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Types of Risk
Unfortunately, the concept of risk is not a simple concept in finance. There are many different
types of risk identified and some types are relatively more or relatively less important in different
situations and applications. In some theoretical models of economic or financial processes, for
example, some types of risks or even all risk may be entirely eliminated. For the practitioner
operating in the real world, however, risk can never be entirely eliminated. It is ever-present and
must be identified and dealt with.
In the study of finance, there are a number of different types of risk the been identified. It is
important to remember, however, that all types of risks exhibit the same positive risk-return
relationship.
Some of the most important types of risk are defined below.

Macro Risk Levels

On a macro (large-scale) level there are two main types of risk, these are systematic risk and
unsystematic risk.

Systematic risk is the risk that cannot be reduced or predicted in any manner and it
is almost impossible to predict or protect yourself against this type of risk. Examples
of this type of risk include interest rate increases or government legislation changes.
The smartest way to account for this risk, is to simply acknowledge that this type of
risk will occur and plan for your investment to be affected by it.

Unsystematic risk is risk that is specific to an assets features and can usually be
eliminated through a process called diversification (refer below). Examples of this
type of risk include employee strikes or management decision changes.

Micro Risk Levels

While the above risk types are the macro scale levels of risk, there are also some more
important micro (small-scale) types of risks that are important when talking about the
valuation of a stock or bond. These include:

Business Risk - The uncertainty of income caused by the nature of a companys

business measured by a ratio of operating earnings (income flows of the firm). This

means that the less certain you are about the income flows of a firm, the less certain
the income will flow back to you as an investor. The sources of business risk mainly
arises from a companies products/services, ownership support, industry
environment, market position, management quality etc. An example of business risk
could include a rubbish company that typically would experience stable income and
growth over time and would have a low business risk compared to a steel company
whereby sales and earnings fluctuate according to need for steel products and
typically would have a higher business risk.

Liquidity Risk The uncertainty introduced by the secondary market for a company
to meet its future short-term financial obligations. When an investor purchases a
security, they expect that at some future period they will be able to sell this security
at a profit and redeem this value as cash for consumption this is the liquidity of an
investment, its ability to be redeemable for cash at a future date. Generally, as we
move up the asset allocation table the liquidity risk of an investment increases.

Financial Risk - Financial risk is the risk borne by equity holders (refer Shares
section) due to a firms use of debt. If the company raises capital by borrowing
money, it must pay back this money at some future date plus the financing charges
(interest etc charged for borrowing the money). This increases the degree of
uncertainty about the company because it must have enough income to pay back
this amount at some time in the future.

Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency. This is
particularly important for investors that have a large amount of over-seas
investment and wish to sell and convert their profit to their home currency. If
exchange rate risk is high even though a substantial profit may have been made
overseas, the value of the home currency may be less than the overseas currency and
may erode a significant amount of the investments earnings. That is, the more
volatile an exchange rate between the home and investment currency, the greater
the risk of differing currency value eroding the investments value.

Country Risk - This is also termed political risk, because it is the risk of investing
funds in another country whereby a major change in the political or economic
environment could occur. This could devalue your investment and reduce its overall
return. This type of risk is usually restricted to emerging or developing countries
that do not have stable economic or political arenas.

Market Risk - The price fluctuations or volatility increases and decreases in the dayto-day market. This type of risk mainly applies to both stocks and options and tends
to perform well in a bull (increasing) market and poorly in a bear (decreasing)
market (see bull vs bear). Generally with stock market risks, the more volatility
within the market, the more probability there is that your investment will increase
or decrease.

Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This type of risk
is of particular concern to investors who hold bonds in their portfolios. Government
bonds, especially those issued by the federal government, have the least amount of
default risk and the lowest returns, while corporate bonds tend to have the highest amount
of default risk but also higher interest rates. Bonds with a lower chance of default are
considered to be investment grade, while bonds with higher chances are considered to be
junk bonds. Bond rating services, such as Moody's, allows investors to determine which
bonds are investment-grade, and which bonds are junk.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a
result of a change in interest rates. This risk affects the value of bonds more directly than stocks.
Price Risk
The uncertainty associated with potential changes in the price of an asset caused by changes in
interest rate levels and rates of return in the economy. This risk occurs because changes in
interest rates affect changes in discount rates which, in turn, affect the present value of future
cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise,
prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows
represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk

The uncertainty associated with the impact that changing interest rates have on available rates of
return when reinvesting cash flows received from an earlier investment. It is a direct or positive
relationship. This type of interest rate risk is also covered extensively in the Bank Management
courses.

Political Risk - Political risk represents the financial risk that a country's government will
suddenly change its policies. This is a major reason why developing countries lack foreign
investment.

Growth in size of a firm

Most firms seek to become bigger increasing sales and market share. Firms can grow
through internal expansion, external growth (merger) or diversification into related
industries. The motives for increasing in size can include:

Greater sales lead to greater profit, making the firm more attractive to shareholders

Successful, growing firms are likely to increase salaries / pay bonuses to managers.

Increasing output enables economies of scale, greater efficiency and lower average
costs.

Increased prestige for managers seeing the firm become more influential and powerful.

Greater risk diversification, e.g. when growth comes from product diversification.

Growing in size enables growth in market share and monopoly power, enabling even
greater profitability.

Owners having a passion for their product and wanting to see it do well.

Globalisation has enabled firms to sell product in global market.

Reasons for firms growing

Profit motive
The profit motive is probably the biggest motive why firms try to grow in size. It is the
incentive of profit which encourages owners to take risks to set up the business in the
first place. When a firm has shareholders, there is a greater incentive to try and make
profit to be able to pay shareholders a dividend. However, when a firm seeks to grow,
there is no guarantee that it will be more profitable. To increase market share may
require lower prices, which reduce profitability. If a firm seeks to grow in size by
diversifying into related industries, it may lack the expertise to do well in these different
industries, e.g if an old media firm like Time Warner buys a new internet firm like AOL,
there is no guarantee that Time Warner can prosper in the internet industry.
Motivations of managers and workers
Managers and workers may prefer to work for a bigger firm. This is maybe in the hope of
getting a better salary or it may just be the personal satisfaction of working for a
successful firm. However, it depends on worker morale; it may be that many workers
and managers have little desire to see the firm grow growth may just increase their
stress and responsibility. Therefore, rather than growing, firms may end up pursuing a
type of satisficing where they do enough to keep their owners happy, but then pursue
other objectives.
Economies of scale
Economies of scale are a justification for many mergers, which lead to a big increase in
the size of firms. For industries with high fixed costs, growing in size may be necessary
to stay competitive in a global market. For example, the building of airlines has become
highly concentrated due to the very large economies of scale in that industry. Other

industries like the car industry have also become increasingly concentrated with a
smaller number of large firms dominating the market. Globalisation has definitely
increased the speed at which large multinational companies have grown due to their
global presence.
However, it does depend on the industry. There could be the danger of dis-economies of
scale if firms get too big i.e. it becomes harder to communicate and co-ordinate within
a big firm.
Risk diversification
Virgin started off as a record shop. If it had just stayed in that industry, it would have
closed down because record shops have been in terminal decline. However, the Virgin
group has diversified into a range of industries such as airlines, insurance, mobile
phones, and even space travel. This diversification enables a firm to grow by reaching
into new industries. Virgin can make use of its strong brand name and financial reserves
to successfully enter new industries
However, it does come at a risk. Not all firms may be as successful as Virgin in moving
from retail to running trains. Also, not all firms may have the strong brand loyalty of
Virgin. For example, I dont think it would work for Barclays bank to diversify into running
a mobile phone service.

Barriers to growth of firms

Some firms may have a unique niche. e.g. expensive clothing labels may lose their aura
of exclusivity if they grow.

Growing the firm may require issuing shares and listing the firm on the stock market.
This means that the original founder has a greater danger of losing control and being more
answerable to shareholders who want short term profitability.

Lack of focus if there is too much diversification.

It becomes harder to retain high standards of service if the firm grows. Original founder
has to do more delegation; it depends whether he can find good people to delegate to.

It depends on the industry. Cafes do not share same economies of scale as airline
industry

Competition regulation. The government may block mergers which gain more than 25%
market share. Some firms may even be forced to de-merge if they abuse their dominant market
position.

What causes decline in profit of a firm

he two main reasons for a decline in operating profit are fairly easy to pinpoint -- you either have
a decrease in sales or an increase in expenses. Understanding the different reasons these occur
can take more digging before you can stem the tide of profit erosion. Understanding common
factors that reduce business profits will help you take steps to address them and spot problems
quickly before they get out of hand.
Operating Profit

Its possible to lose money on sales and still make a profit, depending on your sources of income.
Operating profit refers to the money you make on your core business, such as making and selling
a widget. If you sell $100,000 worth of widgets, but your manufacturing and overhead costs are
$110,000, you have an operating loss of $10,000. If you make $25,000 from royalties,
investments or asset sales, you can still show an overall business profit.
Low Sales

An obvious reason for a decline in operating profit is a decline in sales. However, its possible to
increase your sales revenues and suffer a profit decrease. This can occur if your sales increase
comes from higher sales of low-margin items while you suffer a decrease of sales of high-margin
products. Even during good times, its important to track your sales by margins, territory,
distribution channel and sales rep to spot trends that might lead to problems.
Increased Expenses

Another common reason for a decrease in profits is rising costs. Even if your cost to make a
widget doesnt increase, you might have increasing overhead costs, especially as you increase the
pay of long-term employees each year. If your manufacturing and overhead costs remain the
same and your sales are good, you can still see profit erosion if your debt-service costs increase.
For example, missing a payment on a credit card can raise your interest rate and payments
significantly.
Addressing Profit Erosion

Financial reports help you project income, expense, cash flow and debt service, allowing you to
take steps to manage each of these critical areas. Divide your expenses into manufacturing and
overhead expenses if you havent already. Manufacturing expenses include any costs directly tied
to producing your product or service. Overhead costs are those you accrue to run your business,
such as rent, phones, insurance, marketing and office supplies. Track your manufacturing and
overhead expenses each month as a percentage of sales to spot any large swings that indicate a
problem. Even though credit card interest gets rolled into your balance each month, record it as
an expense in your budget to get a true picture of your profits. Analyze your budget performance
against your projections each month to determine if you need to adjust your spending based on
faulty sales projections.
1. The degree of competition a firm faces. If a firm has monopoly power then it has little
competition, therefore demand will be more inelastic. This enables the firm to increase profits by
increasing the price. For example, very profitable firms, such as Google and Microsoft have
developed a degree of monopoly power, with limited competition.

However, in theory, government regulation may prevent monopolies abusing

their power e.g. the OFT can stop firms colluding (to increase price)
Regulators like OFGEM can limit the prices of gas and electricity firms.

2. If the market is very competitive then profit will be lower. This is because consumers would
only buy from the cheapest firms. Also important is the idea of contestability. Market
contestability is how easy it is for new firms to enter the market. If entry is easy then firms will
always face the threat of competition; even if it is just hit and run competition this will
reduce profits.
3. The strength of demand. For example demand will be high if the product is fashionable, e.g.
mobile phone companies were profitable during the period of rising demand and growth in the
market. Products which have falling demand like Spam (tinned meat) will lead to low profit for
the company. Some companies, like Apple have successfully carved out strong brand loyalty
making customers demand many of the new Apple products.

However in recent years profits for mobile phone companies have fallen
because the high profit encouraged over supply, negating the increase in
demand..

4. The state of the economy. If there is economic growth then there will be increased demand
for most products especially luxury products with a high income elasticity of demand. For
example manufacturers of luxury sports cars will benefit from economic growth but will suffer in
times of recession.

5. Advertising. A successful advertising campaign can increase demand and make the product
more inelastic demand, however the increased revenue will need to cover the costs of the
advertising. Sometimes the best methods are word of mouth. For example it was not necessary
for YouTube to do much advertising.
6. Substitutes, if there are many substitutes or substitutes are expensive then demand for the
product will be higher. Similarly complementary goods will be important for the profits of a
company.
7. Relative costs. An increase in costs will decrease profits, this could include labour costs, raw
material costs and cost of rent. For example a devaluation of the exchange rate would increase
cost of imports therefore companies who imported raw materials would face an increase in costs.
Alternatively if the firm is able to increase productivity by improving technology then profits
should increase. If a firm imports raw materials the exchange rate will be important. An
depreciation making imports more expensive. However depreciation of the exchange rate is good
for exporters who will become more competitive.
8. Economies of scale. A firm with high fixed costs will need to produce a lot to benefit from
economies of scale and produce on the minimum efficient scale, otherwise average costs will be
too high. For example in the steel industry we have seen a lot of rationalisation where medium
sized firms have lost their competitiveness and had to merger with others.
9. Dynamically efficient. If a firm is not dynamically efficient then over time costs will increase.
For example state monopolies often had little incentive to cut costs, e.g. get rid of surplus labour.
Therefore before privatisation they made little profit, however with the workings and incentives
of the market they became more efficient.
10. Price discrimination. If the firm can price discriminate it will be more efficient. This
involves charging different prices for the same good, so the firm can charge higher prices to
those with inelastic demand. This is important for airline firms.
11. Management. Successful management is important for the long-term growth and
profitability of firms. For example, poor management can lead to decline in worker morale,
which harms customer service and worker turnover. Also firms may suffer from taking wrong
expansion plans. For example, many banks took out risky sub-prime mortgages, but this led to
large losses. Tesco suffered from expanding into unrelated business, like garden centre. This led
to over-stretching the company and losing site of core-business.
12. Objectives of firms. Not all firms are profit maximising. Some firms may seek to increase
market share, in which case profits will be sacrificed to gain market share. For example, this is
the strategy of Walmart and to an extent Amazon.