Financial Risk Essay

1797 words - 8 pages

Introduction

Financial risk takes place when an individual or company is exposed through numerous financial transactions. These transactions may include sales, purchasing, different types of investments, loans, volatile markets due to political situations and more. Financial prices may change as a result of changes in interest rates, inflation, the exchange rate, and many more economic reasons such influences of the European markets as well as the United States. These occurrences can result in increased cost and reduced revenues. It is clear that these aspects make it difficult to plan the operations of an organization. Another aspect that greatly influences the financial risk of ...view middle of the document...

Meginson et al. (2010:179) defines systematic risk as those risks that are common across all types of securities. Examples given are fluctuations in gross domestic product, inflation, oil prices, or interest rates as well as certain political factors. These political factors may include the legal system governing investors and markets in a given country can influence systematic risk because the system determines the level of protection given to minority shareholders, creditors and ordinary investors. Investors feel safe to trade and invest in securities when they perceive that the legal system protects their interests. Investors can expect to be compensated only for bearing systematic risk.
Unsystematic risk

This type of risk is also known as specific risk, diversifiable risk or residual risk. It is the type of uncertainty that comes with the company or industry you invest in. Unsystematic risk can be reduced through diversification. News that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.
Measuring risk

Beta is a measure of volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta gives a sense of a stocks’ market risk compared to the greater market. It is also used to compare a stock’s market risk to that of other stocks. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. If a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.
Many stocks have a beta of less than 1. Conversely, most high-tech stocks have a beta greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
Figure 2 below shows a time series of returns (each data point labelled “+”) for a particular portfolio R(p) versus the market return R(m). The returns are cash-adjusted, so the point at which the x and y axes intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us to quantify the passive, or beta, risk and the active risk, which we refer to as alpha. The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every unit increase of market return, the portfolio return also increases by one unit.
Figure 2
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A manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk (i.e., a beta greater than 1) or alternatively decrease portfolio risk (and return) by reducing the portfolio beta below 1. Beta expresses the fundamental trade-off between minimizing risk and...

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