Explain Market Risk & Firm Risk ?

Ans. The market risk affects all the projects in an industry and not a particular project. In this section, the concept of market risk has been explained with respect to factors which are beyond the control of individual corporates. The market risk is further sub-divided into:

(i) Security market risk: Often we read in the newspaper that the stock market is in the bear hug or in the bull grip. This indicates that the entire market is moving in a particular direction either downward or upward. The economic conditions, political situations and the sociological changes affect the security market. The recession in the economy affects the profit prospect of the industry and the stock market. The 1998 recession experienced by developed and developing countries has affected the stock markets all over the world. The South East Asian crisis has affected the stock market world wide. There factors are beyond the control of the corporate and the investor. They cannot be entirely avoided by the investor. It drives home the point that the market risk is unavoidable.Jack Clark Francis has defined market risk as that portion of total

variability of return caused by the alternating forces of bull and bear markets. When the security index moves upward haltingly for a significant period of time, it is known as bull market. In the bull market, the index moves from a low level to the peak. Bear market is just a reverse to the bull market; the index declines haltingly from the peak to a market low point called trough for a significant period of time. During the bull and bear market more than 80 per cent of the securities’ prices rise or fall along with the stock market indices.The forces that affect the stock market are tangible and intangible events. The tangible events are real events such as earthquake,

war, political uncertainty and fall in the value of currency. Another example that can be cited is the Pokhran blast on May 13, 1998,and the fall of BSE sensex by 162 points. Impending sanctions, dampened sentiments and FIIs selling of stocks set a bear phase.Several examples like fall in the value of rupee and post-budget blue can be cited for triggering the bear phase.Intangible events are related to market psychology. The market psychology is affected by the real events. But reactions to the tangible events become over reactions and they push the market in a particular direction. Take for instance, the bull run in 1994 FII’s investment and liberalization policies gave buoyancy to the market.The market psychology was positive. Small investors entered the market and prices of stocks without adequate supportive fundamental factors soared up. In 1996, the political turmoil and recession in the economy resulted in the fall of share prices and the small investors lost faith in the market. There was a rush to sell the shares and the stocks that were floated in the primary market were not received well. Thus, any untoward political or economic event would lead to a fall in the price of the security which would be further accentuated by the over reactions and the herd like behaviour of the investors. If some financial institutions start disposing the stocks, the fear grips in and spreads to other investors. This results in a rush to sell the stocks. The actions of the financial institutions would have a snowballing effect. This type of over reaction affects the market adversely and the prices of the scrips’ fall below their intrinsic values. This is beyond the control of the corporate.

(ii) Interest rate risk: Interest rate risk is the variation in the single period rates of return caused by the fluctuations in the market interest rate. Most commonly interest rate risk affects the price of bonds, debentures and stocks. The fluctuations in the interest rates are caused by the changes in the government monetary policy and the changes that occur in the interest rates of treasury bills and the government bonds. The bonds issued by the government and quasi-government are considered to be risk free. If higher interest rates are offered, investor would like to switch his

investments from private sector bonds to public sector bonds. If the government to tide over the deficit in the budget floats a new loan/bond of a higher rate of interest, there would be a definite

shift in the funds from low yielding bonds to high yielding bonds and from stocks to bonds.Likewise, if the stock market is in a depressed condition, investors would like to shift their money to the bond market, to have an assured rate of return. The best example is that in April 1996, most of the initial public offerings of many companies remained under subscribed but IDBI and IFC bonds were oversubscribed. The assured rate of return attracted the investors from the stock market to the bond market.

The rise of fall in the interest rate affects the cost of borrowing.When the call money market rate changes, it affects the badla rate too. Most of the stock traders trade in the stock market with the

borrowed funds. The increase in the cost of margin affects the profitability of the traders. This would dampen the spirit of the speculative traders who use the borrowed funds. The fall in the

demand for securities would lead to a fall in the value of the stock index .Interest rates not only affect the security traders but also the corporate bodies who carry their business with borrowed funds.The cost of borrowing would increase and a heavy outflow of profit would take place in the form of interest t the capital borrowed. This would lead to a reduction in earnings per share and a consequent fall in the price of share.

(iii) Purchasing Power Risk: Variations in the returns are caused also by the loss of purchasing power of currency. Inflation, is the reason behind the loss of purchasing power. The level of inflation proceeds faster than the increase in capital value. Purchasing power risk is the probable loss in the purchasing power of the returns to be received. The rise in price penalizes the returns to the investor, and every potential rise in price is a risk to the investor. The inflation may be demand-pull or cost-push inflation. In the demand pull inflation, the demand for goods and services are in excess of their supply. At full employment level of factors of production, the economy would not be able to supply more goods in the short run and the demand for products pushes the price upward.d the supply cannot be increased unless there is an expansion of labour force or machinery for production. The equilibrium between demand and supply is attained at a higher price level. The cost-push inflation, as the name itself indicates that the inflation or the rise in price is caused by the increase in the cost.The increase in the cost of raw material, labour and equipment makes the cost of production high and ends in high price level. The producer tries to pass the higher cost of production to the consumer. The labourers or the working force try to make the corporate to share the increase in the cost of living by demanding higher wages. Thus, the cost push inflation has a spiraling effecton price level.

 FIRM RISK

Firm risk is unique and peculiar to a firm or an industry. Firm risk stems from managerial inefficiency, technological change in the production process, availability of raw material, changes in the consumer preference,and labour problems. The nature and magnitude of the above mentioned factors differ from industry to industry, and company to company. They have to be analysed separately for each industry and firm. The changes in the consumer preference affect the consumer products like television sets, washing machine, refrigerators, etc. more than they affect the iron and steel industry. Technological changes affect the information technology industry more than that of consumer product industry. Thus,it differs from industry to industry. Financial leverage of the companies  that is debt-equity portion of the companies differs from each other. The nature and mode of raising finance and paying back the loans, involve a risk element. All these factors from the firm risk and contribute a portion in the total variability of the return. Broadly, firm risk can be classified into:

1. Business risk

2. Financial risk

1. Business risk: Business risk is that portion of the firm risk caused by the operating environment of the business. Business risk arises from the inability of a firm to maintain its competitive edge and the growth or stability of the earnings. Variation that occurs in the operating environment is reflected on the operating income and expected dividends. The variation in the expected operating income indicates the business risk.

For example take ABC and XYZ companies. In ABC company, operating income could grow as

much as 15 per cent and as low as 7 per cent. In XYZ company,the operating income can be either 12 per cent or 9 per cent. When both the companies are compared, ABC company’s business risk is higher because of its high variability in operating income compared to XYZ company. Thus, business risk is concerned with the difference between revenue and earnings before interest and tax.

Business risk can be divided into external business risk and internal business risk.

(a) Internal Business Risk: Internal business risk is associated with the operational efficiency of the firm. The operational efficiency differs from company to company. The efficiency of operation is reflected on the company’s achievement of its pre-set goals and the fulfillment of the promises to its investors. The various reasons of internal business risk are discussed below:

(i) Fluctuations in the sales— The sales level has to be maintained. It is common in business to lose customers abruptly because of competition. Loss of customers will lead to a loss in operational income. Hence, the company has to build a wide customer base through various distribution channels. Diversified sales force may help to tide over this problem. Big corporate bodies have long chain of distribution channel. Small firms often lack this diversified customer base.

(ii) Research and development (R&D)— Sometimes the product may go out of style or become obsolescent. It is the management, who has to overcome the problem obsolescence by concentrating on the in-house research and development program. For example, if Maruti Udyog has to survive the competition, it has to keep its Research and Development section active and introduce consumer oriented technological changes in the automobile sector. This is often carried out by introducing sleekness, seating comfort and break efficiency in their automobiles. New products have to be produced to replace the old one. Short sighted cutting of R & D budget would reduce the operational efficiency of any firm.

(iii) Personnel management— The personnel management of the company also contributes to the operational efficiency of the firm.Frequent strikes and lock outs result in loss of production and high fixed capital cost. The labour productivity also would suffer.The risk of labour management is present in all the firms. It is up to the company to solve the problems at the table level and provide adequate incentives to encourage the increase in labour productivity. Encouragement given to the labourers at the floor level would boost morale of the labour force and leads to higher productivity and less wastage of raw materials and time.

(iv) Fixed cost— The cost components also generate internal risk if the fixed cost is higher in the cost component. During the period of recession or low demand for product, the company cannot reduce the fixed cost. At the same time in the boom period also the fixed factor cannot vary immediately. Thus, the high fixed cost component in a firm would become a burden to the firm. The fixed cost component has to be kept always in a reasonable size, so that it may not affect the profitability of the company.

(v) Single product— The internal business risk is higher in the case of firm producing a single product. The fall in the demand for a single product would be fatal for the firm. Further, some products are more vulnerable to the business cycle while some products resist and grow against the tide. Hence, the company has to diversify the products if it has to face the competition and the business cycle successfully. Take for instance, Hindustan Lever Ltd., which is producing a wide range of consumer cosmetics is thriving successfully in the business. Even in diversification,diversifying the product in the unknown path of the company may lead to an internal risk. Unwidely diversification is as dangerous as producing a single good.

(b) External risk— External risk is the result of operating conditions imposed on the firm by circumstances beyond its control. The external environments in which it operates exert some pressure on the firm. The external factors are social and regulatory factors, monetary and fiscal policies of the government, business cycle and the general economic environment within which a firm or an industry operates. A government policy that favours a particular industry could result in the rise in the stock price of the particular industry. For instance, the Indian sugar and fertilizer industry depend much on external factors. The various external factors are being discussed below:

(i) Social and regulatory factors— Harsh regulatory climate and legislation against the environmental degradation may impair the profitability of the industry. Price control, volume control,import/export control and environment control reduce the profitability of the firm. This risk is more in industries related to public utility sectors such as telecom, banking and transportation.The governments’ tariff policy of the telecom sector has a direct bearing on its earnings. Likewise, the interest rates and the directions given in the lending policies affect the profitability of the banks. Calcutta Electric and Supply Company (CESC) has not been able to increase its power tariff due to the stiff resistance by the West Bengal government. The Pollution Control Board has asked to close most of the tanneries in Tamil Nadu, which has affected the

leather industry.

(ii) Political risk— Political risk arises out of the change in the government policy. With a change in the ruling party, the policy also changes. When Sri. Manmohan Singh was the finance

minister, liberalization policy was introduced. During the Bharathiya Janta Party government, even though efforts are taken to augment the foreign investment, more stress is given to Swadeshi. Political risk arises mainly in the case of foreign investment. The host government may change its rules and regulations regarding the foreign investment. From the past, an example can be cited. In 1977, the government decided that the multinationals must dilute their equity and share their growth with the Indian investors. This forced many multinationals to liquidate their holdings in the Indian companies.

(iii) Business cycle— The fluctuations of the business cycle lead to fluctuations in the earnings of the company. Recession in the economy leads to a drop in the output of many industries. Steel

and white consumer goods industries tend to move in tandem with the business cycle. During the boom period, there would be hectic demand for steel products and white consumer goods. But at the same time, they would be hit much during the recession period. At present, the information technology industry has resisted the business cycle and moved counter cyclically during the recession period. The effects of the business cycle vary from one company to another. Sometimes, companies with inadequate capital and consumer base may be forced to close down. In some other case, there may be a fall in the profit and the growth rate may decline. This risk factor is external to the corporate bodies and they may not be able to control it.