Let’s know about the types of risks involved in investing
Risk can be defined as the possibility of getting an unfavourable outcome in the place of a favourable one. In the world of finance, an individual faces a risk, irrespective of whether he invests or not. Let’s have a look at what are the types of risks present in the market.
1) Inflation risk-
Inflation refers to a fall in the purchasing power of an individual, which is caused by a rise in the prices of goods & services. This means that over a course of time, consumers will have to pay a higher price for availing of the same goods and services. Individuals, who do not invest at all, face the highest risk of eroding their purchasing power. Similarly, individuals investing in fixed return instruments such as bonds & debentures, and retired people dependent on a fixed income face inflation risk. This is because the returns are fixed and not aligned with the changing inflation rate. The only way to beat inflation is to invest in instruments that yield higher returns than the inflation rate.
2) Liquidity risk-
Liquidity risk refers to the absence of marketability of an asset. This means that an individual may not be able to buy or sell an asset easily. There could be two possible reasons for this- a) He may not find a prospective buyer/seller. B) Even if he does, he might have to pay a higher price for the acquisition or receive a lower price after the sale. This type of risk is higher in the real estate market and corporate bonds market. This risk can be countered by diversifying a portfolio in a manner that has a small portion of investments in liquid assets. This way, the investor’s need for immediate funds can be taken care of.
3) Business risk-
Business risk refers to the risk that is associated with the operations of a company. This risk affects the profitability of the company as well as the investors’ returns, in turn. Some examples of operational risks are the rise in the cost of raw materials, entry of new competitors in the market, change in government policies pertaining to the industry in which the business operates, etc. A well-diversified portfolio can help to reduce such risks.
4) Default risk-
Default risk refers to the possibility that a borrower might not be able to fulfill his financial obligations to the lender of the funds. This type of risk is present in debt instruments as they require the borrower to make fixed payments within a stipulated time period. This is one of the main reasons why the instruments are graded by credit-rating agencies. The regular grading helps to monitor the borrower’s ability to pay back the funds at different time periods. With the help of this information, the investors decide whether they can stay invested at a particular risk level. In this regard, government bonds are the safest as the government can always raise funds by means of taxes & loans.
5) Exchange rate risk-
Exchange rate risk refers to the fluctuation in the exchange rate of the base currency with respect to the foreign currency (a.k.a. quoting currency). The changes in the exchange rates affect the profitability of an investment. Domestic investors investing in foreign assets and foreign investors investing in domestic assets face an exchange rate risk. This risk can be countered with the help of effective hedging strategies involving forwards, futures & options contracts.
6) Reinvestment risk-
Reinvestment risk involves a possibility that the investor may not get attractive returns upon reinvestment of profits. This affects the overall returns of an investor. This type of risk is present in fixed income instruments such as bonds. The reinvestment risk is inversely proportional to the changes in the interest rates i.e. the risk reduces when the interest rates rise and increases with a fall in interest rates. This risk can be countered by investing in non-callable securities, or selecting a cumulative option available in debt funds.
7) Interest rate risk-
Interest rate risk is associated with interest-bearing instruments such as bonds. This risk states that bond prices are inversely proportional to interest rates. That is, bond prices will fall in response to the rising interest rates and rise in response to falling interest rates. Interest rate risk directly affects the value of fixed-income securities. This is the main cause of volatility in their prices. The use of derivatives contracts such as futures & options can help reduce the interest rate risk.
8) Market risk-
Market risk refers to the possibility that the value of investments might reduce due to price volatility in the markets. Market risk can arise on account of various events such as changes in government policies, fluctuating exchange rates, interest rate changes done by the central bank, etc. This type of risk affects all financial instruments. Hence, it can’t be countered by diversifying the portfolio.