Risk Meaning, Causes, Types, Components

Causes of Risk

Table of Content:-

  1. Meaning of Risk
  2. Causes of Risk
  3. Types of Risk

Meaning of Risk

The definition of risk may vary, but the basic concept remains the same. To have a better understanding of this concept, let us delve into some of the different perspectives that are discussed in the following paragraphs:

In simple terms, it may be defined as the possibility of experiencing harm or loss. It is a pervasive element which is present in any field or situation. In the context of the Business or Financial World, it represents the uncertainty associated with an investment. In other words, the risk is the possibility that the actual return on an investment may be different from the expected return. An important concept to consider is that an investment carries a higher chance and has the potential of a higher yield. For example, a low-risk investment, such as Government of India dated securities or Treasury Bills, has a low rate of return, while investment in blue chip companies in the mock market has the potential to make an investor very wealthy, but also the potential to get one’s entire investment lost.

Definition of Risk

Another way of defining risk is “the threat or probability that an action or event may impact (adversely or beneficially) an organisation’s ability to achieve its objectives”.

According to Fischer and Jordon, the risk is the “Variability of return around the expected average is thus a quantitative description of risk”.

According to Cornelius Keating, “Risk is the unwanted subset of a set of uncertain outcomes”.

“The probability that an investment’s actual return would be different from the expected return, including the ultimate risk of losing all of the original investment”. Risk usually is measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

Risk is ‘Uncertainty of Result’, either from pursuing a future positive opportunity, or an existing damaging threat to meet a current goal.

Causes of Risk

There may be numerous causes responsible for placing a person or an organisation in a risky situation Sometimes, there are no obvious or specific reasons, which can be pinpointed as the cause of trouble. At times, risk is inherent in an activity or a situation.

The causes of such phenomena may be internal or external to a business. Some of the causes are described below in brief:

1) Wrong Decision

The investment decision may prove to be wrong at a later stage.

2) Wrong Timing

The timing of an investment may not be appropriate.

3) Nature of Instruments

Some categories of financial instruments are risky by nature, (e.g., investment in stock markets through stocks or mutual funds, corporate bonds, chit funds, etc.) when compared with certain other categories of instruments (e.g., bank deposits, Government of India treasury bills, dated securities, postal instruments, etc.).

4) Creditworthiness of Issuer

Creditworthiness of the instruments by GOL, PSUs, and those issued by corporate bodies with ratings from recognised ‘Rating Agencies’ is high when compared with the unrated instruments issued by corporate sectors. The former category of instruments is less risky compared to the latter one.

5) Maturity Period or Length of Investment

Normally, the underlying principle is “Longer the maturity period, the riskier the investment”. Investments of short duration are preferred by the organisation.

6) Amount of Investment

The higher the quantum of investment in security, the higher the risk.

7) Method of Investment

Investments secured by way of collaterals are less risky than unsecured investments.

8) Terms of Lending

Terms of lending, such as maturity date and timing of interest payment are some of the determinants of the risk level.

9) Nature of Industry

Nature of industry or business in which the company is engaged. Chance is embedded in some industries and as much all the companies operating therein are exposed to such risk.

10) National and International Factors

In the present-day world, distances and national boundaries are immaterial. Any event (including an act of God) taking place in some remote comer of the globe has a contagious effect on the rest of the world as well like the occurrence of Hudhoud in Andhra Pradesh and Odisha has affected the Indian economy in the global context.

Related Articles:

Causes of Risk

Types of Risk

There are several risks a business organisation is exposed to, like Market Risk, Interest Rate Risk. Country Risk, Business Risk, Financial Risk, etc. There are two broad categories into which they can be classified:

Systematic Risk

The risk, that is inherent to the entire market or system, is termed a Systematic Risk or Uncontrollable Risk. It is also referred to as Un-diversifiable Risk, and it affects the entire market, not one specific stock or industry. Further, it is associated with the economic, social, political environment and legal dimensions of all securities within the economy. These factors are capable of exerting pressure on all securities in the market in such a manner that all of them would move or change accordingly. During a period of economic growth, prices of all securities tend to rise, whereas, during times of recession, the prices of all securities tend to decline. Systematic Risk is unpredictable and exceedingly difficult to avoid. Diversification alone cannot effectively mitigate this risk however, it can be managed through the implementation of a well-crafted asset allocation strategy.

Components of Systematic

Systematic Risk is a broad category of risk that can be further classified into the following subcategories:

1) Market Risk

Market risk refers to the potential for a decline in the value of an investment as a result of fluctuations in market factors. The reason for such uncertainty is market forces represented in two markets, viz Bull Market and Bear Market. When the economy is booming and other factors and sentiments are positive, the Security Index tends to move upwards and keeps on moving upwards for a considerable period. This is a typical ‘Bull Market’. The ‘Bear Market’, on the other hand, is characterised by a tendency of the Security Index to decline from the peak of the ‘Bull Market’ to a lower level. The lowest point of ‘Bear Market’ is termed the ‘Trough’ and it is from this put that economic recovery or ‘Bull Market’ starts.

The market is influenced by several factors or events, some of which are tangible while others are intangible. Tangible factors refer to actual setbacks such as war, famine, volatility in currency, earthquakes, etc. Intangible factors are not natural events, but are sentiment-driven and at times sequel to a tangible possibility. They possess the ability to influence the market in either direction.

2) Interest Rate Risk

Interest rate risk is the possibility of an unexpected fluctuation in the prevailing interest rates within the market, which harms the value of an investment. Generally, the value of debt instruments such as bonds, debentures, commercial papers, etc is directly influenced by Interest Rate Risk. The movements in market interest rates are prompted by the ‘Monetary Policy’ of the Central Bank of the country (vis Reserve Bank of India), which leads to the changes in the interest rates of Government Bonds and Treasury Bills.

Bonds issued by the ‘Central/State Government’ or ‘Quasi-Government’ bodies are regarded as risk-free, although they carry a low interest rate, i.e., in comparison to the ‘Private Sector’ or ‘Corporate bonds’. If they offer a higher rate of interest on their bonds, investors would find them more attractive given the inherent level of safety and perhaps may prefer to shift their investment from Private Sector Bonds to the papers issued by ‘Central or State Government’ or ‘Quasi-Government’ bodies. Similarly, if the Central or State government issues new loans bearing a higher rate of interest, there would be a reduction in the value of the existing Government papers, due to the switch of funds from low-interest-bearing bonds to high-interest-bearing bonds.

Interest Rate Risk

In the same manner, if the stock market is going through a bear situation,  investors tend to reallocate their funds from stocks to a more secure market, such as the bond market. As investors prefer to have better and assured returns and safety of their investments, they often choose to transfer their funds between different markets and instruments. Interest rate fluctuation in the market affects the cost of borrowing Rates of ‘Badla Transactions’ (The Carry-forward System is known as Badla, which means something in return. Badla transactions have been in practice for several decades in the Bombay Stock Exchange) are also affected by the interest rates prevailing in overnight ‘Call Money’ market.

3) Purchasing Power Risk

‘Purchasing power risk’ is the possible reduction in the purchasing power of the expected returns. Due to the high rate of inflation, there is erosion in the purchasing power of money, which results in a decrease in the returns. An increase in the rate of inflation is swifter than an increase in the value of investment. This results in the punishment of the investors in the form of reduced returns on their investments. The increasing inflation rate presents a significant threat to investors as it is a risk or possible loss for them. Inflation may be a ‘Demand Pull’ (characterised by an increase in aggregate demand and supply cannot keep: pace with the demand) or ‘Cost Push’ (characterised by a reduction in the supply of goods and services, due to improved cost of production).

You May Also Like :-

Leave a Reply

Your email address will not be published. Required fields are marked *