Investment Risk and its Measurement

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In Investments, we always put a footer message says: Investment carries "risks".

Many of us ignore the risk aspect of investing and focus only on the returns aspects.

This is one of the reason why most investors lose money in the market - underestimating risk.

What is *Risk*?

The definition of Risk is very simple.

The possibility that

what is actually earned as return

could be different from what is expected to be earned.

Let us take an example to understand this better.

An investor, Rajesh, invested some money expecting some 20% returns from it in 2 years.

However, because of market down turn, he actually lost 10%.

Here, there is a deviation from what the investor expected and what he actually got.

This deviation is a form of risk.

No investment is free from risk.

Even PPF carries a risk!

In the year 2000, the rate of return for PPF is 11%

If you invested in 2000 feeling the 11% will remain fixed all through the 15 years, you are wrong.

In 2003, the rates came down to 8%

Here, there is a deviation from what we expected and what we are getting in actual.

This is called *Risk*.

These deviations can be positive or negative.

The negative deviations hurt us more.

Types of Risks

Let us now see some types of Risks.

Inflation Risk

Inflation risk represents the risk that

the money received on an investment

may be worth less when adjusted for inflation.

For example, you invested in a bond that gives 10% returns.

The inflation for the year is, say 8%.

The difference, ie 2% is the real rate of return that the investor gets.

Inflation risk is also known as purchasing power risk.

Assume that next year, the inflation rose to 11%.

The bond still is giving at the rate of 10%

Here, the investor is at a disadvantage position.

The inability of the instrument to beat the inflation is called *inflation risk*

Savings bank account interest hardly beats inflation.

So, even though you get interest, there is an inflation risk attached to it.

In otherwords, you are not getting anything advantageous from savings bank deposits.

Default Risk or Credit Risk

Bonds are security products using which companies can borrow.

Sometimes that borrowers will not be able to meet their commitment on paying interest and/or principal as scheduled.

The ability of the issuer of the debt instrument to service the debt may change over time and this creates default risk for the investor.

Even Governments raise money using bonds.

These bonds are called Sovereign bonds.

These do not carry any default risk.

However, any other type of bond carry a default risk.

This is why all bond instruments carry a credit rating.

SEBI made this mandatory.

• Credit rating* is an ..

alpha-numeric symbol

that expresses the credit rating agencies assessment of the ability and

intention of the borrower to meet the obligations arising from the debt.

AAA, A1 indicate the highest degree of credit worthiness

D represents default status

The credit rating changes from time to time and will not be static.

Liquidity Risk or Marketability Risk

This talks about the ability of the investment to be bought or sold in the market.

The market for corporate bonds in India is not liquid, especially for retail investors.

Investors who want to sell a bond may not find a ready buyer.

Some investments come with a lock-in period during which investors cannot exit the investment.

One way of reducing liquidity risk is by diversifying across several investments.

Re-investment Risk

Some investments do not allow re-investment once issued.

Some allow re-investment however the rate of return would be less that compared to when it was issued.

If Interest rate rises , reinvestment risk reduces or is eliminated

If Interest rate falls, reinvestment risk increases

Choosing the cumulative option available in most debt investments is a way for investors to protect the investment from re-investment risk.

Business Risk or Operating Risk

Factors effecting the operations of the company can lead to this risk.

Cost of raw materials, employee costs, introduction and position of competing products, marketing and distribution costs etc bring about changes to business.

Disruptions in any of the factors cause business risk.

Holding a diversified portfolio of securities so that all investments are not affected by a particular business risk is a way to manage this risk.

For example, had you invested 100% of your money only in Gitanjali Gems, you are in high risk.

Had you diversified between, say 10 companies with 10% holding in each, the busimess risk of holding Gitanjali Gems will be limited to 10% only.

Exchange Rate Risk

This risk comes because of changes in the exchange rate of domestic currency relative to a foreign currency.

This impacts when domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment is subject to exchange rate risk.

In currency exchange risk, there are two possibilities:

If *domestic currency depreciates* (falls in value) against foreign currency, the value of foreign asset goes up in terms of domestic currency and the value of domestic assets in terms of foreign currency goes down.

If *domestic currency appreciates* (increase in value) against foreign currency, the value of foreign asset goes down in terms of domestic currency and the value of the domestic assets in terms of foreign currency goes up.

Interest Rate Risk

Now comes the topic that our friend has raised: *Interest Rate Risk*

• Interest rate risk* refers to the

risk that bond prices will fall

in response to rising interest rates,

and rise in response to declining interest rates.

The relationship between rates and bond prices can be summed up as:

If *interest rates fall*, or are expected to fall, *bond prices go up*.

If *interest rates rise*, or are expected to rise, *bond prices decline*.

Simply said: *Bond prices and interest rates have an inverse relationship*

Example: An investor invests in a 5-year bond that is issued at Rs. 100 face value, and pays an annual interest rate of 8%.

Suppose that after one year, the RBI cuts policy interest rates.

As a result all rates in the markets start declining.

New 5-year bonds are issued by companies with a similar credit rating at a lower rate of 7.5%.

Investors in the old bonds have an advantage over investors in the new bonds, since they are getting an additional 0.5% interest rate.

So far so good.. but read on..

Since investors want to earn the maximum return for a given level of risk, there will be a rush of investors trying to buy up the old bonds.

As a result the market price of the old bond will go up.

The price will rise upto a level at which the IRR of the cash flows from the old bond is about 7.5%.

This will take place for all bonds until their yields are aligned with the prevailing market rate.

Investors in debt mutual funds for example are experiencing this.

Because of interest rate volatility, since November - December 2017 till recently, say March 2018, there are slightly negative returns even for debt funds.

Market Risk

• Market Risk* refers to the risk of the loss of value in an investment

because of adverse price movements in an asset in the market.

The price of an asset responds to information that impacts the intrinsic value of an investment.

The classical example of market risk is that of real estate market post demonitisation.

Systematic and Unsystematic Risk

The part of risk that affects the entire system is known as *systematic risk*.

In 2008 financial crisis affected economic growth and led to depressed equity prices across all stocks.

This is an example of systematic risk.

Systematic risk is caused due to factors that may affect the economy/markets as a whole, such as changes in government policy, external factors, wars or natural calamities.

The risk that can be diversified away is known as *unsystematic risk*.

Credit risk, business risk, and liquidity risks are unsystematic risks.

Measuring Risk

In order to measure risk, two types of data is required:

1. Information on the future values of return from that investment and

2. The likelihood of occurrence, or probability estimate for each return value

The most popular risk measurement tool is the *Standard Deviation and Variance*

The standard deviation is the average deviation of observed returns from the average return over a time period.

At least 30 observations are required in the series in order to compute an accurate statistical value of standard deviation.

The *variance* is simply the square of the standard deviation.

In MS Excel, the function STDEV returns the standard deviation of a selected series of data.

The function VAR estimates the variance of the selected values.

Let us uncomplicate the concept with an example.

I am just a math student.. Not a stats student.

An investor has a choise between two investment propositions A and B.

The return from both over the last one year is the same at 12%.

A has a standard deviation of 8% and

B has a standard deviation of 6%.

Which of the two has a higher risk?

Investment A has a higher standard deviation and is associated with higher risk.

Deviation = Moving away from the expectation

i.e prone to surprises

Higher the degree of surprise, higher will be the risk

A is more volatile, and so more risky as compared to B.

Standard Deviation is a good tool to measure risk.

If we draw the probabilities in the form of a chart, it will be bell-shaped.

Questions

Question 1. Is sovereign bonds are treated as default risk ? Yes/No

The term *Sovereign* speaks about guarantee by Government

• Question 2. Corporate bonds are more liquid compare to govt bonds? Yes/ No*

• Question 3. Once credit rating is given to any bond it can not be changed? Yes/No*

• Question 4: Domestic currency value and Foreign assets value runs parallel? Yes/No?*

Hint: Pair Currencies

• Question 5: Bond price will go up when Interest Rates goes up? Yes/No*

• Question 6: Which tool will help to measure Risk on investment?*

• Question 7: The mean and standard deviation can be used to estimate the range within which the returns will fall for an investment whose returns follow a normal distribution.*

• Question 8: Investment in a government security issued at a fixed interest rate is subject to _________ risk*

Answer: Interest rate risk

Related Lessons

• Employees Provident Fund (EPF)
• Gratuity
• National Pension Scheme (NPS)
• Asset Allocation and Investment Strategy
• Investment Adviser and Regulatory Environment
• Investment Products

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