Unit 1

Risk (Concept)

Risk

The probability that actual results will differ from expected results

In finance, risk is the probability that actual results will differ from expected results. In
the Capital Asset Pricing Model, risk is defined as the volatility of returns. The concept of
“risk and return” is that riskier assets should have higher expected returns to compensate
investors for the higher volatility and increased risk.

Risk Types

Broadly speaking, there are two main categories of risk: systematic and unsystematic.
Systematic risk is the market uncertainty of an investment, meaning that it represents
external factors that impact all (or many) companies in an industry or group. Unsystematic
risk represents the asset-specific uncertainties that can affect the performance of an
investment.

Below is a list of the most important types of risk for a financial analyst to consider when
evaluating investment opportunities:

(i)Systematic Risk – The overall impact of the market

(ii)Unsystematic Risk – Asset-specific or company-specific uncertainty

(iii)Political/Regulatory Risk – The impact of political decisions and changes in regulation

(iv)Financial Risk – The capital structure of a company (degree of financial leverage or debt
burden)

(v)Interest Rate Risk – The impact of changing interest rates

(vi)Country Risk – Uncertainties that are specific to a country

(vii)Social Risk – The impact of changes in social norms, movements, and unrest

(viii)Environmental Risk – Uncertainty about environmental liabilities or the impact of

changes in the environment

(ix)Operational Risk – Uncertainty about a company’s operations, including its supply chain
and the delivery of its products or services

(x)Management Risk – The impact that the decisions of a management team have on a
company

(xi)Legal Risk – Uncertainty related to lawsuits or the freedom to operate

Competition – The degree of competition in an industry and the impact choices of

competitors will have on a company

Time vs. Risk

The farther away into the future a cash flow or an expected payoff is, the riskier (or more
uncertain) it is. There is a strong positive correlation between time and uncertainty.

Risk Management

Risk-Introduction- Basis risk in index insurance arises when the index measurements do not
match an individual insured's actual losses. There are two major sources of basis risk in
index insurance. One source of basis risk stems from poorly designed products and the other
from geographical elements. Risks can be considered in three classifications: Financial and
Non-Financial. Pure and Speculative. Fundamental and Particular.

Insurers typically cover pure risks, which have no chance of a constructive outcome, and not
speculative risks. A risk must meet specific criteria to be insurable, including being
statistically predictable, common, random, and clearly defined with a measurable value.
Risk management

Types of risk business faces

Business risk is a broad category. It applies to any event or circumstance that has the
potential to prevent you from achieving your business goals or objectives. Business risk can
be internal (such as your strategy) or external (such as the global economy).

These categories of risks are not rigid and some parts of your business may fall into more

than one category. The risks attached to data protection, for example, could be considered
when reviewing both operations and business' compliance.

Other sources of business risk

Other factors can present certain threats to your business, including:

(a)environmental risks, such as natural disasters

(b)political and economic instability in any foreign markets you export goods to

(c)health and safety risks - Assessment

(d)commercial risks, including the failure of key suppliers or customers

(e)workforce risks, maintaining sufficient staff numbers and cover, employee safety and up-
to-date skills

Importance of understanding risk

Risk is often posed by an event, a change in circumstances or their consequences. A common
definition of risk suggests that risk is the effect of uncertainty on achieving or surpassing
business objectives. This effect may be positive, negative or a deviation from the expected,

for example in forecasts and projections.

Without identifying risks, it is difficult to successfully define objectives and set out
strategies for achieving them. It is best practice to integrate business risk management with
strategy formulation and business planning processes.

Understanding and managing risks allows to control, and often prevent, the financial,
organization, legal and other ramifications associated with risks.

Two different methods of adjusting for uncertainty that is both a function of time.

Risk Adjustment

Since different investments have different degrees of uncertainty or volatility, financial

analysts will “adjust” for the level of uncertainty involved. There are two common ways of
adjusting: the discount rate method and the direct cash flow method.

(a) Discount Rate Method

The discount rate method of risk-adjusting an investment is the most common approach, as
it’s fairly simple to use and is widely accepted by academics. The concept is that the
expected future cash flows from an investment will need to be discounted for the time value
of money and the additional risk premium of the investment.

(b) Direct Cash Flow Method

The direct cash flow method is more challenging to perform but offers a more detailed and
more insightful analysis. In this method, an analyst will directly adjust future cash flows by
applying a certainty factor to them. The certainty factor is an estimate of how likely it is that
the cash flows will actually be received. From there, the analyst simply has to discount the
cash flows at the time value of money in order to get the net present value of the investment.

Risk Management

There are several approaches that investors and managers of businesses can use to manage
uncertainty. Below is a breakdown of the most common risk management strategies:

A. Diversification

Diversification is a method of reducing unsystematic (specific) risk by investing in a number

of different assets. The concept is that if one investment goes through a specific incident that
causes it to underperform, the other investments will balance it out.

B. Hedging

Hedging is the process of eliminating uncertainty by entering into an agreement with a

counter-party. Examples include forwards, options, futures, swaps, and other derivatives that
provide a degree of certainty about what an investment can be bought or sold for in the
future. Hedging is commonly used by investors to reduce market risk, and by business
managers to manage costs or lock-in revenues.

C Insurance

There is a wide range of insurance products that can be used to protect investors and
operators from catastrophic events. Examples include key person insurance, general liability
insurance, property insurance, etc. While there is an ongoing cost to maintaining insurance, it
pays off by providing certainty against certain negative outcomes.
D Operating Practices

There are countless operating practices that managers can use to reduce the riskiness of their
business. Examples include reviewing, analyzing, and improving their safety practices; using
outside consultants to audit operational efficiencies; using robust financial planning
methods; and diversifying the operations of the business.

E Deleveraging

Companies can lower the uncertainty of expected future financial performance by reducing
the amount of debt they have. Companies with lower leverage have more flexibility and a
lower risk of bankruptcy or ceasing to operate.

It’s important to point out that since risk is two-sided (meaning that unexpected outcome can
be both better or worse than expected), the above strategies may result in lower expected
returns (i.e., upside becomes limited).
Spreads and Risk-Free Investments

The concept of uncertainty in financial investments is based on the relative risk of an

investment compared to a risk-free rate, which is a government-issued bond. Below is an
example of how the additional uncertainty or repayment translates into more expense (higher
returning) investments.

As the chart above illustrates, there are higher expected returns (and greater uncertainty) over
time of investments based on their spread to a risk-free rate of return.