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IB Manual – Introduction to Risk

The variability of the actual return from an investment relative to expectations

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 is represented by 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.

 

Introduction to Financial Risk

 

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 of companies)
  2. Market risk (systematic, affecting all firms in the market)

 

Firm-specific vs market-specific financial risk

Firm-specific financial risks can be subdivided into:

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

Market risk is felt, in varying degrees, 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 is illustrated by the notion of “putting all of one’s 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. 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 firm-specific risks diversified away, does not make a portfolio risk-free. The portfolio is still affected by the overall market risk or non-diversifiable/systematic/non-specific risks.

 

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 they are sufficiently compensated for the financial risk with additional potential returns (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)
  • Arbitrage pricing theory (APT)
  • Multi-factor model (MFM)

The CAPM is the most commonly used method.

 

Additional resources

Thank you for reading this section of CFI’s free investment banking book on introduction to financial risk. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Cost of Capital – Capital Asset Pricing Model (CAPM)
  • Cost of Capital
  • Risk and Return
  • Valuation Methods

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