Risk - Definition, Types, Adjusment and Measurement

In finance, risk is the probability that actual results will differ from expected results. In the Capital Asset Pricing Model (CAPM), risk is defined as the ... RiskTheprobabilitythatactualresultswilldifferfromexpectedresultsHome›Resources›Knowledge›Finance›RiskWhatisRisk?Infinance,riskistheprobabilitythatactualresultswilldifferfromexpectedresults.IntheCapitalAssetPricingModel(CAPM)CapitalAssetPricingModel(CAPM)TheCapitalAssetPricingModel(CAPM)isamodelthatdescribestherelationshipbetweenexpectedreturnandriskofasecurity.CAPMformulashowsthereturnofasecurityisequaltotherisk-freereturnplusariskpremium,basedonthebetaofthatsecurity,riskisdefinedasthevolatilityofreturns.Theconceptof“riskandreturn”isthatriskierassetsshouldhavehigherexpectedreturnstocompensateinvestorsforthehighervolatilityandincreasedrisk.  TypesofRiskBroadlyspeaking,therearetwomaincategoriesofrisk:systematicandunsystematic.Systematicriskisthemarketuncertaintyofaninvestment,meaningthatitrepresentsexternalfactorsthatimpactall(ormany)companiesinanindustryorgroup.Unsystematicriskrepresentstheasset-specificuncertaintiesthatcanaffecttheperformanceofaninvestment.Belowisalistofthemostimportanttypesofriskforafinancialanalysttoconsiderwhenevaluatinginvestmentopportunities:SystematicRisk–TheoverallimpactofthemarketUnsystematicRisk–Asset-specificorcompany-specificuncertaintyPolitical/RegulatoryRisk–TheimpactofpoliticaldecisionsandchangesinregulationFinancialRisk–Thecapitalstructureofacompany(degreeoffinancialleverageordebtburden)InterestRateRisk–TheimpactofchanginginterestratesCountryRisk–UncertaintiesthatarespecifictoacountrySocialRisk–Theimpactofchangesinsocialnorms,movements,andunrestEnvironmentalRisk–UncertaintyaboutenvironmentalliabilitiesortheimpactofchangesintheenvironmentOperationalRisk–Uncertaintyaboutacompany’soperations,includingitssupplychainandthedeliveryofitsproductsorservicesManagementRisk–TheimpactthatthedecisionsofamanagementteamhaveonacompanyLegalRisk–UncertaintyrelatedtolawsuitsorthefreedomtooperateCompetition–Thedegreeofcompetitioninanindustryandtheimpactchoicesofcompetitorswillhaveonacompany  Timevs.RiskThefartherawayintothefutureacashfloworanexpectedpayoffis,theriskier(ormoreuncertain)itis.Thereisastrongpositivecorrelationbetweentimeanduncertainty.  Below,wewilllookattwodifferentmethodsofadjustingforuncertaintythatisbothafunctionoftime. RiskAdjustmentSincedifferentinvestmentshavedifferentdegreesofuncertaintyorvolatility,financialanalystswill“adjust”forthelevelofuncertaintyinvolved.Generallyspeaking,therearetwocommonwaysofadjusting:thediscountratemethodandthedirectcashflowmethod.  #1DiscountRateMethodThediscountratemethodofrisk-adjustinganinvestmentisthemostcommonapproach,asit’sfairlysimpletouseandiswidelyacceptedbyacademics.Theconceptisthattheexpectedfuturecashflowsfromaninvestmentwillneedtobediscountedforthetimevalueofmoneyandtheadditionalriskpremiumoftheinvestment.Tolearnmore,checkoutCFI’sguidetoWeightedAverageCostofCapital(WACC)WACCWACCisafirm’sWeightedAverageCostofCapitalandrepresentsitsblendedcostofcapitalincludingequityanddebt.andtheDCFmodelingguideDCFModelTrainingFreeGuideADCFmodelisaspecifictypeoffinancialmodelusedtovalueabusiness.Themodelissimplyaforecastofacompany’sunleveredfreecashflow. #2DirectCashFlowMethodThedirectcashflowmethodismorechallengingtoperformbutoffersamoredetailedandmoreinsightfulanalysis.Inthismethod,ananalystwilldirectlyadjustfuturecashflowsbyapplyingacertaintyfactortothem.Thecertaintyfactorisanestimateofhowlikelyitisthatthecashflowswillactuallybereceived.Fromthere,theanalystsimplyhastodiscountthecashflowsatthetimevalueofmoneyinordertogetthenetpresentvalue(NPV)NetPresentValue(NPV)NetPresentValue(NPV)isthevalueofallfuturecashflows(positiveandnegative)overtheentirelifeofaninvestmentdiscountedtothepresent.oftheinvestment.WarrenBuffettisfamousforusingthisapproachtovaluingcompanies. RiskManagementThereareseveralapproachesthatinvestorsandmanagersofbusinessescanusetomanageuncertainty.Belowisabreakdownofthemostcommonriskmanagementstrategies: #1DiversificationDiversificationisamethodofreducingunsystematic(specific)riskbyinvestinginanumberofdifferentassets.Theconceptisthatifoneinvestmentgoesthroughaspecificincidentthatcausesittounderperform,theotherinvestmentswillbalanceitout. #2HedgingHedgingistheprocessofeliminatinguncertaintybyenteringintoanagreementwithacounterparty.Examplesincludeforwards,options,futures,swaps,andotherderivativesthatprovideadegreeofcertaintyaboutwhataninvestmentcanbeboughtorsoldforinthefuture.Hedgingiscommonlyusedbyinvestorstoreducemarketrisk,andbybusinessmanagerstomanagecostsorlock-inrevenues. #3InsuranceThereisawiderangeofinsuranceproductsthatcanbeusedtoprotectinvestorsandoperatorsfromcatastrophicevents.Examplesincludekeypersoninsurance,generalliabilityinsurance,propertyinsurance,etc.Whilethereisanongoingcosttomaintaininginsurance,itpaysoffbyprovidingcertaintyagainstcertainnegativeoutcomes. #4OperatingPracticesTherearecountlessoperatingpracticesthatmanagerscanusetoreducetheriskinessoftheirbusiness.Examplesincludereviewing,analyzing,andimprovingtheirsafetypractices;usingoutsideconsultantstoauditoperationalefficiencies;usingrobustfinancialplanningmethods;anddiversifyingtheoperationsofthebusiness. #5DeleveragingCompaniescanlowertheuncertaintyofexpectedfuturefinancialperformancebyreducingtheamountofdebttheyhave.Companieswithlowerleveragehavemoreflexibilityandalowerriskofbankruptcyorceasingtooperate.It’simportanttopointoutthatsinceriskistwo-sided(meaningthatunexpectedoutcomecanbebothbetterorworsethanexpected),theabovestrategiesmayresultinlowerexpectedreturns(i.e.,upsidebecomeslimited).  SpreadsandRisk-FreeInvestmentsTheconceptofuncertaintyinfinancialinvestmentsisbasedontherelativeriskofaninvestmentcomparedtoarisk-freerate,whichisagovernment-issuedbond.Belowisanexampleofhowtheadditionaluncertaintyorrepaymenttranslatesintomoreexpense(higherreturning)investments.  Asthechartaboveillustrates,therearehigherexpectedreturns(andgreateruncertainty)overtimeofinvestmentsbasedontheirspreadtoarisk-freerateofreturn. RelatedReadingsCFIofferstheFinancialModeling&ValuationAnalyst(FMVA)™BecomeaCertifiedFinancialModeling&ValuationAnalyst(FMVA)®CFI'sFinancialModelingandValuationAnalyst(FMVA)®certificationwillhelpyougaintheconfidenceyouneedinyourfinancecareer.Enrolltoday!certificationprogramforthoselookingtotaketheircareerstothenextlevel.Tokeeplearningandadvancingyourcareer,thefollowingCFIresourceswillbehelpful:CapitalStructureCapitalStructureCapitalstructurereferstotheamountofdebtand/orequityemployedbyafirmtofunditsoperationsandfinanceitsassets.Afirm'scapitalstructureDebtvs.EquityFinancingDebtvsEquityFinancingDebtvsEquityFinancing-whichisbestforyourbusinessandwhy?Thesimpleansweristhatitdepends.Theequityversusdebtdecisionreliesonalargenumberoffactorssuchasthecurrenteconomicclimate,thebusiness'existingcapitalstructure,andthebusiness'lifecyclestage,tonameafew.Investing:ABeginner’sGuideInvesting:ABeginner'sGuideCFI'sInvestingforBeginnersguidewillteachyouthebasicsofinvestingandhowtogetstarted.LearnaboutdifferentstrategiesandtechniquesfortradingVolatilityVolatilityVolatilityisameasureoftherateoffluctuationsinthepriceofasecurityovertime.Itindicatesthelevelofriskassociatedwiththepricechangesofasecurity.InvestorsandtraderscalculatethevolatilityofasecuritytoassesspastvariationsinthepricesFinancialAnalystTrainingGetworld-classfinancialtrainingwithCFI’sonlinecertifiedfinancialanalysttrainingprogramBecomeaCertifiedFinancialModeling&ValuationAnalyst(FMVA)®CFI'sFinancialModelingandValuationAnalyst(FMVA)®certificationwillhelpyougaintheconfidenceyouneedinyourfinancecareer.Enrolltoday!!Gaintheconfidenceyouneedtomoveuptheladderinahighpoweredcorporatefinancecareerpath. LearnfinancialmodelingandvaluationinExceltheeasyway,withstep-by-steptraining. CorporateFinanceInstituteBacktoWebsite0searchresultsfor‘’Peoplealsosearchfor:excelFreefreecoursesBalancesheetaccountingIRRDCFExploreOurCertificationsFinancialModeling&ValuationAnalyst(FMVA)®LearnmoreCommercialBanking&CreditAnalyst(CBCA)™LearnmoreCapitalMarkets&SecuritiesAnalyst(CMSA)®LearnmoreCertifiedBusinessIntelligence&DataAnalyst(BIDA)™LearnmoreResourcesExcelShortcutsPCMacListofExcelShortcuts 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