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Types of risk 2
Reading through the various systematic risks in the previous chapter was fun and enlightening, right? In this chapter, we’re going to be looking at the various unsystematic risks. Now, if you can recall, unsystematic risk only affects a particular industry or a company, and not the entire market as a whole. This makes unsystematic risk slightly more important and one that needs to be given much thought. Okay so, let’s begin.
Types of unsystematic risk
When it comes to unsystematic risk, there are as many as 10 different types under three different subcategories. In this chapter, we’re going to be taking a look at all 10 of them, one after the other, starting with liquidity risk.
1. Liquidity risk
If an asset cannot be bought or sold freely as and when possible, it is said to be illiquid. And the risk of an asset being illiquid is known as liquidity risk. This is one of the most important financial risks that you need to account for, since it can completely derail your investment strategy.
This is more so when you already possess an illiquid asset and are stuck in a position where you’re not able to sell it. Liquidity risk tends to be high in small cap companies and penny stocks, whereas it is almost little to none in the stocks of blue chip companies. Now, let’s take a look at the two different types of liquidity risks.
Asset liquidity risk
Asset liquidity risk is the risk of an asset not having enough buyers or sellers to execute sell or buy orders as and when needed. In order to be able to mitigate asset liquidity risk, you would have to either bring your selling price down or quote a higher buying price. That said, doing so can lead to significant losses.
Funding liquidity risk
The risk of not being able to make obligatory debt payments on time due to lack of funds is termed as funding liquidity risk. Funding liquidity risk is something that affects companies more than individuals.
However, being an investor, you can be exposed to the effects of this risk if you end up investing in a company that’s facing a funding liquidity risk. For instance, a company that has all of its current assets locked up in inventories instead of cash or bank balances may have a higher funding liquidity risk. And when you invest in such a company, you get indirectly exposed to the risk as well.
2. Financial risk
Financial risk is the risk of your investments losing their value due to the changes in certain factors. That said, here’s something that you should know. The changes in these factors do not usually have a market-wide impact, although their effects can sometimes extend to multiple industries or companies. There are primarily four different types of financial risks that you need to be aware of. Here’s a quick look at them.
Exchange rate risk
As the name itself implies, the risk of your investments losing their value due to exchange rate fluctuations is termed as exchange rate risk. This risk needs to be accounted for when you invest in securities outside of your home country.
For instance, being an Indian, let’s say that you’ve invested in Amazon Inc., which is an American company. At the time of investment, say the USD-INR exchange rate is low and favourable to you. But then, at the time of liquidation of your position, suppose that the exchange rate drops down even further. This fluctuation can end up reducing the value of your investments.
Recovery rate risk
The risk of not being able to recover a debt or a loan that you’ve given is known as recovery rate risk. As with funding liquidity risk, this risk primarily affects companies that are in the practice of lending to other entities.
Banks and NBFCs are generally the ones most affected by the recovery rate risk. That said, if you’ve invested in any such companies that are in the business of lending, then you might also be indirectly exposed to the effects of the recovery rate risk.
The risk of a government not being able to meet its debt or loan obligations is termed as sovereign risk. Sovereign risk primarily affects instruments issued by the government such as T-bills, G-Secs, and gilt-edged funds, among others. Generally sovereign risk is considered to be zero.
While this might hold true for government securities issued by financially stable countries like the U.S.A and India, sovereign risk tends to be high for securities issued by less financially stable countries.
In a market trade, the risk of default by a counterparty is generally known as settlement risk. In this day and age of electronic trading, settlement risks have been mitigated to a very large extent, thanks to robust risk management systems from both stock brokers and stock exchanges. That said, the risk still exists; maybe not as much for equity delivery trades, but for derivative trades, settlement risk is sometimes an issue. Here’s an example that can help you understand this concept.
Let’s say that you purchase a futures contract of Bajaj Auto Limited. According to the terms of the contract, you’re slated to receive 250 shares of Bajaj Auto Limited at Rs. 3,500 per share on expiry. However, on the date of expiry, the counterparty to this trade, the one who was supposed to sell you 250 shares of Bajaj Auto Limited doesn’t honour his end of the contract. Since the counterparty failed to deliver the promised securities, you end up with a loss. The risk of you getting into such a situation is what is termed as settlement risk.
3. Operational risk
Operational risk is the risk of the business operations of a company being disrupted due to a certain set of factors. The disruption in business operations almost always leads to losses or at the very least lower the value of your investments. That said, most of the types of operational risk only have an indirect impact on your investments. Here’s a quick overview of the four types.
Model risk is the risk of losing the value of your investment as a result of using faulty or weak financial analysis models. In some cases, though the model may be strong, there will always be a margin for error. And despite using the model, you may still end up making a wrong investment decision due to this slight margin for error.
This is the risk of having to deal with losses due to the people in an organization not following the set standard of procedures, rules, or practices. Although it affects your investments indirectly, this kind of risk more often than not leaves a huge impact.
Here’s an example. Let’s say that you invested Rs. 20,000 in a private sector bank. And during an audit, it is revealed that one of the key managerial personnel has siphoned off funds from the bank’s account. This situation creates a negative impact on the price of the bank’s shares and can lead to your investments taking a hit.
The risk of losses arising from a company being non-compliant with the legislations, laws, or governmental policies applicable to it is termed as legal risk. It is sometimes also referred to by traders as regulatory risk. Legal risk also adversely affects your investments in an indirect manner. For instance, when the company you’re invested in flouts any norms, it opens itself up for regulatory action and lawsuits, which can negatively affect its share prices.
Political risk is the risk of losing the value of your investments due to changes in policies set by the government. Governmental policies may sometimes negatively impact some businesses. Some policies may also be unfavourable to an industry. In such situations, your investments may end up losing their value or may even go into severe losses.
With this, we’ve looked at all the different types of risks that you, as an investor, should be aware of at all times. In the next chapter, we’re going to be taking a look at the concept of risk and volatility, since both of them share a very close relationship with each other. Keep reading, and keep learning.
A quick recap
- When it comes to unsystematic risk, there are as many as 10 different types under three different subcategories.
- The main subcategories are liquidity risk, financial risk and operational risk.
- If an asset cannot be bought or sold freely as and when possible, it is said to be illiquid. And the risk of an asset being illiquid is known as liquidity risk.
- Liquidity risk can be asset liquidity risk or funding liquidity risk.
- Financial risk is the risk of your investments losing their value due to the changes in certain factors.
- Examples of financial risk include exchange rate risk, recovery rate risk, sovereign risk and settlement risk.
- Operational risk is the risk of the business operations of a company being disrupted due to a certain set of factors.
- Model risk, people risk, legal risk and political risk are some examples of operational risk.