Introduction to Financial Risk
In investing, financial risk is the variability of the actual return generated by an investment relative to what the investor expected. As an example, financial risk would be a stock that is expected to return 5% but instead only returns 2%. Only risk-free assets 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:
- Firm-specific risk (unsystematic, affecting a single firm or a small group)
- Market risk (systematic, 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.
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:
- The investor is deemed to be the marginal investor (trades at the margin and sets prices)
- The marginal investor is well diversified – the marginal investor is only exposed to non-diversifiable risk
- 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:
Because CAPM is the most commonly used method among the three, it will be the focus of these articles.
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