Sources Of Risk

As a holder of company securities like debentures, preference shares or equity shares, the investor is exposed to the risk of poor business performance. There are various factors for the cause of business risks like rigorous competition from the competitors, new technologies emergence, development and arrival of substitute products in the market, change in trends and fashion and thus shifts in consumer preferences, scarcity of inputs for production, government policy changes etc. But apart from the above mentioned causes, inefficient management may be the primary cause of business risk. Inefficient management would lead to poor performance of the business resulting in lower or insufficient profits or in certain cases, losses. It would affect the equity shareholders when the business has insufficient profits left over to pay them their profits share’ after meeting all the expenses and taxes. It would affect the debenture holders if the company has insufficient funds even to pay their legal interest and principal dues.

When the interest rate goes up, the market values of the existing fixed income securities fall and when the interest rate goes down, the market value rises. Thus the changes in the interest rate have an impact on the welfare of the investors. The prices of fixed income securities change as a result of change in interest rate because the buyer of such securities would not buy at its par value if its fixed interest rate is lower than the prevailing interest rate on a similar security. For example, a bond that has a par value of $1,000 and a coupon rate of 10% would sell at a discount if the interest rate increases from 10% to say, 13%. Apart from affecting the fixed income securities, the interest rate changes also affects the equity shares indirectly.

The prices of the securities, particularly equity shares tend to fluctuate and become volatile, even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged. The major cause for this fluctuation may be the sentiment of the investors, which keep changing. Investors sometimes become bullish and their investment horizons lengthen. So when the investors are optimistic, it would drive the share prices to greater heights. Inversely, when the investors are pessimistic, become bearish, forces the share prices to fall. These bullish and bearish behaviors of the investors affect the equity prices and the entire market as a whole, transforming into a greater market risk.