NISM Series XV Research Analyst: Chapter XI Part 2 - Risks in Investment

This is Part 2 of the comprehensive study notes for Chapter XI: Fundamentals of Risk and Return for the NISM Series XV Research Analyst Certification Examination. This section focuses entirely on the diverse types of risks that investors face when allocating capital to different financial instruments.

1. Introduction to Investment Risks

In the securities market, return and risk are two sides of the same coin. While investors commit capital with the expectation of earning returns, they must also understand and evaluate the uncertainties associated with those returns. To perform effective fundamental analysis, a research analyst must identify, measure, and monitor the various sources of risk that can impact an asset's value.

The study notes define ten primary investment risks that affect equity and debt instruments.

2. Detailed Breakdown of the 10 Core Investment Risks

A. Inflation Risk (Purchasing Power Risk)

• Definition: Inflation risk represents the risk that the money received on an investment may be worth less in the future when adjusted for inflation. It is also widely referred to as purchasing power risk.
• Impact on Equities: Inflation risk is fairly less for equity shares.
• The Underlying Mechanism: If prices go up as a result of inflation, and all else is held constant, businesses will see an increase in the selling prices of their products. Consequently, their business profits should go up in nominal terms, which is also highly likely to reflect as higher stock prices over time.
• Syllabus Connection (Inflation-Protected Securities): To mitigate this risk in debt markets, some issuers offer Inflation-Protected Securities. These bonds apply a fixed real coupon rate to an inflation-adjusted principal on each interest payment date, ensuring both coupon income and principal keep pace with inflation.

B. Interest Rate Risk

• Definition: Interest rate risk refers to the risk that bond prices will fall in response to rising market interest rates, and conversely, rise in response to declining market interest rates.
• The Inverse Relationship: Bond prices and interest rates share a fundamental inverse relationship.
• Syllabus Connection (Sensitivity & Magnitude):
  • Duration: Duration measures how sensitive a bond's price is to interest rate movements. Bonds with higher duration will experience larger price gains when rates fall, and larger price losses when rates rise, compared to bonds with lower duration.
  • Modified Duration: While duration indicates sensitivity, Modified Duration measures the actual magnitude of the change in the bond's price.
  • Convexity: The relationship between bond prices and interest rates is inverse but non-linear. When rates go up, bond prices go down, but they do not fall by as much as they would rise if rates went down by the same margin. This specific non-linear property is known as Convexity.

C. Business Risk (Operating Risk)

• Definition: Business risk is the risk that is inherent in the day-to-day operations of a company.
• Alternative Name: It is also known as operating risk, because it is directly caused by factors that affect the company's operational efficiency, cost structures, and revenue stability.

D. Market Risk

• Definition: Market risk refers to the risk of experiencing a loss of value in an investment because of adverse, broad-scale price movements of an asset in the market. It represents the systematic volatility that affects the entire market and cannot be easily diversified away.

E. Credit Risk (Default Risk)

• Definition: Credit risk refers to the probability or possibility that a particular bond issuer will fail to make its expected interest (coupon) payments and/or principal repayments.
• Alternative Name: It is also known as default risk.
• Impact on Debt: Debt instruments are highly subject to default risk because they operate on pre-committed, fixed payouts.
• Syllabus Connection (Credit Ratings & Equity Relevance): Credit ratings measure an issuer's ability to service these obligations. While credit risk is a debt-market concept, it is highly relevant to equity investors because a company can only provide returns to its equity shareholders after all lending and debt obligations are fully serviced first.

F. Liquidity Risk

• Definition: Liquidity risk refers to the absence of active trading or liquidity in an investment product.
• Three Key Implications: High liquidity risk implies that:
  1. The investor may not be able to sell the investment when desired.
  2. The asset may have to be sold significantly below its intrinsic value to find a buyer.
  3. There may be high transaction costs associated with carrying out the trade.

G. Call Risk

• Definition: Call risk is a risk specific to bond issues.
• Key Characteristic: It is the possibility that the bond issuer will choose to redeem or "call" the bond prior to its stated maturity date. This typically happens when market interest rates fall, allowing the issuer to refinance its debt at a lower rate, leaving the investor to reinvest their capital in a lower-yield environment.

H. Re-Investment Risk

• Definition: Re-investment risk arises from the probability that the periodic income flows (such as coupon payments) received from an investment cannot be reinvested to earn the same interest rate as the original investment.
• The CAGR Link: This risk directly impacts the compounding assumption of CAGR, which assumes that all periodic payouts are continuously reinvested at the same rate of return to reach the final accumulated value.

I. Political Risk

• Definition: Political risk is the risk associated with unfavorable government actions that can adversely impact business environments.
• Examples: Typical political risk events include the possibility of nationalization, sudden changes in tax structures, or restrictive licensing policies.

J. Country Risk

• Definition: Country risk refers to the macroeconomic and political risks associated with a country as a whole.
• Primary Concern: It represents the possibility that a country will not be able to honour its external financial commitments or sovereign debt obligations.

3. Summary Table: Risks, Characteristics, and Key Attributes

4. Important Concepts for the Exam

Systemic vs. Inherent Operational Risks

For the NISM examination, always distinguish between risks that are internal to the company and those that are external:

• Internal (Weaknesses): Risks like business risk or operational issues are internal to the company's execution and structures.
• External (Threats): Risks like political risk, inflation risk, interest rate risk, and market risk stem from the external macroeconomic environment.

Credit Risk vs. Equity Returns

An important testable distinction is that debt instruments are subject to direct default risk because of their pre-committed payouts. Although equity does not have pre-committed payouts, equity analysts must track credit risk because lenders have a prior charge on the company's cash flows; equity holders only receive returns after debt servicing is complete.