Sources of Risk

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Sources of Risk:

 Inflation Risk:

The purchasing power risk is the factor that affects all the securities. It also refers as the likelihood that the purchasing power of the invested dollars will fall. Even if the nominal return is safe, the real return involves risk with uncertain inflation. The risk is associated with the interest rate risk because the increase in inflation results in the increase in the interest rates. The reason behind this fact is that additional inflation premiums are demanded by the lenders in order to compensate for the loss of purchasing power.

Business Risk:

Business risk is the risk of conducting business in certain industry or environment. For example the traditional telephone powerhouse AT&T confronts many challenges in quickly changing telecommunication industry.

Financial Risk:

The utilization of debt financing by companies includes the financial risk. When more assets of the company are financed through debt then the variability in the return is enhanced provided other things keep equal. Financial leverage is associated with the financial risk.

LIQUIDITY Risk:

The risk connected with certain secondary market in which there is trading of security is considered as liquidity risk. An investment that can be sold or brought immediately and without any important concession in price is regarded as liquid. When there is high uncertainty about the time aspect arid the concession in price, the liquidity risk is high. There is little or no liquidity risk for the Treasury bill while the over-the-counter (OTC) stock contains sufficient liquidity risk.



Exchange Risk rate:

Exchange rate risk is associated with international investments in which the returns gained in other countries are converted back into the local currency which creates uncertainty. In old days, the US investors did not take into account the international investment alternatives but in current days the exchange risk must be identified and understood by the investors. The variability in returns on security as a result of fluctuations in currency is referred to as exchange rate risk. Exchanger rate risk in also regarded as currency risk.

For example, when US investor purchases German stocks designated in marks. He must finally convert back the returns of the stock into the US dollars. If the exchange rate is not in favor of the investor than the losses from the movements of exchange rate can partially or completely counterbalance the originally gained returns.


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