Risk:

The term risk with reference to investment decision may be defined as the variability in the actual return emanating form a project in future over its working life in relation to the estimated return as forecasted at the time of initial capital budgeting decisions. Quite often, risk is differentiated with uncertainty. Risk is defined as situation where the possibility of happening or non-happening of an event can be quantified and measured, while uncertainty is defined as a situation where this possibility cannot be measured. Thus, risk is a situation when probabilities can be assigned to an event on the basis of facts and figures available regarding the decision. Uncertainty, on the other hand is a situation where either the facts and figures are not available, or the probabilities cannot be assigned.

Risk = the possibility of something unexpected happening or Risk = the possibility of an unexpected outcome occurring

Return:
It is no denying the fact the return is the motivating force and the principal rewards to the investment process. The return may be defined in terms of (i) realized return i.e., the return which was earned or could have been earned, and (ii) expected return i.e., there return which the firm anticipate to earn over some future period. The expected return is a predicted return and may or may not occur. Measuring the realizing return allows a firm to assess how the future expected returns may be. For a firm, the return from an investment is the expected cash inflows. The return may be measured as the total gain or loss to the firm over a given period of item and may be defined as percentage return on the initial amount invested.

The Risk - Return Relationship

Another fundamental relationship in the study of finance is the relationship between expected return and the expected level of associated risk. The nature of the relationship is that as the level of expected risk increases, the level of expected return also increases. The opposite is true as well. Lower levels of expected risk are associated with lower expected returns. This RISK-RETURN

RELATIONSHIP is characterized as being a direct relationship or a positive relationship.

Business firms operate and invest in risky environments. Since these risks impact the level of returns from business investments, they directly affect the economic value of both individual investment projects and the firm as a whole. Because of this, the potential risks associated with project investments must be taken into account when making investment decisions.

The "expectational" nature of the relationship:

It should be noted that the risk-return relationship is stated in expectational terms. That is, it focuses on expected risk and expected returns. When an investment decision is made, the decisions reflect expectations about future performance. After the investment has been made, actual returns and actual risks may be different from what was originally anticipated. The important point, however, is that when investment decisions are made, greater levels of expected risk should be compensated for by greater expected returns on the investment.

The importance of the risk-return relationship

The risk-return relationship has implications for many of the areas of finance. If, for example, two different alternative investments are being considered by a business, the existence of the risk-return relationship dictates that the comparison of alternative investments has to take both expected risks and expected returns into account. The decision cannot be made solely on the basis of the expected return. If two investments have differing risk levels associated with their future cash flows, the risk must be accounted for in the investment decision process. There are a number of different methods that can be used to incorporate risk into the project investment decision. These will be discussed in the advanced Capital Budgeting modules. The risk-return relationship also has implications for the pricing of various financial assets. If two sets of identical cash flows with the same risk levels are available, the risk-return relationship dictates that the two investments must have the same market value and market price. If the prices differ, the opportunity

exists for arbitrage activities and the earning of riskless profits. This aspect of the risk-return relationship is the basis of one of the fundamental asset pricing concepts in finance and economics; the Law of One Price. Risk is a fundamental, underlying, concept that has to be taken into account during any financial decision making process.

Risk Aversion.
Risk aversion refers to the aspect of human nature that causes people to avoid unnecessary risk. In general, people tend to be risk averse. In order to overcome this risk aversion, the investor must be adequately compensated. This concept of risk aversion carries over into the business and financial world as well. In business, people also tend to be risk averse. If they choose to expose themselves to higher levels of risks, they do so only if they are going to be compensated in some financial way for taking on the additional risk. In finance, since risk and return are positively related, the taking on of greater expected levels of risk is always associated with a higher expected financial return. This is the basis for the direct risk-return relationship.

Types of Risk
Unfortunately, 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 everpresent and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. Some of the most important types of risk are defined below.

Default Risk
The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment.

Interest Rate Risk

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 investments, corporate financial planning, and banking.

Price Risk
The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk

The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship.

Liquidity risk
The uncertainty 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.

Market risk
Within 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.

Firm specific risk

The uncertainty associated with the returns generated from investing in an individual firms 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.

Project risk
In 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 unsystematic project risk using the same theoretical risk framework that the CAPM uses.

Financial risk
The uncertainty brought about by the choice of a firms 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.

Business risk
The 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 Management courses.

Foreign Exchange Risks

Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks.

Translation Risks
Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses.

Transactions Risks
Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Total Risk
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 the Capital Asset Pricing Model (CAPM) 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. It is often referred to as a scaled measure of total risk or a relative measure of total risk. The following notes will discuss these concepts in more detail.

Expected Value (Expected Return)

This is the equation for the expected value or expected return of a set of observations from a discreet probability distribution of possible n outcomes where Pi is the probability of a particular outcome.

Expected rate of return =

Scenario Analysis Standard Deviation

This is the equation for the standard deviation of a set of observations from a discreet probability distribution of possible n outcomes where Pi is the probability of a particular outcome. This version is used when calculating the standard deviation of possible outcomes under different assumptions; for example, a best case, worst case, and base case scenario analysis. This manual calculation is best performed using a table approach. It is considered a measure of absolute total risk.

Where Pi = 1/N

Coefficient of Variation
This is the equation for the Coefficient of Variation. This measure scales the standard deviation by the expected return. It is considered a measure of relative (or scaled) total risk.

Often a discrete probability distribution of possible outcomes is considered and the expected return, standard deviation, and coefficient of variation of the distribution of returns is calculated. For example, assume that there are 3 possible states of nature; recession, normal economic growth, and economic boom. Probabilities have been assigned to each of these possible outcomes (for example, 20%, 60%, and 20% respectively) and the level of stock returns given each possible state of the economy (18%, 15% and 12% respectively). The following table calculates the expected value, the variance, the standard deviation and the coefficient of variation. A Pi 0.20 0.60 0.20 = 1.00 B ri 0.12 0.15 0.18 C (Pi)*(ri) 0.0240 0.0900 0.0360 D ^ ri - r -0.0300 0.0000 0.0300 E ^ [ ri - r ] 2 0.0009 0 0.0009 F ^ [ ri - k ]2 * Pi 0.00018 0 0.00018 G

= 0.1500

= 0.00036

Expected Value

0.0360% Variance 0.018973666 Standard Deviation

15.00% ^ r

1.9000%

0.1265

Coefficient of Variation

First note that all percentages are stated as decimals before any calculations are performed. Also note that the summation of all possible probabilities in the first column sum to 1.00 or 100%. The first step is to calculate the expected value of .15 (or 15%) in column C. Next, the expected value of .15 and the possible outcomes in column B are used to calculate the deviations from the expected value in column D, the squared deviations in column E, and the probability weighted squared deviations in column F. Summing up the probability weighted squared deviation for the three possible outcomes in column F gives us the variance of .000360. taking the square root of that number gives us .018973666 or, stating in % and rounding off to two significant decimals, we get the standard deviation of 1.90% . Dividing the .019 standard deviation by the expected value of .15 gives the coefficient of variation of .1265 . It should be noted that this standard deviation calculation approach is appropriate for use with a discreet number of possible outcomes where each outcome has a unique probability of occurrence. Slightly different versions of the standard deviation equation are appropriate when the probability of each occurrence is the same and a standard deviation of a either a statistical sample or an entire statistical population is being calculated.

Different Standard Deviation Calculations

There are variations on the method of calculation of standard deviations for different purposes. Many textbooks are not always clear on the differences. The information below should help.

Scenario Analysis Standard Deviation

To summarize, this is the equation for the standard deviation of a set of observations from a discreet probability distribution of possible n outcomes where Pi is the probability of a particular outcome. This version is used when calculating the standard deviation of possible outcomes under different assumptions; for example, a best case, worst case, and base case scenario analysis. This manual calculation is best performed using a table approach.

Where Pi = 1/N

Population Standard Deviation

If the standard deviation of an entire population is being calculated and each observation has the same probability of occurrence, the summation of the squared deviations is divided by just 'n' (the number of observations). This is because the probability (P) of each observation occurring is equal to 1 divided by the number of observations (n). This variation can be applied to any collection of observations, including a historical time series, if the entire population of observations is included in the calculation. The time series notation is slightly different using t. The version to the right is consistent with the textbook notation.

Sample Standard Deviation

Finally, if you are collecting a sample of observations from a population or a time series of data in order to make inferences about the underlying population of possible returns in the time series, you will calculate a sample standard deviation using the following equation. When we are calculating a sample standard deviation; we are really estimating the standard deviation of the underlying population and the estimation process requires us to make a "degrees of freedom" adjustment so 1 is subtracted from the sample size (N) to get the (N-1) adjustment shown below.