financial_copy - Financial risk is an umbrella term for any...

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Financial risk is an umbrella term for any risk associated with any form of financing . In a financial context risk can be mitigated in two ways. One, by hedging using the correlations of stocks (CAPM), secondly is by using derivatives. Investors normally use both, though their applications are different. In a portfolio, the demand for any financial asset rests on the correlation between all the assets in the portfolio. In a portfolio, if two assets are negatively correlated (a loss in one results in a simultaneous gain in the other) then they have naturally hedged themselves against each other. Financial models are used to evaluate returns on portfolios. The CAPM is the most popular model. CAPM or the Capital Asset Pricing model is the most frequently used financial model to enable portfolio diversification. If returns on risky assets have less than perfect correlation, i.e., they do not naturally hedge against each other, risk averse individuals diversify risk in their holding of assets. A well diversified portfolio would have less fluctuation than returns on individually held financial assets. Assume that you have a portfolio of financial assets (in this case, equity securities). Each stock as explained in the types of risk, has two elements of risk. These are systematic and non- systematic risks. The non-systematic risk of individual securities can be mitigated through a well-diversified portfolio. Theoretically it can be completely negated by holding a diversified portfolio that is identical to the market. This normally does not happened since this would be a very large portfolio or people would make money only based on the entire market moving up or down. Given that non-systematic risk is virtually nullified by a large portfolio (CAPM assumes such a large portfolio), the only risk that remains is the systematic risk. Thus, the only type of risk for which and investor would earn a return would be the systematic risk. This systematic risk is measured as Beta. Beta calculates the volatility/exposure of a security’s return to the entire market (CAPM) portfolio. The rewrite Financial risk is usually is a patio umbrella phrase for the risk regarding any type of financing. Inside a financial circumstance risk might be mitigated in two approaches. One, by hedging utilizing the correlations of stocks (CAPM), the second thing is to apply derivatives. Investors typically use both, though their purposes are very different. Within a portfolio, the need for any financial asset is situated on the relationship involving each
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This note was uploaded on 05/21/2011 for the course ECON 123 taught by Professor Day during the Spring '11 term at Arab Open University, Amman.

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financial_copy - Financial risk is an umbrella term for any...

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