IB Manual – Introduction to Risk

Introduction to Financial Risk

In investing, financial risk is the variability of the actual returnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas for calculating different types of rates of returns including total return, annualized return, ROI, ROA, ROE, IRR generated by an investment relative to what the investor expected. As an example, financial risk would be a stockStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. that is expected to return 5% but instead only returns 2%. Only risk-free assetsTypes of AssetsCommon types of assets include: current, non-current, physical, intangible, operating and non-operating.  Correctly identifying and classifying the types of assets is critical to the survival of a company, specifically its solvency and risk. An asset is a resource controlled by a company which future economic benefit give returns perfectly equal to expected returns. The risks of an asset are measured by its variance and standard deviation.

Types of financial risk

The two main categories of the cause of financial risk are:

1. Firm-specific risk (unsystematic, affecting a single firm or a small group)
2. Market risk (systematicSystematic RiskSystematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and therefore, it is a non-diversifiable risk., affecting all firms in the market)

Firm-specific vs market-specific

Firm-specific financial risks can be subdivided into:

• Project risk – The risks that a firm might’ve misjudged its product demand.
• Competitive risk – The risks arising from the impact of the competition.
• Sector risk – Risks affecting the entire sector but restricted to that sector.

Market risk is felt, in varying degrees by sector, throughout the economy. Any large-scale investment risks are considered market risks.

Risk diversification

Putting all of one’s capital into a single investment exposes the entire portfolio to the financial risk of that investment. Diversifying, or allocating capital across different assets, helps reduce exposure to firm-specific risk.

This concept calls into question the issue of “putting all eggs (capital) into one basket (investment).” Dropping the one basket breaks all the eggs. Putting eggs into multiple different baskets reduces the chance of breaking all the eggs.

The concept is the same in investing. During economic downturns, only a small number of firms will see large deviations in returns. Since firm-specific risks can be diversified away, they are also known as diversifiable risks.

Holding an appropriate number of assets within a portfolio, with all the firm-specific risks diversified away, does not make a portfolio risk-free. The portfolio is still affected by market risks or non-diversifiable/systematic/non-specific risks.

Key risk assumptions in models

Most investment financial risk models are based on two factors:

1. The investor is deemed to be the marginal investor (trades at the margin and sets prices)
2. The marginal investor is well diversified – the marginal investor is only exposed to non-diversifiable risk

Terminology

• Market risk is interchangeably used with systematic risk, non-specific risk, non-diversifiable risk
• Firm-specific risk is interchangeably used with unsystematic risk, specific risk, and diversifiable risk.

Risk and the cost of equity

An investor will only invest in a stock if he/she is sufficiently compensated for the financial risk with additional return (above the risk-free rate). The additional return is otherwise known as the cost of capital. This cost of capital number can be estimated by:

• Capital asset pricing model (CAPM)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security
• Arbitrage pricing theory (APT)
• Multi-factor model (MFM)

Because CAPM is the most commonly used method among the three, it will be the focus of these articles.

Additional resources

Thank you for reading this section of CFI’s free investment banking bookInvestment Banking ManualCFI's Investment Banking book is free, available for anyone to download as a PDF. Read about accounting, valuation, financial modeling, Excel and all skills required to be an investment banking analyst. This manual is 466 pages of detailed instruction every new hire at a bank needs to know to succeed on introduction to financial risk. To keep learning and advancing your career, the following resources will be helpful:

• Cost of Capital – Capital Asset Pricing Model (CAPM)
• Cost of CapitalCost of CapitalCost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. Cost of capital consists of both the cost of debt and the cost of equity
• Risk and ReturnRisk and ReturnIn investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk.
• Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance