DO YOU REALLY KNOW WHAT INVESTEMENT RISK YOU BEAR?

Nowadays, under constantly changing environment conditions influenced by dynamically changing political, micro-economical and macro-economical conditions, taking investment decisions is inseparably connected with risk. For most of investors financial risk is a possibility of making losses. But does such a perception really encompass all aspects of risk phenomenon? The commonly used narrow definition of risk is not useful in taking optimal investment decisions. Under a theoretical framework risk is defined as a possibility of appearance of many (at least two) mutually exclusive material results of the taken decision. Simultaneously, it must be possible to determine for each effect its financial value and probability of appearance. Unfortunately majority of investors does not have resources to estimate probability and severity of each effect, therefore they would a less comprehensive definition. The basic definition of investment risk is as follows: Risk is a possibility of obtaining investment results different from expected. For example, when someone invests in a common stock and expects that it would increase in value by 5% over next month. It might happen that the stock value would drop by 2%, which represents a negative side of risk. But it could as well happen that the stock would increase in value by 15%, which constitutes a positive side of risk. On financial markets assets with different risk profile are traded, all the same the investors should always remember about a fundamental rule: the higher risk of an investment, the higher required rate of return. Taking additional risk should be compensated by greater return. This additional return represents a premium for risk. Risk-free investments are characterized by the lowest return. Instruments issued by a government are assumed to be risk-free. Treasury bills and bonds are theoretically free from credit risk. Based on this assumption, the holding period return from the instruments guaranteed by the state is a point of reference for other instruments listed on the domestic market. The rate of return from Treasure instruments is commonly known as a risk-free rate. All other investments should provide additional return in return for greater risk. Just the same, in order to take the optimal decisions in the risk/return framework, the investors must fully understand their risk exposures. So, why do not we discuss some basic components of overall risk profile? Considering risk from a perspective of frequency of appearance, the following risk categories are distinguished: systematic and unsystematic risk. Economical factors constitute the source of systematic risk. The economic factors have influence over all investments on the market. On the other hand, the sources of unsystematic risk derive from company specific factors and conditions of its industry. This type of risk concerns specific project and could be diversified away. Risk could be also divided into different categories. The most important types of risk include: 1) liquidity risk- is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss, the investments which are difficult to sell for a certain price in short period of time should provide liquidity premium 2) interest rate risk- comes from changes of interest rates on the market. Fixed rate investments (for example fixed rate bonds) are less attractive when the interest rates rise,

because their future flows are discounted at higher rates, therefore their price drops. In opposite directions move the interest only STRIPS which increase in value when the interest rates rise, because there are less prepayment and their investors would receive payments for a longer time. 3) inflation risk- is the risk that changes in the real return the investor will realize after adjusting for inflation will be negative as the inflation decreases purchasing power of money 4) currency risk- is connected with the investments made in a foreign currency, as the real rate of return is then also dependent on changes of the exchange rate. The foreign currency depreciation can decrease the return from the foreign assets. 5) risk of stocks prices- comes into play when stocks or other investments whose value depends on stocks prices (pre-emptive rights, options on stocks). In short run the risk of stocks prices is strongly influenced by behavioural factors, which bring about not always rational behaviours of the investors. 6) credit risk- is the risk that one counterparty would default on its obligation described in the contracts (mainly it would not make payment in favour of the second party). The risk is mainly connected with bonds issued by enterprises where the investors might lose even 100% of invested capital 7)political risk- comes from a possibility of passing a legislation which would influence return from investments. For example some tax advantages (tax exempt bonds) or disadvantage from the financial investment or the risk of expropriation in times of military conflicts. The investors are becoming more conscious of risk of investment which is confirmed by a growing number of people who invest in investment funds. It results from a lack of access to costly information services, a lack of knowledge or experience, a lack of time and many other factors. The investment funds offer the investors a possibility of investing in well diversified portfolio with the specified profile of risk and return. Each investor, having specified investment horizon and ability to take risk, has its own risk profile. In accordance with his own risk profile the investor chooses a proper portfolio offered by the investment fund.