In the previous note on the lecture series of financial institutions and markets, we have learned about the financial markets and financial institutions. Further, we focused on the financial market, how demand and supply of funds affect the financial market, and why financial market equilibrium is required. Furthermore, we have also seen why the financial market should be efficient and different measures of market efficiency and financial development indicators. In the end, we learned the relationship between financial development and economic growth as a whole for a nation.
In this note, we will start a new topic called risks in financial systems. This concept can be used across different financial institutions and markets. We know that the most crucial thing in the financial market is managing risk. As every participant comes to the market knowing that they will expose certain kinds of risk, they want to maximize the return. So keeping these things in mind, we can start some discussion related to different types of risk observed in the financial system.
What is Risk?
Risk is a situation where the objective probability distribution of the values of a variable is known, even though the exact values it would take are unknown.
The exact value means whenever we predict something in the market like a particular stock or bond is going to perform and the percentage of returns it gives. We define a specific probability distribution for every possible event or scenario. For example, a particular market has three scenarios. Let us consider the different scenarios:
- First, a normal condition and associated probability is 30%, and the rate of returns is 8%.
- A boom in the market and related probability is 40%, and the rate of returns is 10%.
- A market recession and corresponding probability are 30%, and the returns rate is 5%.
Here we are more interested in returns from the market. And we have a specific probability distribution for each condition. For example, if the market is normal, there is a probability that the rate of return may be 8%. But, exactly, we don’t know whether we will get the same return or not. However, we can go with the probability distribution of the outcome variable or the focused variable.
We can calculate the probability values from past or historical data about a particular variable (condition). These values can be used to predict the future values of a specific variable. This probability distribution is based on the theory, past experiences, and the law of chance. Thus, the probability distribution can be derived from the past observations, and accordingly, we can assign specific probabilities.
The risk can be defined as the chance that the expected or prospective advantage, gain, profit, or return may not materialize; that the actual outcome of the investment may be less than the desired outcome.
The greater the variability or dispersion in the possible outcomes, the greater the risk. For example, suppose we have an expected return value from the booming market is 10%. However, if there is a high deviation from the expected value, there is a high risk. It is like 12% or 14% or 8% or 6%, etc. When the expected returns are not materialized, we face a certain amount of risk in the market. It tells that positioning in the market is risky because we expect that we may not receive a particular thing.
We called it a risk because we expect something derived from the historical data, and we are getting something else. In this case, the expected value is a mean value returns from a particular distribution. The risk is calculated from the variation of the return of that specific data for the expected return. Thus, variability measures the risk; higher variability means more increased risk.
Measures of Risk
Variance and Standard Deviation: The fundamental measure of risk is the variance and standard deviation of return. It serves as an alternative statistical measure of the risk of a particular security in an absolute sense. However, when we want to compare and analyze the risk relative to particular security with other securities, we use a covariance measure. It measures the risk of a security relative to other securities in a portfolio.
Coefficient of variation: It is advantageous to compare the different securities with the associated parameters. For example, suppose there are two securities, A and B. The yearly return is 10% with a risk factor of 8%, B is 12% and 9%. In this case, using the coefficient of variation, we can conduct an analysis and choose one of the alternatives. It is a ratio between the mean return and standard deviation.
Value-at-Risk: It is a statistical measure of the riskiness of financial assets or portfolios of the assets. It is defined as the maximum amount expected to be lost over a given time horizon at a pre-defined confidence level. It tells a maximum loss somebody can make at a particular time period at a particular confidence level. For example, if 95% one-month VAR is Rs. 5 million, there is 95% confidence that the portfolio will not lose more than Rs. 5 million over the next month.
Types of Risk
Systematic Risk: Systematic risk is the variability in a security’s total return directly associated with the overall movements in the general market or economy. The systematic risk arises due to the fluctuation of the microeconomic fundamentals like interest rate, inflation, etc. It can not be diversified.
Unsystematic Risk: Unsystematic risk is the variability in a security’s total return unrelated to the overall market variability called unsystematic risk. It can be diversified and specific to an individual entity, i.e., an individual company. The unsystematic risk can also be called idiosyncratic risk.
Types of Systematic Risk
These are the risk, which is driven by the changes in the microeconomic fundamentals, and it impacts all the market participants. In the below section, we will learn about the basics and different risks measures.
Market Risk (Beta)
Beta indicates the extent to which the risk of a given asset is non-diversifiable; it is a coefficient measuring a security’s relative volatility. Statistically, beta is the covariance of a security’s return with that of the market for a security class.
Where i represents individual returns of a particular asset, m is a market return to which a particular asset is associated, and 
is a variance of the market. An example can be, let i represents a stock returns, and m represents BSE Sensex returns.
It is the slope of the regression line relating a security return with the market return. The security with a higher (than 1) beta is more volatile than the market, and the asset with a lower (than 1) beta would rise or fall more slowly than the market.
Interest Rate Risk
Interest rate risk is the variability in return on security due to changes in the level of market interest rates. It has two parts, and these two parts of interest rate risk move in opposite directions.
- First, the price risk resulting from the inverse relationship between the security price and interest rates.
- Second, the reinvestment risk results from the uncertainty about the interest rate at which future coupon income or principal can be reinvested.
Inflation Risk
Inflation risk is also known as purchasing power risk as there is always a chance or possibility that the purchasing power of invested money will decline, or that the real (inflation-adjusted) return will decline due to inflation. It is really the risk of unanticipated or uncertain inflation.
Exchange Rate or Currency Risk
Exchange rate risk refers to case-flow variability experienced by economic units engaged in international transactions or internation exchange, on account of uncertain or unexpected changes in exchange rates. There is no exchange rate risk under the fixed exchange rate system, while it is the highest under the freely floating exchange rate system.
Country Risk
Country risk is the degree to which political and economic unrest affect the securities of issuers doing business in a particular country. It is the probability of loss due to political instability in the buyer’s country resulting in inability to pay for imports.
Types of unsystematic Risk
These kinds of risks can be diversified by keeping varieties of assets or instruments in their portfolio. If one asset or instrument is not doing well, others may compensate. So, therefore, unsystematic risk is a fundamental concept that is used in the investment of the portfolio management process. It also plays a significant role in the financial system participantion as a whole. These are different types of unsystematic risk and these are as follows:
Business Risk
Business risk is the uncertainty of income flows that is caused by the nature of a firm’s business.
It is a fluctuations of the sales income of that particular company. If the sales income is fluctuating highly, we can say that particular company is exposed to more business risk. On the other hand, if the fluctuation of sales is relatively less or the deviation of the expected sales and actual sales are less, we can say that the business risk of that particular compnay is less. The business risk is a volatility or the standard deviation of the sales income of that particular company in a quantitative sense as the major source of income for a company is sales.
It has two components: one is internal and another one is the external.
There are many internal factors, and few are listed below:
- Operating efficiency of the company
- How the company operates
- What kind of business strategy do they adopt
- What are the company’s sales maximization strategy
- What is the structure of the company
- What is the advertisement strategy of the company
- How is the customer base
- Product differentiation to bet their competitors
In the same way, there are many external factors, and a few are listed below.
- Cyclic and Seasonal conditions: For example, a company product and sales cold drink, ice cream, etc. Their sales income is highly fluctuated by the seasonal factors. As we can observe in summary, company sales may increase compared to the winter season. It is also related to the strategy which a company adopts internally, but mostly those factors are determined by the internal factors.
Usually, the company does not control external factors to a large extent. However, internal policies and factors can be managed and regulated by the company.
Business risk is measured by the distribution of the firm’s operating income (i.e., the firm’s earnings before interest and tax) over time.
Financial Risk
Whenever any company tries to invest in a business, they want capital. There are two ways to raise money: take debt from the banks, issue bonds, or through equity. So, every company has debt and equity components. However, financial risk is measured through debt financing. It means, if a company has more debt, it is exposed to more risk, and similarly if a company’s debt is less, it is exposed to less risk.
What is the percentage of capital financed through debt and equity? If the percentage of the capital financed through debt is relatively high compared to equity, then we can say that the company’s financial risk is high. The standard measure is the debt-to-equity ratio.
Whenever any company takes a loan or receives debt or issues bonds, in this particular case, the company’s first obligation is to pay them from the profit systematically, and it is fixed. It can’t be avoided compared to paying to the equity holders via dividends or bonuses, etc. So, once a company pays interest, taxes, dividends (optional), etc., to the stakeholders, the effective company’s profit is called return earnings and is an actual profit for a company.
Suppose if a company does not have sufficient earning to pay the interest. The financial risk increases heavily because shareholders may not show interest in a company to invest further, seeing the debts. Consequently, it increases the cost of a company and effectively increases the company’s risk. So financial risk rises when the debt to equity ratio is high.
Default or Credit Risk
Default risk arises from the failure on the part of the borrower or debtor to pay the specific amount of interest and/or to repay the principal, both at the time specified in the debt contract or covenant or indenture.
For example, a company has taken loan and in the loan agreement, interest rate, principal amount and time period are mentioned. And, if a company could not pay the interest, or net principal amount, then it will increase the risk for that particular orginization who has given the that particular loan.
Default risk measures the probability of default. It is essential from the banking or financial institutions’ point of view as financial institutions are mostly doing loan giving business to different companies. If an organization has provided a loan, what is the probability that a particular company may not repay in terms of interest or the principal amount that increases the risk level of that specific organization?
The default risk has the capital risk and income risk as its components, and that it means not only the complete failure to pay but also the delay in payment.
Liquidity Risk
Liquidity is basically how fast a particular asset can be converted into cash. If it is very easily converted into cash, we can say that the asset is more liquid. For example, when we keep money in a savings account, we can withdraw a small amount of cash anytime from ATM. However, when we invest in the stock market, the withdrawal procedure takes time to say that it has less liquid.
Liquidity risk refers to a situation wherein it may not be possible to dispose off or sell the asset, or it may be possible to do so only at great inconvenience, and cost in terms of money and time.
The greater the uncertainty about the time element, price concession, and transaction cost, the greater the liquidity risk.
For banks and financial institutions, liquidity risk refers to their inability to meet depositors’ liabilities when they want to withdraw their deposits. Whereas, from the market perspective, how easily can an asset be converted into cash, cost of withdrawal from the market. If the cost of withdrawal or transaction is less, we can say that the liquidity risk is less and vice versa.
Liquidity and profitability do not go together, so there is a tradeoff, how much liquidity is required, which needs to be calculated smartly. If the liquidity is high, then the profitability may be suffered.
Maturity Risk
Maturity risk arises when the term of maturity of the security happens to be longer. Since foreseeing, forecasting, and envisioning the environment, conditions, and situations becomes more and more difficult as we stretch more and more into the future, the long-term investment involves risk.
Call Risk
Call risk is associated with the corporate bonds which are issued with call-back provision or option whereby the issuer has the right of redeeming the bonds before their maturity. In case of such bonds, the bond holders face the risk of giving up higher coupon bonds, reinvesting proceeds only at lower interest rates, and incurring the cost and inconvenience of reinvestment.
References
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