In the context of an investment, a situation of certainty is one in which the return from the investment is known for sure. Let us say, an individual invests in government securities and holds them to maturity. The individual can be sure about the redemption of the amount invested on maturity and payment of interest. Therefore, his/her rate of return is known for sure.
The term risk, in the context of investments, refers to the variability of the expected returns. It is an attempt to quantify the probability of the actual return being different from the expected return. Though there is a subtle distinction between uncertainty and risk, it is common to find the use of both the terms interchangeably.
Types of Risks associated with Investments
The variability of the return or the risk can be segregated into many components, based on the factors that give rise to it. Broadly, risk is said to be made up of three components: business risk, financial risk and liquidity risk. Let us understand them briefly.
Business risk can be easily understood in the context of an investment in a business entity. This risk is the variability of returns introduced by the nature of business of the entity invested in. Changes in prices of raw materials and finished goods, changes in supply and demand for raw materials and finished goods, changes in wage rates, changes in fuel costs, changes in the economic lives of assets, changes in tax laws and changes in operating costs are some of the factors that cause business risk. These factors have a direct impact on the profitability of the investee and which in turn influences the share price and the dividend payment or the ability of the firm to repay its debt with interest. The share price at the time of sale and the dividend payments or the interest payments and redemption amount determine the return to an investor. In the context of a government bond it may mean the ability of the government to generate adequate revenues. However, this becomes less relevant because of its ability to monetize a deficit.
Financial risk arises from the financing pattern of the investee company. In other words, it is the variability of the returns from investments made in the company brought about by the financing mix used by the company. If a company uses only equity, its financial risk will be relatively less, as there are no obligatory payments to be made. A company using debt will carry more risk, as the obligatory payments on account of interest and repayment of principal have to be met before any money is available for distribution to the equity investors. And, inability to meet the obligations may result in compulsory liquidation. These factors create variability in the profits of the firm and its share price.
Liquidity risk refers to the uncertainty of the ability of an investor to exit from an investment when she desires. The exit route primarily depends on the secondary market where the securities are traded. Though issuer may step in to provide liquidity in the form of buy back of shares, options on bonds, redemption of securities, all such provisions have a time dimension which is determined by the issuer. However, the term liquidity refers to the ability of investor to exit according to his/her requirements. When an investor approaches secondary market for liquidity, his/her concerns are two-fold.
- Time taken for liquidation
- Price realization.
If the security is illiquid, it may become necessary to sell at a price lower than the market price to reduce the time taken for liquidation. Such discount/reduction in price is called Price Concession. Hence price concession on a security and liquidity are inversely related.
The buyer too faces the same uncertainties – how long will it take to buy it and at what price can it be bought? The greater the uncertainty regarding these two, higher the liquidity risk. Investments like T-Bills can be sold or bought instantly while those like investments in real estate in remote areas take considerable amount of time and effort to buy or sell.
The risk premium mentioned earlier is, therefore, a function of these three types of risks associated with investments. To sum up, the factors causing volatility are the business risk, financial risk and liquidity risk.