I.
Types of Risk
•
Market Risk
is the risk that changes in a stock’s price will result from
changes in the stock market as a whole. Market risk is commonly referred to
as nondiversifiable risk.
•
Nonmarket Risk
is the risk that is influenced by an individual firm’s policies
and decisions. Nonmarket risk is diversifiable because it is specific to each
firm.
•
Liquidity (marketability) Risk
is the risk that assets cannot be sold at a
reasonable price on short notice. If an asset is not liquid, investors will
require a higher return than for a liquid asset. The difference is the
liquidity
premium
.
•
InterestRate Risk
is the risk of fluctuations in the value of an asset due to
changes in interest rates. One component of interestrate risk is
price risk
,
for example, the risk of a decline in the value of bonds as interest rates
increase.
Reinvestmentrate risk
is another component, for example, if
interest rates decline, lower returns will be available for reinvestment of
interest and principal payments received.
•
Business Risk
(operations risk) is the risk of fluctuations in EBIT or in
operating income when the firm uses no debt. It is the risk inherent in the
operation of all firms that
excludes
financial risk, which is the risk to the
shareholders from the use of financial leverage. Business risk depends on
factors such as demand variability, sales price variability, input price
variability, and amount of operating leverage.
•
Total Risk
is the risk of a single asset, whereas market risk is its risk if it is
held in a large portfolio of diversified securities. Total risk, therefore,
includes diversifiable and undiversifiable risk.
II. Risk Measurement
•
Standard Deviation
measures the distance from the average mean. The
greater the standard deviation of the expected return, the riskier the
investment. A large standard deviation implies that the range of possible
returns is wide; i.e., the probability distribution is broadly dispersed.

STDEV = square root of (sum of squared deviations from the mean) / (# of
items in population)

STDEV = square root of the variance.
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The
coefficient of variation
is useful when the rates of return and
standard deviations of two investments differ. It measures the risk per unit of
return because it divides the standard deviation by the expected return.

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 Spring '09
 ward
 Accounting, isk

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