Risk is defined as uncertainty in broad terms. This uncertainty can be due to a large number of factors, which depend on the type of risk. Some of the common factors which result in this uncertainty can be changes in input parameters, miscalculation of parameters etc. (Kuritzkes, Schuermann, & Weiner, 2002).
Risk can result in large and unexpected losses and can really hurt the profitability of companies. However, risk is not always bad and little bit of risk can lead to better financial results. However, the relationship between risk and better results is a lot more complex and depends on company specific and risk specific factors.
Measurement of risk can be tedious process if all aspects are not accounted for. It is a continuous process to identify and then measure risk. In quantitative terms, risk is often measured in terms of volatility or standard deviation (Kuritzkes, Schuermann, & Weiner, 2002).
Standard deviation is the average deviation of individual values of a variable from the expected value of the variable. It signifies the average level of deviation that can be expected in the value of the variable.
This measure of total risk has been the basis of most of the modern theories on risk and return. Modern day portfolio management and investment research is based on standard deviation taken as risk associated with the variables.
There can be other measures of risk as well, depending on various asset classes. For example, Beta is a common risk measure associated with equities while Duration is generally used to measure risk in bonds. So overall, risk or uncertainty measurement in the value of a parameter is a variable specific process and has to be devised accordingly.
Various risks that can affect the value of a security or portfolio are broadly credit risk, market risk and liquidity risk. These are broad categories of the risk which affect and modify the value of securities and portfolio (FMA).
Credit risk is defined as the risk due to default by the counterparty. In case of equity, it can be bankruptcy by the company. In case of bonds, it can be due to default by the issuer while paying interest.
Credit risk can also be due to downgrade of rating assigned to the security by the credit rating agency or due to non-delivery of commodities by the counterparty in case of a commodities security.
Market risk can be due to interest rate risk, foreign exchange risk and equity risk. Interest rate risk is the uncertainty regarding price change of the security due to changes in interest rate. This affects bonds much more significantly than any other asset class.
Foreign exchange risk is due to change in the value of the currency in which the security is denominated vis-a-vis the currency of the investor. For example, a US investor who has invested in Euro denominated shares will be at risk of change in Euro to US Dollar rate.
Equity risk is associated with the price uncertainty of equity value of the investment by either an individual or the company. This can affect the value of the entire portfolio.
Liquidity risk can be either pipeline risk or funding risk. Pipeline risk refers to the situation when an investor is unable to sell off the security due to insufficient demand for the security in the market.
Funding risk is when a company is unable to raise the required amount from the market, causing its cost of capital to rise.
Operations of a corporation are affected by credit risk, market risk, liquidity risk, operational risk, strategic risk and legal and regulatory risk (FMA).
These are the broad categories of risks affecting a company and the forms of credit, market and liquidity risks which affect company operations can be different from the forms which affect security value.
For a company’s operations, credit risk is mainly due to default by suppliers or non-payment by debtors. This can affect the profitability of the company directly.
Market risk can be due to interest rate risk and foreign exchange risk. The interest rate changes may affect the cost of raising capital through debt for the company while foreign exchange risk would affect international operations related to trade (import and export), repatriation of profits from a foreign subsidiary or economic value of the products in a foreign country.
Liquidity risk can be through both pipeline risk, when the corporation is trying to sell an asset to raise money but is unable to find the buyer, and also due to funding risk, when cost of capital raising goes up due to insufficient money supply in the market.
Operational risk can be due to technological risks, strikes, natural disasters etc., which may affect the revenues as well as profitability of the company.
Strategic risk may be due to failure of the planned strategy of the company with respect to a product or a market, which would hurt its profitability.
Legal and regulatory risks are due to changes in laws and regulations concerning business operations, which might hurt the company’s operational and financial performance.
A zero risk portfolio of stocks is possible theoretically by combining stocks which are perfectly negatively correlated. So, over time, they would provide a positive return portfolio with zero standard deviation.
However, in real world, such a scenario is not possible as there are no two stocks which are perfectly negatively correlated, i.e. the coefficient of correlation is -1. Stocks of some industries might be negatively correlated but achieving -1 coefficient of correlation is impossible practically.
An example of industries which are negatively correlated are aviation and energy. When energy sector does well, the aviation sector would perform poorly as the cost of fuel would go up. So the stocks of these two industries move in opposite directions.
Combining such negative correlation stocks would reduce standard deviation. This process is known as diversification. Theoretically, it is said that adding a large number of stocks to the portfolio would lead to full effect of diversification, thus reducing the standard deviation to zero.
This assumption forms the basis of many modern portfolio theories and is used extensively in financial management research. But in real world, no matter how many stocks are added, full diversification is impossible to achieve. This would mean that achieving zero standard deviation is impossible.
A portfolio of different asset classes may still have better chances of further reducing the standard deviation as some asset classes may have very high negative correlation. So the diversification effect would be enhanced if the portfolio comprises of securities of such asset classes.
However, for a pure equity portfolio, full diversification, or zero-risk profit is impossible to achieve in real world.
The total market risk associated with equities can be divided into either diversifiable risk or undiversifiable risk. The diversifiable risk is the company specific risk which can be diversified by combining a large number of securities in the portfolio. While Beta denotes the non-diversifiable risk which is associated with the whole market (Da, Guo, & Jagannathan, 2010).
Beta measures the risk associated with a security relative to the general market. So a Beta equal to 1 for a stock means that the expected movement in the share price of the stock in percentage terms will be the same as the movement in general stock market.
A less risky investment is one which has Beta less than 1 while Beta more than 1 denotes a more risky investment. This means that the change in value of the security will be less or more than the change in value of the general market (Da, Guo, & Jagannathan, 2010).
Beta is used to find the expected return on a stock through various methods, of which Capital Asset Pricing Model is the most commonly used. Comparing the performance of different securities through Treynor measure also uses Beta.
Beta is not completely stable over time as the basic measurement of Beta is by dividing the covariance between the stock and the market, by the variance of the market. As the covariance can change over time due to market conditions, the Beta also changes which may change the risk profile of the security (Da, Guo, & Jagannathan, 2010).
This would result in Beta changing over time. However, the range of movement of Beta is very small. It has been empirically observed that the range of Beta for cyclical stocks is larger than the range for counter-cyclical stocks.
Capital market efficiency is the ability of the markets to reflect latest available information in security prices while minimizing the time lag between information dissemination and price change (Malkiel, 1995).
According to the efficient market hypothesis, market can be either strongly efficient, semi-strong efficient or weak efficient. The difference between the three forms is due to the ability to factor in different forms of information.
Capital market is considered to be of weak form efficient if only the historic and public information is factored in the market prices of securities. The market is semi-strong form efficient if both the historic as well as current public information is factored in the prices.
When the historic public and non-public information and the current latest available information including both public and private information is reflected in the security prices, the market is said to be strongly efficient (Malkiel, 1995).
Most of the current markets in developed countries are considered to be semi-strong form efficient non-public information dissemination does not happen as quickly as it should. Further, some degree of information asymmetry exists between the market participants and the management or the Board of various corporations.
A semi-strong form of market efficiency also suggests that the fundamental analysis and technical analysis should not be able to fully predict future market movement. However, these two types of analyses form the basis of most investment decisions taken by the market participants.
Thus overall, it can be said that the market is not fully efficient and the reason for semi strong nature of market efficiency lies in the degree of information asymmetry between the general public and the executives of the companies.
References
Kuritzkes, A., Schuermann, T., & Weiner, S. M. (2002). Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates. Brookings-Wharton Papers on Financial Services.
FMA. Types of risk. Financial Markets Authority. Retrieved from https://fma.govt.nz/consumers/investment-risk/types-of-risk/.
Da, Z., Guo, R., & Jagannathan, R. (2010). CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence. UIC College of Business Administration. Research Paper No. 10-06.
Malkiel, B. G. (1995). Returns from Investing in Equity Mutual Funds 1971 to 1991. Journal of Finance, 50(2): 549-572.
