Page 76 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 4: Risk and Return

securities in an inverse or contrary manner; that is, other things being equal, security Notes
prices move inversely to interest rates. The rationale for this movement is tied up with the
valuation of securities. Interest rate risk has an effect on bonds more directly than common
stocks and is a major risk that all bondholders face. As interest rates change, bond prices
change in the reverse direction.
3. Purchasing Power Risk: A factor affecting all securities is purchasing power risk, also
known as inflation risk. This is the possibility that the purchasing power of invested
dollars will deteriorate. With uncertain inflation, the real (inflation-adjusted) return
involves risk even if the nominal return is safe (for example, a Treasury bond). This risk is
connected with interest rate risk, as interest rates in general rise as inflation increases,
because lenders demand additional inflation premiums to compensate for the loss of
purchasing power.
4. Regulation Risk: Some investments can be comparatively attractive to other investments
on account of certain regulations or tax laws that give them a benefit of some kind.
Municipal bonds, for example, pay interest that is excused from taxation on local, state and
federal levels. As a consequence of that special tax exemption, municipals can price bonds
to yield a lower interest rate since the net after-tax yield may still make them attractive to
investors. The risk of a regulatory change that could adversely affect the stature of an
investment is a real danger. Prices for many limited partnerships tumbled when investors
were left with different securities, in effect, than what they originally bargained for. To
make matters worse, there was no extensive secondary market for these illiquid securities
and many investors found themselves unable to sell those securities at anything but ‘fire
sale’ prices if at all.

Did u know? In 1987, tax law changes dramatically lessened the attractiveness of many
existing limited partnerships that relied upon special tax considerations as part of their
total return.
5. Business Risk: The risk of doing business in a specific industry or environment is called
business risk. For example, as one of the largest steel producers, U.S. Steel faces unique
problems. Likewise, General Motors faces unique problems as a result of such
developments as the global oil situation and Japanese imports.
6. Bull-Bear Market Risk: This risk grows from the variability in the market returns resulting
from alternating bull and bear market forces. When security index rises fairly consistently
from a low point, called a trough, over a period of time, this upward course is called a bull
market. The bull market ends when the market index attains a peak and starts a downward
trend. The period during which the market declines to the next trough is called a bear
market.
7. Management Risk: Management, all said and done, is comprised of people who are mortal,
fallible and capable of making a mistake or a poor decision. Errors made by the management
can harm those who invested in their firms. Forecasting errors is difficult work and may
not be worth the effort and, as a consequence, imparts a needlessly sceptical outlook.

8. Default Risk: It is that part of an investment’s total risk that results from changes in the
financial integrity of the investment. For instance, when a company that issues securities
moves either further away from bankruptcy or closer to it, these changes in the firm’s
financial integrity will be reflected in the market price of its securities. The variability of
return that investors experience, as a consequence of changes in the credit worthiness of a
firm in which they invested, is their default risk.

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