Risk is defined as chance that the actual outcome from an investment will differ from the

expected outcome. This means that, the more variable the possible outcomes that can
occur, the greater the risk.

What are the various sources of risk? What are the factors which make any financial asset
risky? Let us take a look at some of the general sources of risk:

• Interest rate risk: interest rate risk is the variability in a security’s return
resulting from changes in the level of interest rates. Other things being equal,
security prices move inversely to interest rates. The reason for this is related to the
valuation of securities. This risk affects bondholders more directly than equity
investors.
• Market risk: market risk refers to the variability of returns due to fluctuations in
the securities market. All securities are exposed to market risk but equity shares
get the most affected. This risk includes a wide range of factors exogenous to
securities themselves like depressions, wars, politics, etc.
• Inflation risk: with rise in inflation there is reduction of purchasing power, hence
this is also referred to as purchasing power risk and affects all securities. This risk
is also directly related to interest rate risk, as interest rates go up with inflation.
• Business risk: this refers to the risk of doing business in a particular industry or
environment and it gets transferred to the investors who invest in the business of
the company.
• Financial risk: this arises when companies resort to financial leverage or the use
of debt financing. The more the company resorts to debt financing, the greater is
the financial risk.
• Liquidity risk: this risk is associated with the secondary market in which the
particular security is traded. A security which can be bought or sold quickly
without significant price concession is considered liquid. The greater the
uncertainty about the time element and price concession, the greater the liquidity
risk. Securities which have ready markets like treasury bills have lesser liquidity
risk.
• Measurement of total risk: it is associated with the dispersion in the likely
outcomes. Dispersion refers to variability. If an asset’s return has no variability, it
has no risk.
• It is measured with the help of range, standard deviation, and mean.
• The diversion in a portfolio investment reduces the risk of the investor.
• Non diversifiable or non risk factors
• Major changes in tax rates.
• War and other calamities.
• An increase or decrease in inflation rates.
• A change in economic policy.
• Industrial recession.
• An increase in international oil prices, etc.
• Diversifiable or specific risk factors
• Company strike
• Bankruptcy of a major supplier.
• Death of key company officer.
• Unexpected entry of a new competitor in the market.
• If a portfolio is well diversified, the unsystematic risk gets almost eliminated. The
non diversifiable risk arising from the wide movements of security prices in the
market is a very important to an investor. The modern portfolio theory defines the
riskiness of a security as its vulnerability to market risk. This vulnerability is
measured by the sensitivity of the return of the security vis-à-vis the market return
and is called beta.
• What is a derivative contract?
• A derivative contract is a financial instrument whose payoff structure is derived
from the value of the underlying asset.
• You along with a couple of friends want to watch a concert scheduled to be held
next month. Each ticket costs Rs.1, 000. You find that the tickets have been
completely sold out. An acquaintance, who is a part of the concert team, gives
you a reference letter, under which if you show the letter you can buy 3 tickets by
paying the price of those three tickets namely Rs.1,000 each. The letter gives you
the right to buy a ticket; it does not represent a ticket. The letter by itself has no
market value.
• As the concert day gets closer the tickets say are being sold at 1250. At this point
your letter attains a value. This is because, thanks to the letter, you can buy a
ticket, now available in the market at 1250, for 1000. The letter is now worth 250
X 3 i.e. 750. If a week before the concert, the price shoots up to 1400, the value is
now worth 400 X 3 = 1200. If the price falls below 1000 your letter becomes
worth less.
• The following things flow from the example :
• The value of the letter changes with changes in the price of the ticket.
• The letter is called derivative instrument.
• The letter gives you a right to buy the ticket. The underlying asset is the ticket.
• The letter does not constitute ownership. It is instead a promise to convey
ownership.

In the above example the underlying asset was the ticket, in the derivative market;
the underlying asset could be (a) commodities (b) precious metals (c) foreign
exchange rates (d) interest rate relating to financial assets (e) equity shares and (f)
market indices.

What is a forward contract?

A forward contract is an agreement entered today under which one party agrees
to buy and the other agrees to sell a specified asset on a specified future date at
an agreed price.

Today is 7th October, 2010. Mr. enters into a contract with HDFC Bank to buy
dollars one month from today at Rs.48. 48 is the delivery price. On 7th November,
Y will buy dollars by paying 48 and HDFC will buy dollars by collecting 48. If on
7th November, the dollar quotes 50, Mr. Y gains 2, and HDFC Bank loses 2. If on
that day the dollar quotes 44, HDFC has gained 4and Y has lost 4 per dollar.

What is a futures contract?

This is a standardized contract between two parties where one of the parties
commits to buy and the other commits to sell, a specified quantity of a specified
asset at an agreed price on a given date in the future.

In a forward contract there is a risk of default. In a futures contract there is a

guarantee of performance.

In effect, the futures contract merely upgrades a forward contract into a

secured risk less, marketable instrument.