Risk Management and Profitability

Risk Management and Profitability - I Types of Risk Market...

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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 . Interest-Rate Risk is the risk of fluctuations in the value of an asset due to changes in interest rates. One component of interest-rate risk is price risk , for example, the risk of a decline in the value of bonds as interest rates increase. Reinvestment-rate 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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Risk Management and Profitability - I Types of Risk Market...

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