Sources of Risk 🌪️
Why does a stock's price fluctuate? Why do some companies succeed while others fail? Risk doesn't come from just one place—it emerges from a variety of internal and external factors. We call these the Sources of Risk.
1. Business Risk (Internal)
Business Risk is the uncertainty inherent in the operations of a company. It is the risk that the company will not be able to cover its operating expenses (like rent, salaries, and raw materials).
- Causes: Changes in consumer taste, strikes, poor management, or emergence of new competitors.
- Example: A smartphone manufacturer faces the risk that a competitor might launch a much better phone at a lower price.
2. Financial Risk (Internal)
Financial Risk is associated with how a company is financed. Specifically, it refers to the use of Debt (loans).
- Nature: A company with high debt has high financial risk because it MUST pay interest regardless of its profit.
- Example: If a company takes a massive loan and its sales drop, it may default on its interest payments and go bankrupt.
3. Market Risk (External)
Market Risk is the risk of the entire stock market declining due to economic, social, or political factors. It affects almost all securities simultaneously.
- Nature: You cannot avoid this by buying different stocks; it is part of the "system."
- Example: A global pandemic or a major political crisis causing the entire stock index to crash.
4. Interest Rate Risk (External)
Interest Rate Risk is the chance that a change in the interest rates set by the Central Bank (like the RBI or Fed) will affect the value of an investment.
- Impact on Bonds: When interest rates rise, bond prices fall. (Inverse relationship).
- Impact on Stocks: Higher interest rates increase the cost of borrowing for companies, which can lower their profits.
5. Purchasing Power Risk (Inflation Risk)
This is the risk that Inflation will erode the "real" value of your investment.
- Nature: Even if your money grows, if the price of goods grows faster, you are actually poorer.
- Example: Choosing a 5% Fixed Deposit when the inflation in the country is 7%. You are losing 2% purchasing power every year.
Summary of Risk Sources
| Category | Source | Primary Cause |
|---|---|---|
| Internal | Business Risk | Operational efficiency and competition. |
| Internal | Financial Risk | Level of debt (Leverage). |
| External | Market Risk | Global economy and psychology. |
| External | Interest Rate Risk | Changes in central bank policies. |
| External | Purchasing Power Risk | Rising prices (Inflation). |
Summary
- Business Risk depends on what the company does.
- Financial Risk depends on how the company borrows.
- Market Risk is the "mood" of the entire economy.
- Interest Rates and Inflation are powerful external forces that affect all investors.
Quiz Time! 🎯
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