Risks Concepts - Summary Flashcards
Business Risk Defined:
Business Risk: This concept refers to the broad, macro-risk a firm faces largely as a result of the relationship between the firm and the environment in which it operates. Thus, the nature and extent of this broad risk factor would be a function of both the nature of the firm and the nature of the environment.
The nature of the environment would include the general economic conditions (e.g. as reflected by business cycles), competition, customer demand, technology, and other major elements of the environment in which the firm operates. The firm’s business risk would be embodied in the firm’s sensitivity (given its nature) to changes in the general economic environment (given its nature).
It’s an inherent risk on all operating activities faced by a firm.
Business Risk Elements:
Business Risk Elements: The various business risk elements faced by a company are frequently classified into two types, diversifiable and nondiversifiable.
- Diversifiable risk – (also called Unsystematic, Firm-Specific or Company-Unique) This is the portion or elements of risk that can be eliminated through diversification of investments. For example, in our discussion of capital budgeting we noted that a firm could mitigate certain risks associated with individual projects by investing in diverse kinds of projects. Similarly, a firm would reduce certain risks associated with its securities investments by diversification of the securities in its portfolio.
- Nondiversifiable risk – (also called Systematic or Market-Related) This is the portion or elements of risk that cannot be eliminated through diversification of investments. The factors that constitute nondiversifiable risk usually relate to the general economic and political environment. Examples include changes in the general level of interest, new taxes, and inflation/deflation. Since these broad changes affect all firms, diversification of investments does not tend to reduce the risk associated with these factors of the environment.
Financial Risk:
Financial risk – This is the particular risk faced by the firm’s common shareholders that results from the use of debt financing, which requires payment regardless of the firm’s operating results, and preferred stock, which requires dividends before returns to common shareholders.
The payment of interest reduces earnings available to all shareholders and the payment of preferred dividends reduces the retained earnings available to common shareholders. The existence of these obligations increases the risk to common shareholders that variations in earnings will result in inadequate residual profits to reward common shareholders and could result in insolvency.
Default Risk:
Default risk -- This is the risk associated with the possibility that the issuer of a security will not be able to make future interest payments and/or principal repayment.
In the U.S. the lowest uncertainty of future payments-the lowest default risk-is ascribed to U.S. Treasury obligations. They are considered to be free of the risk of default (risk-free) and are used as the benchmark when evaluating the default risk of other securities. For securities which are not considered risk-free, a default risk premium is included in establishing the rate of interest appropriate for a security or for evaluation purposes.
Interest Rate Risk:
Interest rate risk –
This is the risk associated with the effects of changes in the market rate of interest on investments. The clearest illustration is provided by the effect of changes in the market rate of interest on long-term debt investments. When debt investments are made, the price paid depends on the market rate of interest for comparable investments at the time. As the market rate of interest subsequently changes, so also does the value of the debt investment-they change inversely, i.e., in opposite directions. Therefore, if the market rate goes up, the value of the outstanding debt goes down.
A firm (or individual) that invests in debt has the risk that the market rate of interest will go up, causing the value of the debt to go down, which if sold before maturity would result in a loss.
