What is this ‘Risk’?
The common understanding of the term „risk‟ is the chance of incurring loss. Investments which have a higher chance of loss are considered more risky than investments for which the chances of incurring loss are less.
Sources of Risk
Financial assets face many types of risks such as:
1. Interest Rate Risk
2. Market Risk
3. Inflation Risk
4. Business Risk
5. Financial Risk
6. Exchange Rate Risk
Interest Rate Risk
Interest rate risk refers to the risks associated with changes in the interest rate. The effect of change in interest rates is felt more on debt instruments, namely, bonds and debentures, than on equity. Companies with high interest burden, benefit when interest rates come down and take a beating when the rates go up.
Market risk refers to risks associated with market movements because of sentiments, that is, because of the psychology of the people in the market.
During a bull market run, even the companies that are not doing well may have a better price in the stock market (such as, internet stocks, granite stocks and so on). However, during a bear phase, even good company shares tend to come down. It does not have anything to do with the performance but is driven by market psychology.
Inflation risk rate has a bearing on the market and investors. If the inflation rate is high, people tend to avoid buying. Let us consider consumer goods, which affect the sales of companies involved in manufacturing and sales of, for example, TVs, VCDs, microwave ovens, washing machines and so on. The change in price levels of goods and services is measured by the „Consumer Price Index‟ for industrial workers.
Business risk refers to the risks arising from variability of business, sales, income, and profit. However, this in turn depends on the market conditions for the product mix, input supplies, and strength of competitors.
Business risks can be caused by external factors or internal factors. An external factor to the company includes changes in government policy, strategies of competitors or unforeseen market conditions. The internal business risk factors could be the fall in revenues and in profits of the company. These can be offset by certain changes in the company‟s policies.
Financial risk mainly refers to the financial aspects of the company. This relates to financing adopted by the company. They arise from high leverage leading to larger debt servicing problems, short term liquidity problems, delayed receivables, and so on. These problems could be solved, but they may lead to fluctuations in profits,earnings and dividends to shareholders.
financial planning should be proper along with other financial adjustments can be used to correct financial risk and as such, it is controllable.
Exchange Rate Risk
Exchange rate risk arises due to the change in the currency exchange rates.
Software companies exporting to USA are affected if there is a change in the exchange price of Indian Rupee and US Dollar. This risk mainly affects companies involved in exports and imports of services and goods.