Types of Risk
the concept of risk is not a simple concept in finance.
There are many different types of risk identified and some types are
relatively more or relatively less important in different situations and
applications. In some theoretical
models of economic or financial processes, for example, some types of risks or
even all risk may be entirely eliminated.
For the practitioner operating in the real world, however, risk can never
be entirely eliminated. It is
ever-present and must be identified and dealt with.
the study of finance, there are a number of different types of risk the been
is important to remember, however, that all types of risks exhibit the same
positive risk-return relationship.
of the most important types of risk are defined below.
The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment.
The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes.
associated with the ability to sell an asset on short
notice without loss of value. A
highly liquid asset can be sold for fair value on short notice.
This is because there are many interested buyers and sellers in the
market. An illiquid asset is hard
to sell because there there few interested buyers.
This type of risk is important in some project investment decisions but
is discussed extensively in Investment courses.
Inflation Risk (Purchasing Power Risk)
The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value.
the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty
that all assets are exposed to and cannot be
diversified away. Often referred to
as systematic risk, beta risk, non-diversifiable risk, or the risk of the market
portfolio. This type of risk is discussed extensively in Investment courses.
associated with the returns generated from investing
in an individual firmís common stock. Within
the context of the Capital Asset Pricing Model (CAPM), this is the investment
risk that is eliminated through the holding of a well diversified portfolio.
Often referred to as un-systematic risk or diversifiable risk. This type
of risk is discussed extensively in Investment courses.
the advanced capital budgeting topics, the total risk associated with an
investment project. Sometimes
referred to as stand-alone project risk. In
advanced capital budgeting, project risk is partitioned into systematic and
un-systematic project risk.
uncertainty brought about by the choice of a firmís financing methods and
reflected in the variability of earnings before taxes (EBT), a measure of
earnings that has been adjusted for and is influenced by the cost of debt
financing. This risk is often
discussed within the context of the Capital Structure topics.
uncertainty associated with a business firm's operating environment and
reflected in the variability of earnings before interest and taxes (EBIT).
Since this earnings measure has not had financing expenses removed, it
reflect the risk associated with business operations rather than methods of debt
financing. This risk is often discussed in General Business
that is associated with potential changes in the foreign exchange value of a
currency. There are two major
types: translation risk and transaction risks.
While there are many different types of specific risk, we said earlier that in the most general sense, risk is the possibility of experiencing an outcome that is different from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment.
Measures of Total Risk
The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will discuss these concepts in more detail.
Be sure to see the text book assignments for more information on this topic.
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