Page 68 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 2: Risk and Return

not always the case - 'creative' accounting practices in firms like Enron, WorldCom, Arthur Notes
Anderson and Computer Associates may maintain quoted prices of stock even as the
company's net worth gets completely eroded. Thus, the bankruptcy losses would be only
a small part of the total losses resulting from the process of financial deterioration.
10. International Risk: International risk can include both country risk and exchange rate
risk.
Exchange Rate Risk: All investors who invest internationally in today's increasingly global
investment arena face the prospect of uncertainty in the returns after they convert the
foreign gains back to their own currency. Unlike the past, when most US investors ignored
international investing alternatives, investors today must recognize and understand
exchange rate risk, which can be defined as the variability in returns on securities caused
by currency fluctuations. Exchange rate risk is sometimes called currency risk.

Example: A US investor who buys a German stock denominated in marks (German
currency), must ultimately convert the returns from this stock back to dollars. If the exchange
rate has moved against the investor, losses from these exchange rate movements can partially or
totally negate the original return earned. Obviously, US investors who invest only in US stocks
on US markets do not face this risk, but in today's global environment where investors
increasingly consider alternatives from other countries, this factor has become important.
Currency risk affects international mutual funds, global mutual funds, closed-end single country
funds, American Depository Receipts, foreign stocks, and foreign bonds.
Country Risk: Country risk, also referred to as political risk, is an important risk for
investors today. With more investors investing internationally, both directly and
indirectly, the political, and therefore economic stability and viability of a country's
economy need to be considered.

Example: The United States has the lowest country risk, and other countries can be
judged on a relative basis using the United States as a benchmark. Examples of countries that
needed careful monitoring in the 1990s because of country risk included the former Soviet
Union and Yugoslavia, China, Hong Kong, and South Africa.
Liquidity Risk: Liquidity risk is the risk associated with the particular secondary market in
which a security trades. An investment that can be bought or sold quickly and without
significant price concession is considered liquid. The more uncertainty about the time
element and the price concession, the greater the liquidity risk. A Treasury bill has little or
no liquidity risk, whereas a small OTC stock may have substantial liquidity risk.
Liquid Assets Risk: It is that portion of an asset's total variability of return which results
from price discounts given or sales concessions paid in order to sell the asset without
delay. Perfectly liquid assets are highly marketable and suffer no liquidation costs. Illiquid
assets are not readily marketable and suffer no liquidation costs. Either price discounts
must be given or sales commissions must be paid, or the seller must incur both the costs,
in order to find a new investor for an illiquid asset. The more illiquid the asset is, the
larger the price discounts or the commissions that must be paid to dispose of the assets.

Political Risk: It arises from the exploitation of a politically weak group for the benefit of a
politically strong group, with the efforts of various groups to improve their relative
positions increasing the variability of return from the affected assets. Regardless of whether
the changes that cause political risk are sought by political or by economic interests, the
resulting variability of return is called political risk, if it is accomplished through legislative,
judicial or administrative branches of the government.

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