SEMINAR REPORT

SUBJECT: FINANCIAL SERVICES TOPIC: SYSTEMATIC RISK

RIYAS.PK NO:38 SEM 4 MBA

INTRODUCTION TO RISK
Risk implies the extent to which any chosen action or an inaction that may lead to a loss or some unwanted outcome. The notion implies that a choice may have an influence on the outcome that exists or has existed. In general it refers to the possibility of incurring a loss in a financial transaction. It can be called as the possibility of variation of actual return from expected return.Eg: Equity shares whose return are likely to fluctuate widely are considered risky investments.Government securities whose returns are fairly stable are considered to posses low risk.However, in financial management, risk relates to any material loss attached to the project that may affect the productivity, tenure, legal issues, etc. of the project.

ELEMENTS OF RISK
The factors which produce variations in the return from an investment constitute element of risk. In finance, different types or elements of risk can be classified under two main groups, viz., 1. Systematic risk (External factors) 2. Unsystematic risk (Internal factors) So shortly we can say the +UNSYSTEMATIC RISK total risk as TOTAL RISK=SYSTEMATIC RISK

Two main groups under which types of risk are classified is depicted below.

The first group includes the external factors which affect large number of securities simultaneously. (Systematic risk). Systematic risk is uncontrollable by an organization and macro in nature.

The second group includes the internal factors which affect only some of the companies and can be controllable to some extent. (Unsystematic risk or specific risk) . Unsystematic risk is controllable by an organization and micro in nature.

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. The impact of economic, political, & social changes is system wide and that portion of total variability in security returns caused by such system wide factors is referred to as systematic risk. It affects all securities and all companies, it is uncontrollable .Changes in the economic social and political factors will affect the performance of the companies and thereby on their stock price in varying degree. The variability on the rate of return due to this various factors is termed as the systematic risk or nondiversifiable risk or unavoidable risk. It can be classified in to 3 types as follows. Types of risk under the group of systematic risk are listed as follows: 1. Interest rate risk. 2. Market risk. 3. Purchasing power or Inflationary risk. The types of risk grouped under systematic risk are depicted below.

1. Interest rate risk Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest. Interest rate is a type of systematic risk that particularly affects the debt securities like bond and debenture. A bond or debenture normally has fixed coupon rate of interest. The issuing company pays interest to the bond holder at this coupon rate equal to the interest prevailing in the market. Market interest rate may change after the issue but the coupon remains constant till the maturity period of the securities. This will create some risk known as interest rate risk. Example: a bond having a face value of Rs 100 issued with coupon rate of 10% when the market interest rate is also 10% will have a market price of Rs 100.If, subsequent to the issue, the market interest rate moves up to 12.5, then investors will buy the bond with 10% coupon interest rate unless the holder of the bond reduces the price 80. Thus we can see that the market price of the debt securities fluctuate in response to variation in market interest rate. This tendency is known as interest rate risk The interest-rate risk is further classified into following types. 1. Price risk. 2. Reinvestment rate risk. The types of interest-rate risk are depicted below.

Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may decline or fall in the future. Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't be reinvested with the same rate of return as it was acquiring earlier.

2. Market risk Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities in the stock market. Market risk is the type of the systematic risk that affects shares. A general rise in the share price is known bullish trend and general fall in the share price is known as bearish trend. The volatility in the market causes variation in return. This phenomenon is known as market risk. Political factors will also affect the market risk. The market risk is further classified into following types. 1. Absolute risk, Relative risk, Directional risk, Non-directional risk, Basis risk, Volatility risk. The types of market risk are depicted in the following diagram.

Absolute Risk is the risk without any content. For e.g., if a coin is tossed, there is fifty percentage chance of getting a head and vice-versa. Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a relative risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an organization are of export sales. Directional risks are those risks where the loss arises from an exposure to the particular assets of a market. For e.g. an investor holding some shares experience a loss when the market price of those shares falls down. Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk. Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks which are in offsetting positions in two related but non-identical markets. Volatility risk is the risk of a change in the price of securities as a result of changes in the volatility of a risk factor. For e.g. volatility risk applies to the portfolios of derivative instruments, where the volatility of its underlying is a major influence of prices.

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. Inflation results in lowering the purchasing power of money. When an investors purchase a security he forgoes an opportunity to buy some good and services. Meanwhile if there is inflation in the economy, the price of goods and service would increase and thereby investor looses purchasing power of their money. The purchasing power or inflationary risk is classified into following types. 1. Demand inflation risk. 2. Cost inflation risk.

The types of purchasing power or inflationary risk are depicted below.

Demand inflation risk arises due to increase in price, which result from an excess of demand over supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In other words, demand inflation occurs when production factors are under maximum utilization. Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually caused by higher production cost. A high cost of production inflates the final price of finished goods consumed by people.