Risk in a Traditional Sense
Risk in holding securities is generally associated with possibility that realized returns will be less than the returns that were expected. The source of such disappointment is the failure of dividends (interest) and/or the security’s price to materialize as expected.
Forces that contribute to variations in return price or dividend 9interest) constitute elements of risk. Some influences are external to the firm, cannot be controlled, and affect large numbers of securities. Other influences are internal to the firm and are controllable to a large degree. In investments, those forces that are uncontrollable, external and board in their effect are called sources of systematic risk. Conversely, controllable internal factors somewhat peculiar to industries and/or firms are refereed to as sources of unsystematic risk.
Finding stock prices falling from time to time while a company’s earnings are rising, and vice versa, is not uncommon. The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investors’ attitudes toward equities in general, or toward certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk.
Interest-rate risk refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates. The root cause of interest-rate risk lies in the fact that, as the rate of interest paid on U.S. government securities (USGs) rises or falls, the rates of return demanded on alternative investment vehicles such as stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for nearly risk-free securities (USGs), the cost of money to more risk-prone issuers (Private sector) will also change
Market risk and interest-rate risk can be defined in terms of uncertainties as to the amount of current dollars to be received by an investor. Purchasing-power risk is the uncertainty of the purchasing power of the amounts to be received. In more everyday terms, purchasing-power risk refers to the impact of inflation or deflation on an investment.
Unsystematic risk is the portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. Factors such as management capability, consumer preferences, and labor strikes can cause unsystematic variability of returns for a company’s stock. Because these factors affect one industry and/or one firm, they must be examined separately for each company.
Business risk is a function of the operating conditions faced by a firm and the variability these conditions inject into operating income and expected to increase 10 percent per year over the foreseeable future, business risk would be higher if operating earnings could grow as much as 14 percent or as little as 6 percent than if the range were from a high of 11 percent to a low of 9 percent. The degree of variation from the expected trend would measure business risk.
Financial risk is associated with the way in which a company finances its activities. We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money of debt in the capital structure creates fixed payment in the form of interest that must be sustained by the firm. The presence of these interest commitments fixed interest payments due to debt of fixed-dividend payments on preferred stock causes the amount of residual earnings available for common-stock dividends to be more variable than if no interest payments were required. Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk.