An activity in which an entity puts some financial resources with an expectation of amplified returns is known as investment activity. For any investment the major concern for investors is always the “return”. But as we know that the return is a function of the future and the future is always uncertain so one can never be sure about the returns associated with some investment.
In practical world, some risk will always be associated with the returns. Investors try their best to identify the exact risk associated with some return in order to make a healthy decision about the investment. Risk can simply be defined as the uncertainty associated with any expected outcome. In finance, there are two units of return—one is the “absolute rate of return” and other one is the “real rate of return”
Absolute and real rate of return
The absolute rate of return simply reflects the expected and theoretical return associated with some investment; on the other hand, the real rate of return includes the concept of time value of money and other risks associated with the investment activity. So, the real rate of return is an effort to calculate the actual practical returns to be got out of an investment. Financial management deals with efficient and proper risk assessment for various theoretical returns.
Types of risk
As major classification risks can broadly be classified into two categories—systematic risk and unsystematic risk.
Systematic risk is also known as uncontrollable risk, simply because this risk lies beyond the possibility of regulation. It cannot be avoided due to certain factors. Various types of systematic risks are—market risk, purchasing power risk and bond rate risk.
Market risk: These are the risks associated with the demand and supply conditions. It can’t be regulated by an individual.
Purchasing power risk: After investment, it may be possible that the inflation rate in economy increases, and as a result, purchasing power of the investor decreases. The theoretical return will lose some of its value under such conditions. This risk depends upon the monetary policy of the government.
Bond rate risk: This risk is associated with the fluctuations of prevailing interest rates in the economy. It depends upon the fiscal policy of the government. Actually, the return given by the companies (dividend, interest etc) depends upon their performance and companies possess huge amount of debt financing (loans). So, if interest rate increases in the economy, the performance of the companies decreases, and as a result, returns also decrease.
Unsystematic risk is also known as controllable risk, because it can be avoided by the proper management and decisions of top level management. Various types of unsystematic risks are—business risk and financial risk.
Business risk: This risk is associated with the behaviour of the top level management of the organization. Flexibility of management of the organization is required to be at optimum level for managing this risk.
Financial risk: This risk is associated with the capital structure of the organization i.e. managing the proper proportion of debt and equity financing. Higher the debt financing, higher will be the financial risk.