Types of risk 1

4.1

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Welcome to another module of Smart Money! You’ll recall that we briefly touched upon systematic and unsystematic risks in the first chapter of the previous module. But those are not the only risks associated with investing. In this module, we are going to delve into the different types of risks in detail and get to know the risks that you’re likely to encounter in the markets.

Systematic and unsystematic risks are essentially broad financial risks. There are plenty of other categories and subcategories of risk that fall under these two. Now, in this chapter, we’ll restrict our focus to only exploring the various types of systematic risk. So, without any further ado, let’s jump right in.

Types of systematic risk

As you’ve already seen, systematic risk is a market-wide risk that affects all the industries collectively. There are as many as 10 different subcategories of systematic risk. Here’s a brief look at them.

1. Interest rate risk

Interest rates generally don’t stay the same. They are periodically revised from time to time. And an asset’s value can also change based on these interest rates. The risk of an asset losing its value due to the changes in the interest rate is known as the interest rate risk. Interest rate risk is generally associated with debt instruments such as bonds.

For instance, when the interest rates are increased, the value of the bonds tend to go down. and vice versa. So, when you invest in bonds or other debt instruments, you generally take on an element of interest rate risk. There are two different types of interest rate risk - price risk and reinvestment risk. Let’s take a look at a short overview of these two.

  1. Price risk
    Price risk is basically the risk of the price of an asset - such as shares, commodities, or bonds - declining in the future due to a change in the interest rates. For instance, if the price of the shares of a company falls due to an increase in the interest rates, it is said to carry some price risk.
  2. Reinvestment risk
    Investments often give out interest or dividend payouts. The risk of not being able to reinvest interest or dividend payments at the same rate of return as the original investment is termed as reinvestment risk. Here’s an example of reinvestment risk.

Let’s say that you invested Rs. 10,000 in a bank fixed deposit scheme at 6% interest. You receive Rs. 600 as annual interest. However, by the time you reinvest the interest payout, the interest rates have dropped down to 5.5%. Now, this investment option is said to carry reinvestment risk.

2. Market risk

Market risk is essentially the risk of an asset losing its value due to the fluctuations in its price. Stocks are a great example of investment options that carry market risk. Let’s say that you’ve invested in 10 shares of Reliance Industries for Rs. 2,000. After a few days, the price of the share comes down to Rs. 1,900. Now your investment also loses its value, which drops down from Rs. 20,000 to Rs. 19,000. There are as many as six different types of market risks. Here’s a quick look at these. 

  1. Absolute risk
    Absolute risk can be defined as the probability of a stated event happening. In the case of an investment, you can consider it as the risk of making a loss on an investment. Here’s an example that can help you understand absolute risk. Assume that you enter into a coin tossing competition with your friend. You choose tails and your friend chooses heads. Now, when you toss the coin, the probability of you getting tails is 50%, right? This essentially means that there’s also a 50% chance of you not getting tails as well. This 50% chance of not getting a tail is what is known as absolute risk.

  2. Relative risk
    When you compare the probability of a stated event happening for two different assets, you get relative risk. Confusing? Don’t worry. Here’s an example that can help you understand it better.
    Take two assets - shares and bonds.

    • Assume that the risk of the shares losing their value in the near future is 50%.

    • On the other hand, say the risk of bonds losing their value in the near future is just 20%.

You can use this data to calculate relative risk, which is essentially a comparison between the risks of these two assets. This is how you get the relative risk of shares with respect to bonds.

Relative risk = Risk of shares ÷ Risk of bonds = 50% ÷ 20% = 2.5

The relative risk here comes up to 2.5. What this essentially means is that shares are 2.5 times more likely to lose their value in the near future when compared to bonds.

  1. Directional risk
    The risk of an asset moving against the direction that you want it to move is termed as directional risk. For instance, assume that you take a long position in State Bank of India, with the view that the stock price would rise up in the near future. However, say the price of the shares moves downward, against your expectation, causing you to take a loss on your investment. This movement causes directional risk.
  2. Non-directional risk
    If you do not consistently follow a particular method of trading, that kind of strategy comes with its own brand of risk. This is known as non-directional risk. For instance, when you keep switching between long and short positional trades without following any one particular method consistently, you take on a non-directional risk. One way to reduce this risk is to initiate both long and short positional trades simultaneously on the same asset.
  3. Basis risk
    A hedged position may not always be perfectly matched. There may be slight fluctuations or differences between the two positions, which can still end up causing small losses to a trader. The risk that you take on as a result of imperfect hedging is termed as basis risk. Let’s take a look at an example.
    Assume that you buy 400 shares of HDFC for Rs. 2,500 each. To offset the long position risk, you simultaneously initiate a short position in HDFC futures. Due to the inherent nature of the derivatives contract, there’s always going to be a slight price difference between the spot price and the futures price.
    And say the futures price of HDFC is at Rs. 2,505. Now generally, when the spot price of HDFC moves up by Rs. 1 (to Rs. 2,501), the futures price should also move up by Rs. 1 (to Rs. 2,506). In some rare cases, this may not happen. For instance, when the spot price moves up by Rs. 1, the futures price may move up by Rs. 2. The risk of such an event happening leads to basis risk.
  4. Volatility risk
    The risk of an investment losing its value due to the volatility of its price is termed as volatility risk. For instance, let’s say that you invested in Tata Motors at Rs. 300. At the time of investment, the volatility in the counter was low. However, the volatility in the counter spikes after a while due to the company’s quarterly results announcement.
    And to add to this, the stock also moves against your expectations. As a result of this increased volatility and simultaneous downmove, say the share price drops to Rs. 250. Had the volatility not spiked, you may have ended up with a loss of less than Rs. 50. This is a great example of volatility risk and how a simple change in volatility can lead to higher losses.

3. Inflation risk

Inflation risk can be summed up as the risk of your investments losing their value over time due to the effects of rising inflation. This risk primarily affects debt and money market instruments, and it doesn’t particularly apply to stock investments. Here’s a great example. Assume that you invest in a debt instrument that offers a rate of return of 6%. And suppose that the current inflation rate is at 5.5%. The rate differential of 0.5% is your gain.

Now, if the inflation rate rises to 6%, you would end up in a no-loss and no-gain situation. The rising inflation has caused your investment to lose its value and has reduced its worth. The risk of encountering such a situation is what is known as inflation risk. 

There are two primary ways through which inflation risk occurs: demand and cost. Here’s a quick look at both of them.

  1. Demand inflation risk
    When inflation risk is brought about through excessive demand and not enough supply, it is known as demand inflation risk. Demand inflation generally occurs when production facilities, even when under maximum utilization, are still not able to supply goods fast enough to cover the increase in demand.
  2. Cost inflation risk
    Alternatively, when inflation risk is brought about through the increase in production costs of goods or services, it is known as cost inflation risk. Due to the increase in cost of production, the final prices of goods or services go up, which ends up raising the inflation rate. 

Wrapping up

Well, that sums up the types of risks in detail. We’ve managed to cover all the types of systematic risks that you’re likely to encounter through the course of your investment journey. In the next chapter, we’re going to be focusing purely on unsystematic risks. Stay tuned!

A quick recap

  • Systematic risk is a market-wide risk that affects all the industries collectively. There are as many as 10 different subcategories of systematic risk. 
  • We can broadly categorize them as interest rate risk, market risk and inflation risk.
  • The risk of an asset losing its value due to the changes in the interest rate is known as the interest rate risk.
  • There are two different types of interest rate risk - price risk and reinvestment risk. 
  • Market risk is essentially the risk of an asset losing its value due to the fluctuations in its price. 
  • There are as many as six different types of market risks, namely absolute risk, relative risk, directional risk, non-directional risk, basis risk and volatility risk.
  • Inflation risk can be summed up as the risk of your investments losing their value over time due to the effects of rising inflation. 
  • There are two primary ways through which inflation risk occurs: demand and cost.
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