Study Notes

Financial Risks
Financial Risks

Introduction

Risk in financial terms, refers to the degree of uncertainty and/or potential financial loss inherent
in an investment decision. In simple words financial risk is the possibility of losing money on an
asset.

Example

Kingfisher Company goes to the bank to raise loan for purchase of new planes to increase /
expand its business

Here, the bank is the Lender and the Kingfisher Company is the borrower.

 The possibility that the borrower will not repay back the borrowed amount is the Risk
factor for the bank (the lender)
 If the company took the loan on fixed interest rate, as it expected the interest rates will
increase in future, but later the market interest rates fall, the potential loss suffered by the
company as it is unable to take advantage of lower interest rate on loans, is a risk faced
by the borrower.

The types of investment risk

Types of Risks

Unsystematic
Systematic Risk
Risk

uncontrollable/ Controllable/
undiversifiable Macro in nature Diversifiable by Micro in nature
by organisation organisation

The 2 broad types of risk are systematic and unsystematic.

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Financial Risks

Systematic risk is risk which affects all and cannot be mitigated or avoided. This is the kind of
risk that applies to an entire market or market segment. All investments are affected by this risk,
for example risk of a government collapse, risk of war or inflation, or the recent economic
downturn due to pandemic that affected the entire world. It is virtually impossible to avert these
kinds of risk. It is also known as un-diversifiable risk or market risk.

Example

The pandemic of COVID-19 adversely impacted the travel industry. As a result, Kingfisher
Airlines, that took loan from the bank, is in loss and is unable to service the loan. The downturn
in travel industry due to pandemic is not specific to the company and is known as Systematic
risk.

Unsystematic risk is also known as specific risk or diversifiable risk. It is unique to a company
or a particular industry. For example, strikes, lawsuits and such events that are specific to a
company, and can to an extent be diversified away by other investments in the portfolio are
unsystematic risk.

Example

Tata Motors is looking to set up its new plant in Singur to manufacture its Nano car. But, due to
unrest and strong opposition from the activists with regards to the setting up of the plant in the
area and lawsuits filed the whole project was delayed.
When the news of Tata Motors launching new car came, the investors estimated positive cash
flows and so a buy position was created for the company in the share market. But due to risks
like the above the whole project was delayed and the money of the investors did not give as
much return as expected.
This situation only affected the company on a standalone basis; other companies of the vehicle
industry were not affected at all and could possibly have recorded higher sales than earlier. This
is an unsystematic risk or diversifiable risk, or specific risk to Tata Motors.

Within these two types, there are certain specific types of risk, which every investor must know.

Under Systematic Risk:

a) Interest Rate Risk
b) Market Risk
c) Inflationary Risk

Under Unsystematic Risk

a) Liquidity Risk
b) Credit Risk or Default Risk
c) Operational Risk

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Financial Risks

Interest Rate Risk:

Interest rate risk is the risk which arises due to the movements in variable interest rates that
affect financial performance. Changes in market rates of interest may also affect fixed-rate
securities where they are marked to market, in which case the capital value of the securities will
change.

Management needs to use sensitivity analysis to predict the impact on profit and loss of a given
change in interest rates on the investments or other assets.

In case of bond, Interest rate risk is of two types:

 Price risk – the risk of change in value of the bond due to change in interest rates
 Reinvestment risk - the possibility that an investor will be unable to reinvest cash flows
(e.g., coupon payments from bond) at a rate comparable to their current rate of return.

Example

If an investor has invested some amount in a fixed rate bond at the prevailing price, which offers
him a coupon rate of 5%, and if thereafter interest rises to 6%, then the price of the bond would
decline. This is because the bond is offering a rate of 5% while the market is offering a rate of
return of 6%. Hence if the investor wants to sell this bond in the market, the buyer would offer
him a lesser amount for the bond as this bond is low-yielding as compared to the market. In
other words, the opportunity cost of getting a better return elsewhere increases with an increase
in the interest rate.

Market Risk:
Market risk is the risk of losses on financial investments caused by adverse price movements.
Examples of market risk are: changes in equity prices or commodity prices, or foreign exchange
fluctuations.
Market risk is one of the three core risks all banks are required to report and hold capital
against, alongside credit risk and operational risk. The standard method for evaluating market
risk is value-at-risk (VaR).

Inflationary Risk:
Inflation Risk commonly refers to how the prices of goods and services increase more than
expected or inversely, such situation results in the same amount of money resulting in less
purchasing power.
Inflation Risk is also known as Purchasing Power Risk

Liquidity Risk
Liquidity refers to how quickly an asset can be converted into cash. Liquidity risk is the financial
risk that a given asset cannot be traded quickly enough to prevent a loss or expected profit
when it is liquidated/ sold.

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Financial Risks

There are two kinds of liquidity risks –

1. Asset liquidity. This is where an asset cannot be sold in the market when you want to
sell it. This is most common with houses where depressed conditions puts a stop on
demand and pushes away buyers.
2. Funding liquidity. This is where one does not have enough money to pay off a loan
when it comes due. This may be because the borrower’s money is stuck somewhere
else. For example, a merchant is expecting the goods to hit the port in Mumbai this
Friday but due to adverse weather conditions, the goods will be delivered only the week
next.

Example

Classic example of Liquidity crunch would be announcement of the closure of 6 debt mutual funds
by Franklin Templeton in April 2020. The fund received many redemption requests from investors
following which Franklin Templeton started to sell the debt securities in the market to raise money
and meet the redemption requests of its unit holders. However, there were not many buyers for the
debt securities held by the mutual fund and Franklin Templeton was unable to arrange the
necessary cash, which led to the closure of the 6 debt funds.

The fund could not arrange for the cash, which is nothing but liquidity risk.

Credit Risk or Default Risk

Credit risk is the risk that the person you have given credit to, i.e. the borrower (company or
individual), will be unable to pay the interest or pay back the principal and honour the debt
obligations associated with the debt.

Government bonds have the lowest credit risk (but it is not zero - think of Portugal, Ireland or
Spain).

Credit Rating agencies like CRISIL, ICRA or CARE estimate the credit risk of a loan/bond or
corporate deposit.

Example

“As per the reports published in September 2020 Reliance Capital Ltd.’s credit rating was
downgraded to default grade. Care Ratings Ltd has placed the debt of tycoon Anil Ambani’s
conglomerate at risk, reigniting India’s credit risk. CARE cut Reliance Capital’s bonds by eight
notches to D from BB, citing a delay in coupon payments on several of the lender’s non-
convertible debentures. That raises the default risk on the debt of the Reliance ADAG Group,
which has ballooned to about 939 billion rupees ($13 billion) at four of its biggest units.”

This is how credit rating agencies play an important role by informing the investors in advance the
credibility of the borrower.

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Financial Risks

Operational Risk
Operational risk can be defined as, the uncertainties and hazards a company faces when it
attempts to do its day-to-day business activities. A type of business risk, it can result from
breakdowns in internal procedures, people and systems.
For example, risks of internal or external fraud, breakdown of the computer system, loss of data
due to hacking, technical or human errors.

Reputational risk, often called reputation risk, is the potential loss to financial capital, social
capital and/or market share resulting from damage to a firm's reputation. This is often measured
in lost revenue, increased operating, capital or regulatory costs, or destruction of shareholder
value. Reputational risk is consequential of an adverse or potentially criminal event even if the
company is not found guilty.

Adverse events typically associated with reputation risk include ethics violations, safety
issues, security issues, a lack of sustainability, poor quality, and lack of or
unethical innovation. Corporate trust and relations often have an impact on the degree of
reputational risk a business will experience.

Political risk is the risk due to change in Government policies or political structure.
Some of the political risks are war, corruption, nationalisation of business, tax law changes, etc.

Systemic risk is the possibility that an event at the company level could trigger severe
instability or collapse an entire industry or economy. Systemic risk was a major contributor to
the financial crisis of 2008. Companies considered to be a systemic risk are called "too big to
fail."