Risk in security analysis is generally associated with the possibility that the realized returns will be less than the returns that were expected. In finance, different types of risk can be classified under two main groups, viz., systematic risk and unsystematic risk.
A. Systematic risk.
B. Unsystematic risk.
A. Systematic Risk
Those forces that are uncontrollable, external, and broad in their effect are called sources of systematic risk. Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization’s point of view. Systematic risk is a macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned by the organization.
In this way, economic, political, and sociological changes are sources of systematic risk. For example, if an economy moves into recession or if there is political upheaval, it will cause the prices of nearly all the securities, whether bond or equity to decline.
Firms with high systematic risk tend to be those whose sales, profits, and stock prices follow the general trend in the level of economic or stock market activity. These may include companies that deal in basic industrial goods like automobile manufactures.
The types of systematic risk are depicted and listed below.
1. Interest rate risk
Interest-rate risk is the variation in the single period rates of a return caused by the fluctuations in the market interest rate. It particularly affects debt securities as they carry the fixed rate of interest.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it arises due to a rise or fall in the trading price of listed shares or securities in the stock market.
3. Purchasing power or inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
B. Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are controllable, internal factors that are peculiar to a particular industry or firm/(s). It may be because of change in management, labor strikes which will impact the returns of only specific firms that are facing the problem.
It is micro in nature as it affects only a particular organization. It can be planned so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
A higher proportion of unsystematic risk is found in firms producing nondurable consumer goods. Examples include suppliers of telephone, power, and foodstuffs.
The types of unsystematic risk are depicted and listed below.
1. Business or liquidity risk
Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and purchase of securities affected by business cycles, technological changes, etc.
2. Financial or credit risk
Financial risk is also known as credit risk. It arises due to a change in the capital structure of the organization. The capital structure mainly comprises three ways by which funds are sourced for the projects.