Risk is a vast topic but we will limit our discussion to the basics which are useful for individual investors. One point should be understood by every investor that risk is associated with purchasing power and not just about the amount. Risk management is about preserving purchasing power.
Most investors are conscious of this risk - mostly because it is so much talked about. This risk arises due to fluctuation of the market price of a security. Volatility is one of the measures of this risk.
INTEREST RATE RISK
This risk is relevant to debt assets such as Bonds and Debentures. Interest rate risk arises from changes in the market interest rates. When market interest rates increase, the value of existing bonds decrease. Why? Because, new investors will be more interested in investing in new bonds, which pays higher interest than the old ones issued at lower interest rates. The opposite happens when interest rates decrease, i.e. the value of the existing bonds increase because now the holder can earn higher interest than market rate.
This risk is not applicable for buy and hold (till maturity) i.e. when someone is not selling the security before maturity. So, people who invest in Fixed Deposits are not affected by this risk. But, if you are investing in a Debt Fund, you will be influenced by this risk because the Net Asset Value (NAV) of the fund will change due to price volatility of the underlying debt instruments. The funds need to mark their holding to the current market value. Only Fixed Maturity Plans (closed ended Debt Funds where the tenure of the debt instruments and tenure of the fund match) is not affected by this.
CREDIT RISK OR DEFAULT RISK
So, what is credit risk? Credit risk is associated with inability (or unwillingness in case of willful defaulters) to make the interest or principal payments. Default risk is only applicable in case of debt instruments and funds because debt instruments have predefined payments whereas equity does not.
Whenever an investor invests in debt instruments or funds which invest in debt instruments, they are exposing themselves to credit risk.
As mentioned at the beginning of this chapter, risk management is about preserving purchasing power. Inflation, in simple language, is the rate of increase in the general level of prices. It reduces the purchasing power of money. So, the amount of goods and services one could buy reduces from period to another due to inflation.
There are two types of inflation -
Headline Inflation refers to change in value of all goods in the basket.
Core Inflation excludes fuel and food items and calculates the general inflation for the rest of the items.
Consider a situation that you have invested in your friend's restaurant last year and own part of the restaurant. Due to an emergency now you need money. You decided to sell the shares you own in the restaurant. Apart from the performance of the restaurant, what will affect the amount you can fetch and whether or not you will be able to fetch any amount? Simply, how many people actually want to buy shares in the restaurant. As there is no automatic price discovery due to absence of liquid market, the price you will be able to sell the share will be decided by negotiation. Your rush to sell will decrease your negotiating power and you may be forced to sell at a price much lower than the intrinsic value.
This is liquidity risk. This risk is associated with direct real estate investments. An investor may be exposed to liquidity risk indirectly by investing in funds which invest in real estate or infrastructure projects.
This risk is associated with difficulty finding suitable investment opportunities with the redeeming amount from an existing investment.
Consider a callable bond which can be redeemed by an issuer before maturity. Now, when will be the maximum probability of such redemption? When the market interest rates go down. At this point the bond issuers can redeem the old bonds with higher interest rate and issue new bonds with lower interest rates based on lower market rates. But, the investor will have a difficult time finding bonds, which pay the interest she used to earn from the bond. She can either invest in a bond of same yield, but lower credit rating, i.e. take more default risk or invest in a bond of same credit rating but lower yield. This is reinvestment risk.