A risk-free investment is defined as one where the investor is doubly sure of the amount and timing of the expected returns. Returns from most investments do not fit this pattern. An investor typically is not completely certain of the income to be received or when it will be received.
Investments can range in uncertainty from basically risk-free securities, such as treasury bills and bank term deposits, to highly speculative investments, such as the equity shares of small companies engaged in high-risk enterprises.
Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the risk-free rate is known as risk premium. Basically, the risk premium represents a composite of all uncertainty such as business risk, financial risk or leverage risk, liquidity risk, exchange rate risk and country or political risk.
Business risk: It is the uncertainty of income flows caused by the nature of a company?s business. The less certain the income flows of the company, the less certain are the income flows to the investor too. It is influenced by factors such as sales, input costs, competition, overall economic climate and government regulations in that segment of the industry. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic nature of the business of the firm.
Finance risk: It is the uncertainty introduced by the method by which the company finances its assets. If a company uses only equity shares to finance its assets, it incurs only business risk. If a company borrows loans to finance its assets, it must pay fixed financing charges (in the form of interest to the bankers or lenders) before providing income to the equity shareholders; so, the uncertainty of returns to the equity investor increases.
This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the share?s risk premium.
Liquidity risk: It is the uncertainty that exists in the stock market for a share. When an investor acquires an investment, he or she expects the investment to mature (as in the case of bonds) or to be salable to someone else. In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments.
The more difficult it is to make this conversion, the greater is the liquidity risk. Uncertainty regarding how fast an investment can be bought or sold, or the existence of uncertainty about its price, increases liquidity risk.
Exchange rate risk: It is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her home currency. This risk arises owing to the fluctuations in the exchange rate between investors home currency and securities currency. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries.
Country risk: It is also called as political risk and it is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. Countries where political and economic systems are the most stable are known to have less country risk and vice versa. The analysis and measurement of country risk is much more subjective and must be based on the history and current environment of the country.
The different risk components discussed above constitute a security?s fundamental risk because it deals with the intrinsic factors that should affect a security?s returns over time.
* The writer is an associate professor of accounting and finance in IIM Shillong
Risk alert
* Business risk: It is the uncertainty of income flows caused by the nature of a company?s business. The less certain the income flows of the company, the less certain are the income flows to the investor
* Finance risk: It is the uncertainty introduced by the method by which the company finances its assets
* Liquidity risk: It is the uncertainty that exists in the stock market for a share. When an investor acquires an investment, he or she expects the investment to mature (as in the case of bonds) or to be salable to someone else
* Exchange rate risk: It is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her home currency
* Country risk: It is also called as political risk and it is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country
