Scribd
Upload
50 views3 pages

Risk and Return Analysis Overview

The document discusses investment risk, defining it as the likelihood of losses relative to expected returns, and categorizes risks into systematic and unsystematic types. Systematic risks affect the entire market and include factors like exchange rate, inflation, and interest rate risks, while unsystematic risks are specific to individual companies or industries and can be mitigated through diversification. Additionally, it highlights the importance of portfolio risk management, addressing various risks that could impact overall investment performance.

Uploaded by

Maruthi N
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
50 views3 pages

Risk and Return Analysis Overview

The document discusses investment risk, defining it as the likelihood of losses relative to expected returns, and categorizes risks into systematic and unsystematic types. Systematic risks affect the entire market and include factors like exchange rate, inflation, and interest rate risks, while unsystematic risks are specific to individual companies or industries and can be mitigated through diversification. Additionally, it highlights the importance of portfolio risk management, addressing various risks that could impact overall investment performance.

Uploaded by

Maruthi N
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

M.V.

Sandeep GCW Kolar

Chapter 3
Risk Return Analysis
Risk
Investment risk can be defined as the probability or likelihood of occurrence of losses
relative to the expected return on any particular investment.P
Investment risk is defined as the probability or uncertainty of losses rather than expected
profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate,
etc.
Types of Risks
 Systematic Risk
 Unsystematic Risk
SYSTEMATIC RISK
Systematic risk is defined as the risk that is inherent to the entire market or the whole
market segment as it affects the economy as a whole and cannot be diversified away; thus is
also known as an “undiversifiable risk” or “market risk” or even “volatility risk.” Systematic risk is
that part of the total risk that is caused by factors beyond the control of a specific company or
individual. Systematic risk is caused by factors that are external to the organization.
Types of systematic risks
 Exchange Rate Risk/Currency Risk: For investments that involve foreign exchange,
currency risk, or exchange rate risk, comes into play. It refers to the potential for loss due
to variations in the currency exchange rate .In a globalized economy, most companies
have exposure to foreign currency. Exchange rate risk is the uncertainty associated with
changes in the value of foreign currencies. Therefore, this type of risk affects only the
securities of companies with foreign exchange transactions or exposures such as export
companies, MNCs, or companies that use imported raw materials or products.
 Purchasing power risk/Inflation risk: When inflation occurs, it causes purchasing power
risk. Inflation is when prices of goods and services increase at once, causing individuals
to be able to buy less with the same amount of income. Therefore, if an investor’s income
does not increase in times of rising inflation, then the investor is actually getting lower
income in real terms.
 Socio Political Risk: Political Risk is the chance that a government’s actions could affect
the value of an investment. Political Risk can include war, civil unrest, changes in tax laws,
and other events out of investors' control. Political instability, regulatory changes, and
geopolitical conflicts can lead to socio-political risk, impacting markets and investment
values globally.
 Interest Rate Risk: This type of systematic risk arises from fluctuations in interest rates,
which can significantly affect the value of fixed-income securities. When interest rates rise,
the prices of existing bonds typically fall, and vice versa
 Market Risk: Market risk is caused by the herd mentality of investors, i.e. the tendency of
investors to follow the direction of the market. Hence, market risk is the tendency of
security prices to move together. If the market is declining, then even the share prices of
good-performing companies fall.
 Liquidity Risk: This risk refers to the potential difficulty in selling an investment at its fair
market value due to a lack of buyers, which can be exacerbated during market stress

Notes only for class circulation 1


[Link] GCW Kolar

Unsystematic Risk
Unsystematic risk is unique to a given business or industry. It is also known as specific
risk, non-systematic risk, residual risk, or diversifiable risk.
Unsystematic risk is caused due to internal factors; it can be avoided and controlled.
Unsystematic risk can be minimised by diversification in the sense of an investment portfolio.
 Business risk: Business risk includes all the risks that threaten a company’s revenue,
profitability and overall performance. Business risk could arise due to internal factors like
production disruptions or external factors like changes in consumer preferences.
 Financial risk: Financial risks includes the risks associated with the financial structure of
a company. A less than ideal or weak financial structure due to an incorrect or sub optimal
debt equity mix is one of the major financial risks a company faces.
 Regulatory risk: Regulatory risk includes disruptions that are caused due to changes in
the laws, regulations and policies governing a company or an industry. E.g., change in
corporate taxation, environment regulations etc.
 Management Risk: Management risk is the uncertain surrounding the competency and
decisions of a company’s key management team. Some of the factors that contribute to
management risk involve poor strategic choices, ineffective leadership, and corporate
governance issues.
 Industry risk: Industry risk involves all the factors that affect an entire industry. Generally,
industries that are characterised by rapid innovation and stringent regulations often have
significant higher industry risk
 Strategic Risk: Strategic risks are such that can happen to a business at any time. This
could be due to the change in customer preferences. Hence, businesses need to have a
real time feedback system for recognising customer feedback.
 Operational Risk: This involves all the factors that threaten the day to day operations of
the company. This includes the breakdown f critical machinery, date breaches and
supply chain management
Difference between Systematic and Unsystematic Risk
 Unsystematic risk is specific to a particular industry, segment, or security, while the
systematic risk is associated with the entire market or segment.
 Unsystematic risk arises from internal factors that can be controlled or reduced, while the
systematic risk is uncontrollable.
 Diversification can help to eliminate unsystematic risks, but not in the case of systematic
risks.
 Unsystematic risk can be mitigated through measures such as proper management and
diversification of investments. In contrast, systematic risk cannot be eliminated entirely
and requires investors to accept some level of market risk.
 Systematic risk can lead to losses in both bull and bear markets, whereas unsystematic
risk mostly affects investments during unfavourable conditions.
Portfolio Risk Management
Portfolio risk management is the process of identifying, measuring, and addressing the
potential risks that could have an impact on the overall performance of a portfolio. Some types
of portfolio risk include:
 Company-Specific Risk – the possibility that a single holding could perform poorly
 Foreign Currency Risk – currency fluctuations could have a negative impact on returns
Notes only for class circulation 2
[Link] GCW Kolar

 Liquidity Risk – the possibility that an investment might not be sold readily without
affecting the market price
 Interest Rate Risk – a movement in interest rates could negatively affect investment value
 Inflation Risk – rising prices could have a negative impact on the value of portfolio
holdings
 Systematic Risk – market risk, which cannot be avoided
 Climate Risk – the impact of climate change could have a negative impact on holdings
 Reinvestment Risk: Reinvestment risk occurs in the event of declining interest rates. For
example, you invest in bonds at a specific interest rate and gain high returns. But with
falling interest rates, you are unable to reinvest and avail that initial interest rate which
gave you high returns previously.
 Horizon Risk: Horizon risk is when you decide to invest in an asset for a longer duration,
e.g., 10 years. However, due to unforeseen events, you may be forced to sell the
investments even if the market is down, resulting in a loss.
 Credit Risk: Applicable for debt investment (bonds), credit risk is when the company that
issued the bonds faces financial difficulties. Always check the credit ratings of bonds
before investing.
 Concentration Risk: The risk of losing your money because you decided to invest all your
money in only one type of asset, such as the stock market, is known as concentration risk.
A good investment portfolio does not invest only in just one asset.

Notes only for class circulation 3

Common questions

Powered by AI

Interest rate risk, a form of systematic risk, arises when fluctuations in interest rates affect the value of investments, particularly fixed-income securities such as bonds. When interest rates rise, the prices of existing bonds typically fall, since newer issues would pay higher rates, making older bonds less attractive . This can lead to reduced portfolio value and lower returns on investments. In scenarios of falling interest rates, investors face reinvestment risk where they are unable to lock in the previously high yields . To mitigate this, investors can adjust the duration of their bond holdings and consider floating-rate securities to reduce sensitivity to rate changes .

Diversification reduces unsystematic risk by spreading investments across various assets or sectors, thereby minimizing the impact of loss from any single investment. Unsystematic risk arises from factors specific to individual companies or industries, which can be controlled through diversification . However, systematic risk, which is inherent to the entire market, cannot be mitigated through diversification. This is because systematic risk affects all investments across the board due to overarching economic factors like inflation or currency fluctuations that impact every asset class . Therefore, while diversification is a powerful tool against specific risks, it leaves market-wide risks untempered .

Systematic risk is associated with the entire market or market segments and includes risks such as currency fluctuations, inflation, socio-political instability, and interest rate changes. These risks are beyond control and cannot be diversified away, meaning investors must accept some level of this risk . Unsystematic risk, on the other hand, is specific to a company or industry and is influenced by factors such as management decisions, financial practices, or industry changes. It can be mitigated through diversification and effective management . Investors can manage systematic risk by diversifying their portfolio geographically and by asset class. For unsystematic risk, diversification within the industry and monitoring for internal company and sector-specific issues are key management strategies .

Global investments expose companies to systematic risks such as currency exchange rate fluctuations, socio-political risks, and regulatory changes. Currency risk arises from changes in the value of foreign currencies, potentially affecting multinationals negatively if the local currency strengthens against major trading partners’ currencies . Socio-political risks, including geopolitical tensions or political instability, can disrupt operations and market conditions abroad. Additionally, regulatory risks from varying international laws and policies can affect both operational costs and market access for multinational companies. These factors can reduce profitability and increase uncertainty for multinationals, affecting their financial performance and investment valuations .

Systematic risk impacts investors in both bull and bear markets since it influences the entire market irrespective of individual stock performance. During a bull market, systematic risks like geopolitical tensions or inflationary pressures can temper gains by increasing market volatility or leading to asset price corrections . In a bear market, these risks exacerbate downward trends, further eroding investment values. Systematic risk is unavoidable because it encompasses the external macro-economic factors that affect all market participants, making it impossible to eliminate entirely through diversification or strategic investment . Compensating for systematic risk involves risk tolerance adjustment and strategic asset allocation to balance potential returns against these unavoidable market-wide risks .

Liquidity risk can be both systematic and unsystematic. It becomes systematic when market-wide declines lead to insufficient buyers, making asset liquidation difficult at fair value . It is unsystematic when it pertains to a specific security or market segment, independent of broader economic conditions. Strategies to mitigate liquidity risk include diversifying investments to avoid over-concentration in illiquid assets and maintaining a balanced portfolio with a mix of liquid and less liquid assets. Additionally, monitoring market trends and having a strategic exit plan ready can reduce the impact of liquidity challenges .

Climate risk contributes to portfolio risk as it encompasses both physical risks from climate change (e.g., extreme weather events) and transitional risks associated with shifts towards a low-carbon economy (e.g., policy changes). These can impact asset values, particularly in sectors like energy, agriculture, and infrastructure, due to damage, increased operating costs, or regulatory constraints . To address climate risk, investors can adopt a sustainable investment approach by integrating environmental, social, and governance (ESG) criteria into investment processes and favoring companies that are proactive in managing climate risks. Diversifying into industries less susceptible to climate impacts or investing in renewable energy and sustainable technologies are additional strategies to minimize this risk .

Horizon risk in investments refers to the possibility that unforeseen events may force an investor to sell an investment earlier than planned, such as when market conditions are unfavorable, resulting in potential financial loss . Factors influencing horizon risk include changes in personal financial situations, economic downturns, unexpected expenses, and liquidity needs. Macro factors like recessions or regulatory changes can also necessitate premature liquidation of assets. Investors can manage horizon risk by maintaining a diversified and liquid portfolio, regularly reviewing financial goals, and preparing for contingencies through disaster planning and maintaining accessible emergency funds .

Concentration risk arises when investors allocate a large portion of their portfolio into a single asset or a narrow market sector, increasing vulnerability to specific adverse events . This can lead to significant financial loss if that asset or sector performs poorly. To mitigate concentration risk, investors should ensure portfolio diversification across various asset classes, industries, and geographical regions. This reduces dependency on any one investment for overall portfolio performance. Regular portfolio reviews and reallocation to avoid over-concentration in high-performing sectors can further manage this risk .

Unsystematic risks have varying effects on a company's performance. Business risk arises from factors that can threaten revenue, such as shifts in consumer preferences or operational failures. Financial risk, linked to the company's financial structure, can lead to excessive debt burdens affecting company solvency . Regulatory risk involves changes in laws or tax policies that can increase compliance costs or limit business operations. Management risk emerges from poor corporate governance or strategic missteps, damaging company performance and investor confidence. Industry risk could result from rapid innovation or competition within the sector, potentially reducing market share and profitability . Addressing these risks involves strategic planning, risk assessment, and effective management practices. Diversifying the product lineup and maintaining flexible operations can also help mitigate these risks .

You might also like