Business risk examples (4)
- Operational failings
- Government action
- Failure in strategy
- Technological change
Non business risks (2)
- Event risk
- Financial risk
Event risk
Arises due to an adverse event eg natural disaster
Financial risk (3)
Arises from long term/ short term factors:
- Credit risk
- Liquidity risk
- Currency and interest rate risk
Risk management
The process of assessing risk and adopting policies to manage this risk to an acceptable level
Risk management examples (3)
- Risk mapping
- Policy options
- Risk register
Risk of an individual share measured by
Standard deviation
Shareholders reduce the risk (measured by standard deviation) through
Diversification
Type of risk reduced through diversification =
Unique/ specific risk
Market (systematic risk)
Portion of risk that will still remain even if diversified portfolio has been created
Beta factor measures
Market risk
Beta factor =
Measure of the sensitivity of a share to movements in the overall market
Beta factor < 1
Below average risk
Beta factor = 1
Average risk
Beta factor > 1
Above average risk
Negative beta
Security price moves in opposite direction to market as a whole.
Rare, eg gold
Can measure portfolio risk
In terms of average of the beta of the securities held
Risk premium =
Difference between the average stock market return and the risk free rate
CAPM formula =
r = rf + beta ( risk premium)
CAPM expresses
Required rate of return on any security
Ungeared (asset) beta measures only
Business risk (NOT financial)
Beta application to investment appraisal > Step 1
Ungear the equity beta relating to the comparable company
Beta application to investment appraisal > Step 2
Re-gear this asset beta with the capital structure to be used in the new investment
Beta application to investment appraisal > Step 3
Use the adjusted equity beta to calculate a cost of equity to use in the appraisal of the project
