Risk is one of the main features that characterizes the entire financial world, and it heavily influences the type of security that investors will invest into as well as the particular kind of strategy they will follow while doing it. With respect to this last concept, it is important to know that risk is strongly correlated with the return on an investment. In fact, the potential return on a particular investment increases as the risk that affects that operation grows. This also means that, in the worst case scenario, the potential loss will be considerably higher. The standard deviation is the main measure of risk used when examining a particular type of instrument. When the standard deviation value for the security is very high, the corresponding volatility level of the possible future returns on that asset is huge, while the dispersion decreases as the same trend is followed by the square root of the variance (sigma=standard deviation, sigma^2=variance). Looking at the two main types of securities traded, bonds and stocks, they are totally different with respect to risk. Bonds are basically risk-less, it is nearly impossible that the periodic coupons as well as the nominal value will not be paid back during its “Life”. For this reason, the potential return on them is very low. If we move to stocks, the situation changes a lot. Here, the risk is considerably higher, taking into account that there is no certainty regarding the fact that dividends will be systematically paid by the company that issued the stocks. Also, the market share price systematically fluctuates during the course of the trading days, forcing investors to be always focused on market trends in order to decide whether to keep or sell their stocks. So, the return you can expect to get by investing in stocks is very high if compared to the bonds’ one, and the same is for the potential loss. But this does not mean that bonds do not have any types of risk embedded in them at all. Some of the risks that bonds have are:
- interest rate risk, it is a typical feature of floating rate bonds and it is related to movements in the rate applied to the bond that are unfavorable to bondholders, resulting in lower coupons paid to them as well as a lower price at which the security can be traded and sold in the secondary market (if the coupon rate decreases and consequently goes below the yield to maturity, the price of the bond becomes lower than its par value).
- liquidity risk, it is represented by the possibility that the bondholder will not be able to trade the bond at the desired price on the secondary market, and he will be forced to sell it at a considerably lower price than what he expected.
- credit risk, is probably the most known one, and it consists in the possibility that the company issuing the bonds will face insolvency and it will not be able to respect its financial obligations.
- currency risk, it arises from exchange rate fluctuations between different currencies when for example you decide to purchase a bond in a different currency than the one you use in your everyday life (living in Italy but purchasing a U.S. bond issued in dollars). This could impact your returns because, if the dollar strengthens in value, the price of your bond in euros will decrease. In fact, a stronger dollar means it takes more euros to purchase the same amount of dollars, and so the market value of your bond will decrease.
If we consider to create our own portfolio of multiple investments, we should focus on: specific risk and systematic risk. The specific risk is related only to the issuer of the distinct asset and it is possible to reduce the exposure to it (eliminating it is not possible) by increasing the diversification in our portfolio, meaning that we will have to put our funds into a greater number of assets of various types, not just one. In the other case, we are talking about a feature of the market as a whole, something exogenous let’s say. This implies that being a very open-minded investor, with the capability of choosing multiple different industries to invest into, will not lead to a decrease in the level of exposure to this kind of risk. To understand this better, we should consider the role of the Beta parameter in the CAPM formula. The Capital Asset Pricing equation links the return on a security with the Beta that is the measure of the volatility of the asset price relative to the previously cited systematic risk. A Beta of 1 means the asset price movements have a strong positive correlation with the ones of the market value, while if it is greater/lower than 1 this implies that the single instrument volatility is greater/lower than the market one. Investors can have a risk-taking tendency, a risk aversion or be completely indifferent.
In order to understand how these individuals act, let’s analyze a specific example. We have two choices: receiving 100€ for sure, or gambling, gaining 200€ with a probability of 50% or nothing with the same measure of probability. In this specific case, an investor with a risk-taking tendency will probably decide to gamble, even if the expected gain is equal to the €50 that is possible to obtain without taking any risks, while a risk-adverse person will opt for the opposite choice.
Now let’s talk about options. Options represent a type of derivative instrument that is vital in order to protect ourselves from the typical risks that affects heavily traded assets like stocks, commodities, currencies, interest rates and so on. The two classes of options we are referring to are call options and put options. The call options give us the right, not the obligation, to buy the underlying asset at a pre-specified price at a certain time or times in future, protecting ourselves from a possible increase in its value, while the only difference for the put option is that it gives us the right to sell, offsetting the negative effects deriving from a possible future decrease in the underlying asset value (the concept of “Protective put” is strongly linked to what we have just said).
Authors: Piero Foberti and Filippo Ferrero