Financial Management: Risk Assessment

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In today’s business environment the management often has to participate in the business’s capital budgeting process. They may have the capacities of a sponsor, a reviewer or an approving authority. Their tasks are to analyze cash flows, income statements, balance sheets etc. also it is important that they assess the risk the company may face. Capital budgeting investment resolutions are crucially important because they affect the company’s present and future assets. To make sure that the investment decisions will not lead to unpredictable consequences the managers of the company have to analyze thoroughly the potential risks.

In many companies the Capital Asset Pricing Model (CAPM) is used to measure the possible risk. This model was invented by William F. Sharpe. In it a heretical notion of investment risk is developed. Many years later, in 1990, Sharpe was awarded by the Nobel Prize committee (Burton, 1998, 3).

According to the CAPM model, two risks are possible in every investment. The so-called systematic risk is they risk which a company faces being in the market. This risk was later called “beta”; it is considered to be common to all securities. The other one, unsystematic risk, depends on a company’s fortunes. It is associated with individual assets. This model helps assess portfolio risk and helps to understand what the investor has to expect for taking this particular risk. Including more assets in the portfolio, this risk can be differentiated to smaller levels.

The CAPM is used in many companies to compensate the investors in two ways. The first way is time value of money, the second one is risk itself. As for the first one, this principle means that the faster the sum is invested the more the money is worth in the future. But this compensating for risk may prove to be not very reliable because usually the investors want to see the calculations in order to know that the chance for their money to return is good. But the other way round the investors can refuse to take risks because of fear to lose their investments (Mcmenamin, 1999, 186).

Often investors do not take any diversifiable risk, because only non-diversifiable risks prove to be rewarded when it comes to this model. That is why the return on the asset must be connected with the riskiness in the portfolio context. In the context of CAPM the portfolio risk is denoted by less predictability.

Jonathan Burton writes

The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in one security as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing badly in bad times. Beta is a measure of that. Securities or asset classes with high betas tend to do worse in bad times than those with low betas (Burton, 1998, 4).

For Strident Marks it is important to demonstrate the investors that their priority is owner’s wealth maximization. It is necessary that Strident Marks shows the investors reliable financial results and consistent forecasting. If they fail to optimize their financial practices, they may face the risk of losing the confidence of their investors; this can of course create troubles in the future.

The biggest risk one can face investing money is losing one’s capital. Risk can be defined as a chance for suffering a financial loss. A mutual fund which every month goes up by different amounts is considered to be more risky than one which goes down by a specific amount.

Standard deviation is and easily understood statistic; this tool helps to understand how often the event analyzed strays from the norm. Risk is a very important factor when it comes to determining the variation is the returns on the asset. It provides the investors with a mathematical basis for the further investment decisions. The standard deviation measurement is used to measure the risk of a stock portfolio. It is a measure of volatility of a mutual fund. Volatility indicates the risk of a mutual fund in comparison with the average mutual fund of the class. The higher the standard deviation is, the higher the risk and the anticipated return are. As the risk increases, the return on the asset increases too because of the earned risk premium (Mcmenamin, 1999, 190).

The standard deviation is a widely used risk measurement tool, but still it is not perfect.

It is a measurement of variability and volatility with a fund price. If the fund is a consistent high performer or a consistent low performer, the standard deviation is low. (Gallagher, 2003, 68). But it is not always like this. So to make accurate calculations it is important to consult a fund’s consistency over the period of some calendar years. In our case it is impossible.

To use standard deviation correctly we can only use it for funds of comparable returns.

But standard deviation is of great help when it comes to assessing the cost of possible accidents, health costs or workplace injuring. It provides the ability to study the population and to assess the possibility of certain events. This all makes the basics of the insurance industry.

As for the coefficient of variation (CV), it is a measure of dispersion of a probability distribution. This tool is useful, because as for the standard deviation it can be used with the mean of the data. The coefficient of variation is useful because it is a dimensionless data. The coefficient of variaiton is used to expresses the standard deviation in the form of the percentage of the sample mean. It can be useful when we are interested in the size of variation corresponding to the size of the observation (Gallagher, 2003, 117).

Its advantage is that the coefficient of variation does not depend on the units of observation. If the value of the standard deviation of is for example a set of weights the standard deviation will be different. It will depend on whether the weights are measured in pounds or kilograms. As for the coefficient of variation it will be the same in these cases because it does not depend upon the unit of measurement.

One of its disadvantages is that CV is sensitive to all the changes in the mean, and this fact limits its usefulness.

So we come to the conclusion that it is very important to estimate the risks the company may face. But the choice of tools for such measurements depends on many factors.

Reference

Burton, J. (1998). Revisiting the Capital Asset Pricing Model. Dow Jones Asset Manager. 2008. Web.

Gallagher & Andrew, 2003, Financial Management Principles & Practice, Pearson Education, Inc., Upper Saddle River, New Jerse

Mcmenamin, J. (1999). Financial Management: An Introduction. London: Routledge. (p186).

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Financial Management: Risk Assessment

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