Types of Risks Associated with a Portfolio - Essay Example

Evaluate the ment that the objective of portfolio investment is to minimise risk Contents Contents Introduction 3 Discussion 3 Conclusion 10 References 10 Introduction In any investment there are two types of risk that is associated. In fact it is said greater is the risk greater the associated return is. However the investor wants to minimize the risk that is associated with any investment. Out of the risk that is associated with any investment, one type of risk is systematic risk or market risk and another type of risk is the unsystematic risk. Systematic risk is applicable to all sectors and industries in a market and just too specific industry. The systematic risk cannot be controlled through diversification. Diversification or portfolio management can only control unsystematic risk. Unsystematic risk on the other hand is specific to a particular industry and can only b controlled through proper diversification or portfolio management strategy. The following pages describes the two types of risks and critically analyzes the statement that objective of portfolio diversification is to minimize risk. Discussion In finance all the different classes of risk can be broadly grouped under two headings. One is systematic risk and another is unsystematic risk. Systematic risks are the macro risk and affect all sectors and all industries in a market (Back, 2010). This risk cannot be minimized by an investor through portfolio diversification. From the company’s view point this risk cannot be controlled by the company. This type of risk is both unavoidable and impossible to predict (An, 2007). Such type of risk is impossible for the company to control. Another type of risk is the unsystematic risk. Systematic risks are the risks that arise due to the influence of external factors that are beyond the control of an organization (Chance and Brooks, 2015). Since these types of risks are beyond the control of an organization so these risks do not affect a particular organization but affects all types of organization that are present in the market. The organization cannot plan in advance for such type of risks. Such types of risks are macro in nature and have its impact across the market spectrum irrespective of the industry or sector types (Fouque and Langsam, 2013). The systematic risks can be of various types and can be further subdivided into Interest rate risks, Purchasing power risk and Market risk. Interest rate risk: Interest rate risk is mainly associated with debt instruments and refers to the variability of interest rates from time to time. Interest rate risks can be further subdivided into price risk and reinvestment rate risk (Gai, 2013). Price risk as the name suggests is the risk that is associated with the probable fall in the price of shares or any other commodity in the future. Reinvestment risk is the risk that is associated with the fact that the return ore dividend that is earned from an investment cannot be reinvested with the same or higher rate of return as that of the original investment. Market risk: This type of risk is associated with fluctuations in the market price of a security. Market risk arises due to rise or fall in the price of securities that are listed in the stock market. There are various types of market risk. Following is a list of different types of market risk. 1. Absolute risk 2. Relative risk 3. Directional risk 4. Non directional risk 5. Basis risk 6. Volatility risk Another type of systematic risk is known as purchasing power risk. The purchasing power risk is also known as inflationary risk as it increases in inflation rate causes the decrease in purchasing power of an individual (Graham and Smart, 2011). There are various types of purchasing power or inflationary risk. The two types of risks are known as Demand inflation risk and cost inflation risk. Unsystematic risk is also known as micro risk and is applicable only to a particular organization (Haubrich and Lo, 2013). Unsystematic risk can be controllable from the organizations point of view. The portfolio management techniques that has been devised and experimented on are there to minimize risk also centres around controlling unsystematic risk. As these types of risks can be controlled as it affects a particular organization (Hitchner, 2006). The organization can take on necessary steps in order to mitigate the risks. One of the widest and best examples of the systematic risk is the great recession that happed in the year 2008. In that event all the asset classes were more or less impacted and it was beyond the ability of a particular company to control the risk. There are three different types of unsystematic risk. The unsystematic risks are: Business risks or liquidity risk Financial risk or credit risk Operational risk Business risk is also known as liquidity risk. This risk originates from the sale or purchase of goods and securities that are in turn affected by business cycle, technological challenges etc. There are two types of business or liquidity risk (Megginson, Lucey and Smart, 2008). One is asset liquidity risk and another is funding liquidity risk. Financial risk refers to the risk that is related to the source of fund that the organization uses to fund its operation. Funding rate risk can be further subdivided into exchange rate risk, recovery rate risk, credit event risk etc. Operational risks are the risks that area associated with the normal business operations that are associated with a business. The operational risks mainly arise due to human errors and changes from one industry to another (Moyer, McGuigan, Rao and Kretlow, 2011). The various types of operational risks are Model, people, legal and political. A portfolio consists of a basket of securities of securities that belong to different asset classes. Creating a perfect portfolio is a mix of art and engineering. Creating a perfect portfolio can boost return as well as can reduce volatility (Reilly and Brown, 2011). This may seem surprising due to the fact that the CAPM model predicts a liners relationship between risk and return where the return follows risks. However, CAPM is only a straight line projection and the actual scenario at the efficient frontier is a curve (Siddaiah, 2010). The securities differ amongst themselves on the basis of risk and return that they offer. The objective of the portfolio management is to minimize risk for a given return or to maximize risk for given return. There are basically two types of risks that are associated with any security or any portfolio (Strong, 2008). One type of risk is the systematic risk that is common to all industries or sectors and cannot be controlled through diversification. This type of risk is measured by beta. Beta actually measures how much the stock or portfolio is risky as compared to the market risk. If β of a stock is greater than 1 then the stock or portfolio is riskier than the market (Swensen, 2009). The fund or the portfolio managers are however not concerned with the systematic risk and are only concerned with the unsystematic risk. The main objective of the fund managers is to reduce the diversifiable risk through portfolio management. Traditional portfolio theory: Traditional portfolio theory was a not quantitative method of portfolio creation. It just depended on creating a portfolio that has asset classes that are either not correlated or are negatively correlated with each other so as to create a portfolio where diversifiable risk is minimized Modern portfolio theory: Modern portfolio management on the other hand differs from the traditional portfolio management in the fact that the modern portfolio management techniques are more quantitative in nature as compared to the traditional approach. Modern portfolio management techniques are actually based on finding the efficient portfolios that matches with the individual investors’ utility curve. The goal is maximize return for a given level of risks. There are thus two steps in selecting the best portfolio for an individual investor. The first is to find the efficient frontier and then to find out the point at which the individual’s utility curve based on his or her risk taking capability matches the efficient frontier. The efficient frontier is formed by the set of all portfolios which gives the highest return for a given risk. Investors in general are ready to assume higher amount of return for higher risk. However the capacity to take risk varies from one investor to another. An individual who is risk averse would want to have higher amount of return for a given amount of risk on the other hand an individual who is risk lover will be satisfied with lower return for a given amount of risk. The risk affinity of an individual is measure by finding out the utility curve. After the risk aversion curve is found out the next step is to find out the point at which risk aversion curve intersects the efficient portfolio and that point gives the most efficient portfolio for a given risk aversion level. Conclusion In the course of this essay the various types of risks that are associated with a portfolio are discussed. As discussed in the above pages there are mainly two types of risks that are associated with a portfolio. One of the risks is known as systematic risk and is uncontrollable and cannot be eliminated through diversification. The portfolio managers mainly try to reduce the other element of the risk that is diversifiable risk. Through proper management of the portfolio an investor can generate a return that is greater than that offered by individual portfolio and has lower risk levels than when individual portfolios are considered. This is achievable due to the fact that efficient portfolio frontier is a curved one. References An, X., 2007. Macroeconomic conditions, systematic risk factors, and the time series dynamics of commercial mortgage credit risk. Ann Arbor: ProQuest. Back, K., 2010. Asset pricing and portfolio choice theory. Oxford: Oxford University Press Chance, D., and Brooks, R., 2015. Introduction to derivatives and risk management. MA: Cengage Learning. Fouque, J.-P., and Langsam, J. A., 2013. Handbook on systemic risk. Cambridge: Cambridge University Press. Gai, P., 2013. Systemic Risk: The Dynamics of modern financial systems. Oxford: Oxford University Press. Graham, J., and Smart, S., 2011. Introduction to Corporate Finance: What Companies Do. OH: Cengage Learning Haubrich, J.G., and Lo, A. W., 2013. Quantifying Systemic Risk. Chicago: University of Chicago Press. Hitchner, J.R., 2006. Financial Valuation: Applications and Models. NJ: John Wiley & Sons. Mayo, H., 2013. Investments: An Introduction. OH: Cengage Learning. Megginson, W. L., Lucey, B. M., and Smart, S. B., 2008. Introduction to Corporate Finance. London: Cengage Learning EMEA. Moyer, R. C., McGuigan, J., Rao, R., and Kretlow, W., 2011. Contemporary Financial Management. OH: Cengage Learning. Reilly, F., and Brown, K., 2011. Investment Analysis and Portfolio Management. OH: Cengage Learning. Siddaiah, T., 2010. International Financial Management. New Delhi: Pearson Education India. Strong, R., 2008. Portfolio Construction, Management, and Protection. OH: Cengage Learning. Swensen, D. F., 2009. Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. NY: Simon and Schuster. Read More