Market risk or price risk is the risk that the price of an asset may move in an unfavourable direction. Prices such as those of shares, and exchange rates, which are the prices of various currencies, are essentially random variables. That is, their outcomes are uncertain at the outset.
What is risk in finance?
A product is described as risky if there is more than one possible outcome, and at least one of these outcomes will lead to a loss. There are various facets of the financial markets that expose participants to risk. From the standpoint of price risk, holders of securities, also known as longs, have the fear of declining asset prices, which could lead to a loss when the long position is unwound. For the shorts, or traders who have sold borrowed securities, and consequently need to buy subsequently to return them to the lender, the spectre of rising asset prices will haunt them. Interest rates are also random variables. A party who has made an investment faces the risk that market rates of interest will be low, when the investment matures, which would imply that the funds will have to be redeployed at a lower rate of interest.
This issue is particularly important for holders of conventional bonds or investors in a non-cumulative fixed or time deposit. In these cases there will be periodic inflows of cash, and the risk is that these inflows may happen when market rates of interest are low.
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Credit risk or default risk is the risk that a party who owes money may be unable to repay. Central or federal government securities are virtually risk-less because unlike private citizens, governments have two key rights. They can print money as and when required, and they can raise the tax rates whenever they deem it necessary. Consequently for a given asset class, central government securities are perceived to be the safest and consequently they carry the lowest yields. It must be clarified at this stage is that unlike commercial entities, central and state governments cannot issue equity shares.
The only way they can raise funds is by issuing bonds. Unlike the central government, state governments cannot print money. In countries like the US, states are empowered to levy income tax whereas in countries such as India they cannot. Thus state government debt is in theory more risky. However, in most cases the perception is that the central government of a country is unlikely to allow a state government to default.
The yields demanded from such securities may be lower than what would be the case in the absence of this implicit guarantee. Public sector enterprises can issue bonds as well as shares, for they are incorporated as corporations. In theory they can default, however they carry the backing of the government, which provides an element of reassurance to investors.
Like stock prices, currency rates are also subject to ups and downs. An appreciating rupee will translate to higher imports and lower exports, while a depreciating rupee will lead to lower imports and higher exports. Thus, companies, which derive the bulk of their income from foreign sources, such as IT and ITES companies stand to benefit from a depreciating rupee, since it will boost their income in the domestic currency.
Sunil K Parameswaran
The writer is a visiting faculty at various business school including the IIMs.