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Definition of 'Financial Risk'

The possibility that shareholders will lose money when they invest in a company that has debt, if the
company's cash flow proves inadequate to meet its financial obligations. When a company uses debt
financing, its creditors will be repaid before its shareholders if the company becomes insolvent.


Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which
would cause those bondholders to lose money.


Explanation of 'Financial Risk'

Investors can use a number of financial risk ratios to assess an investment's prospects. For example, the debt-
to-capital ratio measures the proportion of debt used, given the total capital structure of the company. A high
proportion of debt indicates a risky investment. Another ratio, the capital expenditure ratio, divides cash
flow from operations by capital expenditures to see how much money a company will have left to keep the
business running after it services its debt.
Probability Distribution:
It is a set of possible values that a random variable can assume and their associated probabilities
of occurrence.

For risky securities, the actual rate of return can be viewed as a random variable subject to a
probability distribution.
The probability distribution can be described in terms of two parameters.
1) The expected return
2) The standard deviation

Expected Return
It is the weighted average of possible returns, with the weights being the probabilities of
occurrence.

So the expected return, R is:
R =
t=1

n
(R
i
)(P
i
)
Where
R
i
= the return for the ith possibility
P
i
= the probability of the return occurring
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N= the total number of possibilities




Standard Deviation:
It is a statistical measure of the variability of a distribution around its mean and it is the square
root of the variance.

We must keep in mind that,
The greater the standard deviation of returns, the greater the variability of returns and greater
the risk of the investment.

The standard deviation can be expressed mathematically as
= [
t=1

n
( R
i
- R)(P
i
)]
Where,
R
i
= Possible Return
R= Expected Return
P
i
= Probability of Return occurring


Coefficient of Variation
It is the ratio of the standard deviation of a distribution to the mean of that distribution and it is
the measure of relevant risk, i.e. a measure of risk per unit of expected return.



Coefficient of Variation (CV) = /R
Where,
= Standard deviation
R= Expected Return
The larger the CV, the larger the relative risk of the investment.

RISK:
The chances of financial loss or more formally the variability of returns associated with a given assest.
The chance that an investment's actual return will be different than expected. Risk includes the possibility of
losing some or all of the original investment. Different versions of risk are usually measured by calculating the
standard deviation of the historical returns or average returns of a specific investment. A high standard
deviation indicates a high degree of risk.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk
that an investor is willing to take on, the greater the potential return. The reason for this is that investors
need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when
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compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is
much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate
bond is higher, investors are offered a higher rate of return.
Return:
In finance, return is a profit on an investment. It comprises any change in value, and interest or
dividends or other such cash flows which the investor receives from the investment.
Ambiguously, return is also used to refer to a profit on an investment, expressed as a proportion of
the amount invested. This is also called the holding period return.
A loss instead of a profit is described as a negative return.
Rate of return is a profit on an investment over a period of time, expressed as a proportion of the
original investment. The time period is typically a year, in which case the rate of return is referred to
as annual return.
Income received on an investment plus any change in market price, usually expressed as a
percent of the beginning market price of the investment.
Measuring return:


Risk and Return Trade off:

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Popular sources of risk:


Every business potentially faces challenges, or risks. The types of risk can vary from
business to business but there are some most businesses have in common and generally
can be split into two factors- internal and external.
The list below outlines the most common threats or risks to your business.
Internal risk factors
Organisational and operational
These are part of your operational and administrative procedures. These include
disorganised or inaccurate record keeping, outdated or faulty IT systems or interruptions to
your supply chain. If you don't stay on top of these your customers could come to see you as
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unreliable, or you could potentially lose all your data.
Strategic risks
These affect your businesses ability to reach the goals or objectives outlined in your business
plan. They could be due to the effects of changes in customer demand or technological
evolutions and could pose threats to your business in regards to how your products or
services are viewed and perceived by your customers (e.g overprices, or dull and outdated).
Innovation
For a business to keep up with competitors, or more importantly to get one step ahead, there needs
to be innovation. This could be in the form of marketing and promotional initiatives detailed in
the marketing plan, staff training and welfare or embracing new technology. Regardless, a lack of
innovation can therefore pose a serious risk to a business progressing or growing, causing it to
remain boring, dull, stagnant and irrelevant.
Financial
Financial risks are part of the financial structure of your business, business transactions, and
the financial systems you use. You could find being overly reliant on a single customer or
changes in interest rates.
Employee risks
Although employees are vital to business success, there are risks associated with having
employees. Some risks include key staff being ill and unable to work at an important or
extended time or an industry strike action.
External risk factors
Compliance risks
Compliance risks are part of the laws and regulations you must meet, such as taxation,
employment, health and safety, and fair trading.
Environmental or natural risks
Each location and its business practices will influence the likelihood of each risk, but some to
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consider are natural disasters such as bushfire, hail, flooding and wind storm, property
damage such as water pipes bursting or power failure.
Technological
To keep your business current, and relevant to the needs of your customers there are
instances where it may be important to keep up with technological developments. It's
important to monitor what is happening with technology outside your business, chat with
other business owners, stay tuned in to current trends by reading online, or find out more
about how to develop an online presence that succeeds.
Health and safety
Apart from the legal and moral reasons for keeping your business safe for employees and
customers , your business could suffer if you don't manage the health and safety risks. Some
potential risks include regulations that might increase your production costs e.g. higher
quality standards, or changes to OHS that could mean an increase to your costs e.g. having
to provide safety equipment to your workers.
Political and economic
Some businesses can be affected by a change of government and government policy.
Likewise, economic changes, such as a recession or interest rate fluctuations, could be a risk
to your business.







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RISK preference:
Feelings about risk differ among managers and firms.
Three types of risk are:
1:Risk preffering or seeking
2:Risk aversion
3:Risk indifference or neural
1:Risk preffering or seeking:
The attitude towards risk in which a decreasing return would be accepted for an increasing
in risk.Theoritically,because they enjoy risk these managers are willing to give up some
return to take more risk.however such behavior would not be likely benifited to the firm.
2:Risk aversion:
The attitude toward the risk in which an increasing return would be required for increasing in
risk.Becouse the shy away from the risk ,these managers required higher expected return to
compesate them for taking greater risk.
3:Risk neural or indifference:
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The attitude towards risk in which no change in returns would be required for an increasing in
risk.No change in return would be required for the increasing in risk.clearly,this attitude is is
nonsensical in almost business context.

How we measure risk of a single asset?
The total risk of a single asset is measured by the standard deviation of return on asset.Standard
deviation is the square root of variance. To measure variance, you must have some distribution/
possibility of asset returns. However, the relevant risk of a single asset is the systematic risk, not the
total risk. Systematic risk is the risk that cannot be diversified away in a portfolio. Systematic risk of
an asset is measured by the Beta. Beta can be found using Regression (between market return and
asset's return) or Covariance formula.
Risk assessment
Sensitivity analysis and probability distribution can be used to assess the general level of risk
embodied in given assets
Senstivity analysis:
An approach for assessing risk that uses several possible returns estimates to obtain a sense of the
variability among outcomes. One method include in this is called is rang.
Range:
A measurement of an assets risks which is found by substracting the pessimistic outcomes from the
optimistic outcomes.
Probability:
The probability of an event is a measure of the chance that the event occurs.
Probability is the chance that something will happen - how likely it is that some event
will happen.

Sometimes you can measure a probability with a number: "10% chance of rain", or
you can use words such as impossible, unlikely, possible, even chance, likely and
certain.

Example: "It is unlikely to rain tomorrow".

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Probability distribution:
A model that relates probabilities to the associated outcomes.an outcome with an 80%proability of
accouring would be expected to accour 8 out of 10 times an outcome with a probability of 100%is
certain to occur.outcomes with the probability of zero will never occurred.
Risk measurement:
We considered two statistics the standerd deviation and the co efficient of variation that can be used
variability of asset return.
Standard deviation:
The most common statistical indicator of an assets risk ;its measures the dispersion around the
expected value.its denoted by k.which measure the dipersion around the expected value.the expected
value of return k
expected return is calculated as the weighted average of the likely profits of the assets in the portfolio,
weighted by the likely profits of each asset class. Expected return is calculated by using the following
formula:



EFFICIENT PORTPOLIO
Definition:
A portfolio that provides the greatest expected return for a given level of risk, or equivalently, the
lowest risk for a given expected return. also called optimal portfolio.

Portfolio:
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To determine the expected return on a portfolio, the weighted average expected return of the assets that
comprise the portfolio is taken.

kp = w
1
R
1
+ w
2
R
q
+ ...+ w
n
R
n

W1=PROPORTION
of the portfolio tata doolars vaue represents by assets i
Kp=standard deviation of expected portfolio.

R1=Return on assets.
Standard deviation of expected portfolio:
We learned about how to calculate the standard deviation of a single asset. Lets now look at how to
calculate the standard deviation of a portfolio with two or more assets.
The returns of the portfolio were simply the weighted average of returns of all assets in the portfolio.
However, the calculation of the risk/standard deviation is not the same. While calculating the variance,
we also need to consider the covariance between the assets in the portfolio. If the assets are perfectly
correlated, then the simple weighted average of variances will work. However, when we have to
account for the covariance, the equation will change.
Definition of 'Correlation'

In the world of finance, a statistical measure of how two securities move in relation to each other.
Correlations are used in advanced portfolio management.

Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1.
Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or
down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative
correlation means that if one security moves in either direction the security that is perfectly negatively
correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said
to have no correlation; they are completely random.
Types of Correlation
1. Positive and negative correlation
2. Linear and non-linear correlation
A) If two variables change in the same direction (i.e. if one increases the other also increases, or if one
decreases, the other also decreases), then this is called a positive correlation. For example :
Advertising and sales.
B) If two variables change in the opposite direction ( i.e. if one increases, the other decreases and vice
versa), then the correlation is called a negative correlation. For example : T.V. registrations and
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cinema attendance.
Positive correlation :
Positive correlation occurs when an increase in one variable increases the value in another.

Strong Correlation
A correlation is stronger the closer the points are located to one another on the line.

Weak Correlation
A correlation is weaker the farther apart the points are located to one another on the line.
Perfect Correlation
Perfect correlation occurs when there is a funcional dependency between the variables.
Portfolio diversification;
Definition:
Investing in different asset classes and in securities of many issuers in an attempt to reduce overall
investment risk and to avoid damaging a portfolio's performance by the poor performance of a single
security, industry, (or country).
Balancing risk and expected return is a challenge for any investor considering different investment choices.
Portfolio diversification may help reduce risk, and the lower the correlation between returns from different
securities in a portfolio, the greater the diversification benefit. Quantifying exposure to the market can be
challenging, especially when the number of securities in a portfolio increases. Moreover, correlations between
securities are dynamic and further complicate portfolio analysis, as illustrated in the Analysis Concepts paper,
Understanding and Using Correlation Analysis


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Definition of 'Diversification'

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale
behind this technique contends that a portfolio of different kinds of investments will, on average, yield
higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive
performance of some investments will neutralize the negative performance of others. Therefore, the
benefits of diversification will hold only if the securities in the portfolio are not perfectly correlatated.

.


nternational diversification
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Definition
An allocation of investments in a portfolio of international securities in order to achieve broader equity
exposure to many foreign markets while spreading the risks associated with investing in any one
foreign market.

international Diversification
Investment of one's portfolio in securities that are traded in various countries. This is done to reduce
risk, often political risk. For example, if one country's government announces a larger than normal
budget deficit, or the central bank raises interest rates, this may affect security prices in one country,
but not necessarily in other countries that did not take equivalent steps. Likewise, if a whole industry
fails in one country but thrives in another, investing in the same industry in both countries hedges
one's risk. Some analysts argue that international diversification is less effective in an era of
globalization, but other analysts dispute that.

International Diversification and Risk
The case for international diversification of portfolios can be decomposed into two
Components
( 1)
the potential risk reduction benefits of holding international securities and
(2)
the potential added foreign exchange risk.

Portfolio Risk Reduction
We focus first on risk. The risk of a portfolio is measured by the ratio of the variance of the
portfolios return relative to the variance of the market return. This is the
beta
of the port-
folio. As an investor increases the number of securities in a portfolio, the portfolios risk
declines rapidly at first, then asymptotically approaches the level of
systematic risk
of the
market. A fully diversified domestic portfolio would have a beta of portfolio diversification, it is
not possible to eliminate it totally because security returns are
affected by a common set of factorsa set we characterize as the market.
The total risk of any portfolio is therefore composed of
systematic risk and unsystematic risk
(the individual securities). Increasing the number of securities in the port-
folio reduces the unsystematic risk component leaving the systematic risk component
unchanged.

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Types of Diversification
There are many types of portfolio diversification. Those quantifiable types may be reduced to only
two; systematic diversification and idiosyncratic diversification. Idiosyncratic diversification is
increased by simply holding more investments. Equally weighting the portfolio is the approach which
maximizes the portfolios idiosyncratic diversification. Idiosyncratic diversification is typically easy to
achieve.
Systematic diversification is typically harder to achieve. Systematic diversification is the obverse of
systematic risk. Greater systematic risk is observed as financial assets move up or down in unison. If
all of an investors portfolio positions moved in unison they have large systematic risk and poor
systematic diversification. In most market conditions, intelligent diversification across asset classes
and within those asset classes will provide a substantial decrease to the systematic risk.
Diversification Measurement
Gravity Investments invented and patented a framework for measuring diversification in an integrated
framework that equates diversification to dimensionality. Higher dimensional portfolios have more
diversification. Because optimal diversification naturally balances the number of investments
(idiosyncratic diversification) with the exposure to systematic diversification, a full accounting of a
portfolios diversification must include both. The framework for measuring diversification by
dimensions accomplishes this. A dimension and a factor are synonymous, they are abstractions
obtained from inputs including the weights of all the assets in the portfolio as well as a measure of the
relationship among each of the portfolio positions. This measure is typically a correlation value.
Examples
The simplest example of diversification is provided by the proverb "Don't put all your eggs in one
basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more
diversified, the probability of any one basket being dropped notwithstanding. Geographically
dispersing those baskets thus represents another dimension of diversification. There is more risk of
losing one egg (assuming at least one basket has a higher probability of being dropped than the
original basket), but less risk of losing all of them.
In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not
unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20
stocks to go down that much, especially if they are selected at random. If the stocks are selected from
a variety of industries, company sizes and types (such as some growth stocks and some value stocks) it
is still less likely.

Since the mid-1970s, it has also been argued that geographic diversification would generate superior
risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing
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some of the higher rates of return offered by the emerging markets of Asia and Latin America.
[2][3]

Return expectations while diversifying
If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on
a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will
do better than others; but since one does not know in advance which assets will perform better, this
fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that
of the top-performing investment, and indeed will always be lower than the highest return (unless all
returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than
that of the worst-performing investment. So by diversifying, one loses the chance of having invested
solely in the single asset that comes out best, but one also avoids having invested solely in the asset
that comes out worst. That is the role of diversification: it narrows the range of possible outcomes.
Diversification need not either help or hurt expected returns, unless the alternative non-diversified
portfolio has a higher expected return.
[4]



Capital Assets Pricing Model:


The capital asset pricing model, almost always referred to as the CAPM, is a centerpiece of modern financial
economics. The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner
(1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the
Nobel Memorial Prize in Economics for this contribution to the field of financial economics. The model
gives us a precise prediction of the relationship that we should observe between the risk of an asset and its
expected return. This relationship serves two vital functions:

First, it provides a benchmark rate of return for evaluating possible investments.
Second, the model helps us to make an educated guess as to the expected return on assets that have not yet
been traded in the marketplace.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money
and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the
investors for placing money in any investment over a period of time. The other half of the formula represents
risk and calculates the amount of compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period
of time and to the market premium (Rm-rf).

CAMP Formula:

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Assumptions Underlying the CAPM

There are many investors. They behave competitively (pricetakers).
All investors are looking ahead over the same (one period) planning horizon.
All investors have equal access to all securities.
No taxes.
No commissions.
. Investors can borrow and lend at the one risk free rate.
Investors can short any asset, and hold any fraction of an asset.

BETA
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall market. In
other words, it gives a sense of the stock's market risk compared to the greater market. Beta is used also to
compare a stock's market risk to that of other stocks. Investment analysts use the Greek letter '' to represent
beta. This measure is calculated using regression analysis. A beta of 1 indicates that the security's price tends
to move with the market. A beta greater than 1 indicates that the security's price tends to be more volatile
than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utility stocks
have a beta of less than 1, and, conversely, many high-tech Nasdaq-listed stocks have a beta greater than 1.






Types of risk


:
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1. What is an unsystematic risk?


-- Safeway and a strike
-- Microsoft and antitrust cases
2. What is an systematic risk?


-- energy prices, interest rates, inflation, business cycles

SECURITY MARKET LINE

Security market line (SML) is the representation of the Capital asset pricing model. It displays the
expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its
beta). Also referred to as the "characteristic line"3.
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-
axis represents the risk (beta), and the y-axis represents the expected return. The market risk
premium is determined from the slope of the SML. The security market line is a useful tool in
determining whether an asset being considered for a portfolio offers a reasonable expected return for
risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return
is plotted above the SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the investor would be
accepting less return for the amount of risk assumed.



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The Formula
The Y-intercept of the SML is equal to the risk-free interest rate. The slope of the SML is equal to
the market risk premium and reflects the risk return trade off at a given time:
Where:
rf =Risk free rate
a=Beta of security (portfolios exposure to market risk)
rm =Expected market return
When used in portfolio management, the SML represents the investment's opportunity cost
(investing in a combination of the market portfolio and the risk-free asset). All the correctly priced
securities are plotted on the SML. The assets above the line are undervalued because of a given
amount of risk (beta), they yield a higher return. The assets below the line are overvalued because
for a given amount of risk, they yield a lower return.
Advantages & Disadvantages of SML
ADVANTAGES


DISADVANTAGES

ich also varies over time


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