TYPES OF RISK
 

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Objectives

• To identify and demonstrate an understanding of systematic (market) risk and unsystematic (market) risk

• Identify and demonstrate an understanding of credit risk, foreign exchange risk, interest rate risk, market risk, and political risk

• Distinguish between individual security risk and portfolio risk

• Demonstrate an understanding of diversification 

 

Outline

Risk is a broad concept that can be broken down into several types of risk. Understanding what each type of risk means is important to evaluating how it can affect business operations and financial performance. This lesson reviews key terms and definitions for understanding risk in its various forms.  

 

I. Unsystematic (Company) Risk and Systematic (Market) Risk

a. Unsystematic risk refers to the risk to an investor from owning stock in one particular company. It is a broad term that encompasses any type of risk that may affect the returns of a company's stock. Unsystematic risk comes from company-specific factors such as the company's financial leverage, effectiveness of business operations, strategy, sales cycle and seasonality, credit risk of customers, labor stoppages, and overall company management. Each company faces a unique set of risks. Investors can reduce their exposure to risk arising from one company by diversifying their equity investments across different industries and companies.

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b. A diversified portfolio is one with a mix of investments from different industries. In a diversified portfolio, the chances of all investments performing very well or very poorly is small. Thus, a diversified portfolio can effectively eliminate unsystematic risk.

 

c. Systematic risk is the risk that arises from high-level economic cycles and political environments. Systematic risk is affected by macroeconomic factors such as interest rates, inflation, growth rates of gross domestic product (GDP), currency exchange rates, government rules and regulations, and public policies. Investors cannot diversify away systematic risk. Systematic risk is often called nondiversifiable or market risk. A measure of systematic risk is called beta, which measures how correlated an individual stock's returns are with the broader market returns.

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II.      Portfolio Risk

a.  When evaluating a single investment, risk is often measured as the standard deviation of returns. However, investors normally invest in a variety or portfolio of assets. In order to measure the risk of assets in a diversified portfolio, other measures than standard deviation are used. In a diversified portfolio, the only risk of an individual asset comes from systematic risk. This is measured as the correlation between returns on an individual asset and the returns of the broader stock market.

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b. Assets whose stock prices move in the same direction are said to have a positive correlation. Stocks in the same industry will generally move in the same direction and have a positive correlation. This happens because the macroeconomic factors related to systematic risk will typically affect companies in the same industry in similar ways. In contrast, stocks in very different industries, such as a utility stock and a technology stock, could move in opposite directions and have a negative correlation.

 

c. Correlation is measured as a number between −1 and +1. The closer the correlation is to −1 or +1, the stronger the relationship between the two variables. A +1 correlation means the two variables move in the same direction and in an exact measurable amount. A −1 correlation means the two variables move in the opposite direction and in an exact measurable amount. A zero correlation means there is no linear relationship between the two variables.

 

d. Diversified portfolios are typically less risky for a given level of expected returns than an individual asset. This reduction in risk comes from eliminating the unsystematic risk associated with an individual asset.

 

e. Portfolio risk is not the weighted average of the individual stocks deviations. The portfolio’s risk is generally smaller than the average of the stocks standard deviation because diversification lowers the portfolio risk

 

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III.       Types of Risk

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a. Credit risk or default risk—The risk that a borrower will not repay the investor as promised. When there is a greater probability that a borrower will default, the lender will charge a higher interest rate to compensate for the higher risk.

 

b. Interest rate risk—The risk that market interest rates will vary and impact the value of interest-bearing securities, such as bonds.

 

c. Foreign exchange risk or currency risk—The risk that economic value will be lost due to fluctuations in exchange rates. Companies exporting goods and services benefit when their home currency weakens relative to a foreign currency. More goods and services will be purchased by those using a foreign currency because the goods and services are relatively less expensive. In contrast, companies importing goods and services benefit when their home currency strengthens relative to a foreign currency because they can acquire the goods and services for relatively less money.

 

d. Industry risk—The risk associated with the factors specific to a given industry. For example, agricultural companies are likely to face the risk of a drought negatively affecting their performance, whereas financial companies would not be as affected by the risk of a drought.

 

e. Political risk—The risk that political influence and decisions may affect the profitability and effectiveness of an organization. For example, environmental regulations may affect the operations and costs of chemical producers and manufacturing firms.

 

Sources: 

• Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management. John Wiley & Sons 

• Parrino, R., Kidwell, D., and Bates, T. (2017). Fundamentals of Corporate Finance, 4th Edition. Hoboken, NJ: John Wiley & Sons.

 

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QUESTIONS: 

 

1. Which of the statement/s below is/are true? 

Statement 1: The unsystematic risk can be eliminated through diversification. 

Statement 2: The systematic risk is that portion of an asset’s risk that is attributable to firm-specific, random causes. 

Statement 3: In a diversified portfolio, market risk is the primary source of risk that affects the overall portfolio's performance?

a. All are true

b. All are false

c. One statement is true

d. Two statements are true 

 

2. Systematic risk is also referred to as 

a. Diversifiable risk

b. Economic risk

c. Nondiversifiable risk

d. Total risk  

 

3. The portion of an asset’s risk that is attributable to firm-specific, random causes is called 

a. Non-diversifiable risk

b. Unsystematic risk

c. Systematic risk

d. None of the above 

 

4. How does political risk impact multinational corporations operating in different countries?

a.It has no effect on multinational corporations.

b.It increases regulatory compliance costs.

c.It can disrupt business operations and affect profitability.

d. It encourages investment in emerging markets.

 

5. Which factor affects foreign exchange risk for companies engaged in international trade?

a. Interest rate fluctuations.

b. Inflation rates.

c. Currency exchange rates.

d. Political instability.

 

6. Which measure indicates how correlated an individual stock's returns are with the broader market returns?

a. Alpha

b. Correlation coefficient

c. Standard deviation

d. Beta

 

7. What is the primary objective of having a diversified portfolio across different industries and companies?

a. To increase unsystematic risk

b. To reduce systematic risk

c. To enhance credit risk

d. To eliminate interest rate risk

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8. It is the measure used to assess the likelihood of a borrower defaulting on a loan. 

a. Beta

b. Correlation coefficient

c. Credit risk

d. Standard deviation

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9. What is the primary measure of risk when evaluating a single investment?

a. Correlation coefficient

b. Beta

c. Standard deviation

d. Alpha

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10. In a diversified portfolio, what is the primary factor contributing to the overall portfolio risk?

a. Market risk

b. Credit risk

c. Unsystematic risk

d. Interest rate risk

 

Answer Key:

1. Which of the statement/s below are false? 

Statement 1: The unsystematic risk can be eliminated through diversification. 

Statement 2: The systematic risk is that portion of an asset’s risk that is attributable to firm-specific, random causes. 

Statement 3: In a diversified portfolio, market risk is the primary source of risk that affects the overall portfolio's performance?

Answer: c. One statement is true. Statement 1 is true, as unsystematic risk can indeed be reduced or eliminated through diversification. Statement 2 is false because systematic risk refers to factors affecting the entire market, not just firm-specific causes. Statement 3 is true; in a diversified portfolio, market risk is the primary source of risk that affects the overall portfolio's performance.

 

2. Systematic risk is also referred to as 

Answer: c. Nondiversifiable risk. Systematic risk is also known as nondiversifiable risk because it cannot be mitigated through diversification.

 

3. The portion of an asset’s risk that is attributable to firm-specific, random causes is called 

Answer: c. Unsystematic risk. The portion of an asset’s risk that is attributable to firm-specific, random causes is called unsystematic risk, also known as company-specific risk.

 

4. How does political risk impact multinational corporations operating in different countries?

Answer: c. It can disrupt business operations and affect profitability. Political risk can impact multinational corporations by introducing uncertainties related to government policies, regulations, and stability, which can disrupt business operations and affect profitability.

 

5. Which factor affects foreign exchange risk for companies engaged in international trade?

Answer: c. Currency exchange rates. Foreign exchange risk for companies engaged in international trade is affected by fluctuations in currency exchange rates, as it can impact the value of transactions conducted in foreign currencies. 

 

6. Which measure indicates how correlated an individual stock's returns are with the broader market returns?

Answer: d. Beta. It measures how correlated an individual stock's returns are with the broader market returns, indicating its sensitivity to market movements.

 

7. What is the primary objective of diversifying a portfolio across different industries and companies?

Answer: b. To reduce systematic risk. The primary objective of diversifying a portfolio across different industries and companies is to reduce systematic risk, as it allows investors to spread their investments and reduce exposure to any single economic event or market downturn.

8. It is the measure used to assess the likelihood of a borrower defaulting on a loan. 

Answer: c. Credit risk. Credit risk is the measure used to assess the likelihood of a borrower defaulting on a loan. It affects the interest rates charged to compensate for the risk of default.

9. What is the primary measure of risk when evaluating a single investment?

Answer:  c.  Standard deviation. When evaluating a single investment, the primary measure of risk is typically the standard deviation of returns, which measures the dispersion of returns around the average return.

10. In a diversified portfolio, what is the primary factor contributing to the overall portfolio risk?

Answer: a.  Market risk. In a diversified portfolio, the primary factor contributing to the overall portfolio risk is market risk, which refers to the risk associated with macroeconomic factors and overall market conditions.