BBS/BBA/MBS Exam Notes

What is Risk in Finance? What are the Types of Risk?

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Types of Risk

Risk Analysis on Common Stock

risk is an uncertainty happening. It is a peril (cause of loss), or a hazard (something that makes the occurrence of a peril more likely or more danger). In other words Risk involves the chance an investment’s actual return will differ from the expected return. Risk is the potential chance of gaining or losing something of investment value.

The three main components, which can be called the “three Ms” of risk analysis, are:

  • Modeling risk: This includes identifying economically dangerous uncertainties and the risk factors associated with them. Modeling risk also includes the method of observing data and estimating probabilities to quantify and control the risk.
  • Measuring risk: This relates to a quantitative assessment of the amount of risk caused by the methodology used to measure risk.
  • Managing risk: This consists of all actions needed to mitigate the risk and/or to alleviate the consequences of unwanted events. It involves selecting appropriate risk-management techniques, making optimal decisions, and implementing and reviewing the risk management process. (Investment Risk Management by H. Kent Baker, Greg Filbeck, 2015, Pg. No. 18)

Categories & Types of Risk

  1. Market risk

It is the risk of investment declining value by economic factors and market situation such as demand and supply. There are three main types of market risk such are equity risk, interest rate risk and currency risk.

  • Liquidity risk

It is the risk of being unable to sell the investment at a fair market price and get the profit from investments. It creates less value and forced to sell in lower price.

  • Concentration risk

It is a risk of loss because money is concentrated in only one investment or type of investment. It is also a portfolio risk such as diversify the investment and spread the risk into different types of investment.

  • Credit risk

It is a risk that the company who issued the debt will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity.

  • Re-investment risk

It is a risk of loss from re-investing principal or income at a lower interest rate. It also focused on change on re-investment interest rate and occur loss.

  • Inflation risk

Inflation is reducing the purchasing power of money over time and the same amount of money will buy fewer goods and services. That kind of risk and creates a loss in the value of investments if called inflation risk.

  • Horizon risk

It is a risk arise from investment horizon because of an unforeseen event occur and forced to sell the holding securities before maturity. In case of market down in such timing that create a loss from these types of risk.

  • Foreign investment risk

It is a risk of loss when investing in foreign countries. When someone buy foreign investments, but that risk occur only in domestic countries but not other countries then these types of risk occur.

  1. Interest rate risk

It is the risk that an investment’s value will change because of change in the level of interest rates, in the spread between two rates. Interest rate risk is the risk that arises for financial securities owners from fluctuating interest rates.

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