investments won't keep pace with inflation. Conversely, if you invest too aggressively
when you're older, you could leave your savings exposed to market volatility, which could erode the value
of your assets at an age when you have fewer opportunities to recoup your losses.

One way to balance risk and reward in your investment portfolio is to diversify your assets. This strategy
has much complex iteration, but at its root is the simple idea of spreading your portfolio across several
asset classes. Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing
the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure
a profit or guarantee against loss.

b. IMPORTANCE OF DIVERSIFICATION
Most investment professionals agree that, although it does not guarantee against loss, diversification is
the most important component of reaching long-range financial goals while minimizing risk. Here, we look
at why this is true and how to accomplish diversification in your portfolio.

c. WHY SHOULD WE DIVERSIFY?

Let's say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an
indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your
portfolio will experience a noticeable drop in value.

If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of
your portfolio would be affected. In fact, there is a good chance the railway stock prices would climb, as
passengers turn to trains as an alternative form of transportation.

But, you could diversify even further because there are many risks that affect both rail and air because
each is involved in transportation. An event that reduces any form of travel hurts both types of companies.
Statisticians, for example, would say that rail and air stocks have a strong correlation.

Therefore, you would want to diversify across the board, not only different types of companies but also
different types of industries. The more uncorrelated your stocks are, the better.

It's also important to diversify among different asset classes. Different assets such as bonds and stocks
will not react in the same way to adverse events. A combination of asset classes will reduce your
portfolio's sensitivity to market swings. Generally, bond and equity markets move in opposite directions,
so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive
results in another.

And finally, don't forget location. Diversification also means you should look for investment opportunities
beyond your own geographical borders. After all, volatility may not affect stocks and bonds, so investing
in that part of the world may minimize and offset the risks of investing at home.

VI. BONDS AND STOCKS

a. Bonds
 A bond is a debt security. Borrowers issue bonds to raise money from investors willing to lend them
money for a certain amount of time.

When you buy a bond, you are lending to the issuer, which may be a government, municipality, or
corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond
and to repay the principal, also known as face value or par value of the bond, when it "matures," or comes
due after a set period of time.

Three main types of bonds

1. Corporate bonds-are debt securities issued by private and public corporations.

2. High-yield-These bonds have a lower credit rating, implying higher credit risk, than investment-
grade bonds and, therefore, offer higher interest rates in return for the increased risk.

3. Municipal bonds-called “munis,” are debt securities issued by states, cities, counties and other
government entities. Types of “munis” include:

 General obligation bonds-these bonds are not secured by any assets; instead, they are
backed by the “full faith and credit” of the issuer, which has the power to tax residents to
pay bondholders.

 Revenue bonds-instead of taxes, these bonds are backed by revenues from a specific
project or source, such as highway tolls or lease fees. Some revenue bonds are “non-
recourse,” meaning that if the revenue stream dries up, the bondholders do not have a
claim on the underlying revenue source.

 Conduit bonds-governments sometimes issue municipal bonds on behalf of private

entities such as non-profit colleges or hospitals. These “conduit” borrowers typically
agree to repay the issuer, who pays the interest and principal on the bonds. If the conduit
borrower fails to make a payment, the issuer usually is not required to pay the
bondholders.

Investment-grade-These bonds have a higher credit rating, implying less credit risk, than high-yield
corporate bonds

U.S. Treasuries-are issued by the U.S. Department of the Treasury on behalf of the federal government.
They carry the full faith and credit of the U.S. government, making them a safe and popular investment.

Types of U.S. Treasury debt include:

1. Treasury Bills- short-term securities maturing in a few days to 52 weeks

2. Notes- long term securities maturing within ten years
3. Bonds-long-term securities that typically mature in 30 years and pay interest every six months
4. TIPS-Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted based on
changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities
of five, ten, and 30 years.

VII. STOCKS
A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation.
This entitles the owner of the stock to a proportion of the corporation's assets and profits equal to how
much stock they own. Units of stock are called "shares."

Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well,
and the foundation of many individual investors’ portfolios. These transactions have to conform to
government regulations which are meant to protect investors from fraudulent practices. Historically, they
have outperformed most other investments over the long run.

Shareholders are the owners of publicly traded companies. Bondholders are lenders or creditors, if you
will. Corporate bonds carry a lower risk than stocks because bondholders are higher on the ladder when
making claims on a company's assets. In the event of liquidation, paying bondholders therefore takes
precedence over satisfying stockholders. The two basic kinds of stock are common and preferred. Bonds
come in basic varieties with the main differences being the type of issuer — a municipality, a corporation
or the government.

a. Types of stocks

1. Common stock shares may be categorized by classes:

For example, a company may issue Class A and Class B stock. However, there is no uniform
description from company to company. One publicly traded company may issue a Class B stock
that carries voting rights. Another company's Class B stock may have no voting rights attached.
Shares of common stock are bought and sold on the major exchanges. Investors in common
stock anticipate growth and an increase in share prices and plan to receive dividends.

2. Preferred Stock- Preferred stock shares have characteristics in common with corporate bonds.
Preferred shares pay fixed dividends and there is little variation in price of individual shares.
Preferred shares usually carry no voting rights but preferred shareholders hold claims on assets
before common shareholders. The board of directors of the company must vote to pay dividends
on preferred stock shares with no guarantee that the dividends will be paid. However, not paying
dividends hurts the credit reputation of the company.

VIII. STOCKS VS BONDS

Stocks are issued by companies to raise capital, paid-up or share, in order to grow the business or
undertake new projects. There are important distinctions between whether somebody buys shares directly
from the company when it issues them (in the primary market) or from another shareholder (on the
secondary market). When the corporation issues shares, it does so in return for money.

Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the
corporation, and are entitled to interest as well as repayment of principal. Creditors are given legal priority
over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to
sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive
nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently
riskier investments that bonds

KNOWLEDGE CHECK

TRUE OR FALSE 5 points (Idiosyncratic Risk and Systematic Risk)

___________1 idiosyncratic risk refers to the inherent factors that can negatively impact individual
securities or a very specific group of assets.

___________2 the opposite of idiosyncratic risk is a systematic risk, which refers to broader trends that
impact the overall financial system or a very broad market.

___________3 systematic risk can generally be mitigated in an investment portfolio through the use of
diversification.

___________4 Investors can somewhat mitigate the impact of systematic risk by building a diversified
portfolio.

___________5 if inherent to the market as a whole, reflecting the impact of economic, geo-political and
financial factors it is defined as systematic risk.

LEARNING ACTIVITIES

ACTIVITY 1 Answer the following questions below. 10 points each 6 pts - content (answer is logical
and based on factual assessment of the issues, 4 pts – form (answer is neatly written; proper grammar
was observed in forming sentences.)

1. What possible situation or opportunities in a business can you think of that may be risky?

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

2. Why do investors buy bonds? List down at least three reasons below.

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

3. Based on this module, how does diversification affects investment?

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

ACTIVITY 2 Answer the following questions below. 5 points each 3 pts - content (answer is logical and
based on factual assessment of the issues, 2 pts – form (answer is neatly written; proper grammar was
observed in forming sentences.)
 1. In your own opinion, are bonds safer than stocks? Why and why not?

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

2. If given a chance to which one would you invest in, a bond or a stock?
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

ACTIVTY 3 Give at least three advantages and three disadvantages of stocks and bonds. 1 point each

BONDS

ADVANTAGE OF BONDS DISADVANTAGE OF BONDS

STOCKS

ADVANTAGES OF STOCKS DISADVANTAGES OF STOCKS

ACTIVITY 4 List down below the top 10 Philippine stocks for long-term investments 15 points

1. AYALA CORP A holding company for diversified interests

in banking, real estate, and utilities/water
distribution.

REFERENCES

1. Course Syllabus
2. https://www.investopedia.com/terms/r/risk.asp#:~:text=Risk%20is%20defined%20in
%20financial,all%20of%20an%20original%20investment.
3. http://mrsc.org/Home/Stay-Informed/MRSC-Insight/October-2018/An-Introduction-to-Risk-
Management.aspx
4. https://corporatefinanceinstitute.com/resources/knowledge/other/idiosyncratic-risk/
5. https://www.investopedia.com/terms/s/systematicrisk.
6. https://www.investopedia.com/investing/importance-diversification