THE SOURCES OF RISK

Since financial decisions are made in the present but the results occur in the future, risk permeates all
financial decision making. The future is not certain; it is only expected. However the sources of risk can
be identified. They are frequently classified into “diversifiable” risk or “unsystematic risk” and
“nondiversifiable” risk or “systematic risk”.

1. Diversifiable risk (unsystematic risk)

Refers to the risk associated with the individual asset. Since the investor buys specific assets,
such as the stock of IBM or the bonds of Verizon, that individual must bear the risk associated with each
specific investment
Sources of Diversifiable risk
Business Risk - refers to the nature of the firm’s operations
Financial Risk – refers to how the firms finances its assets (whether the firm uses a
substantial or modest amount of debt financing.
For example, the business risk of Continental Airlines depends on such factors as the cost of fuel, the
capacity of planes, and changes in demand. The financial risk associated with Continental Airlines
depends on how it finances it planes. Were the assets acquired by leasing, by retained earnings, or by
issuing bonds, preferred stock, or common stock? The use of debt obligation and lease obligations
increases financial risk while the use of equity financing reduces financial risk.

Although business and financial risk differ (one is concerned with the nature of the firm’s operations and
the other with how management chooses to finance its operations), management uses financial leverage to
affect the firm’s total risk exposure. As is explained in Chapter 21 on the cost of capital, management
may reduce the firm’s cost of funds by using financial leverage. However, increased use of financial
leverage increases risk and raises the cost of funds. The problem facing management is to determine what
combination of debt and equity financing minimizes the cost of funds. That combination is the firm’s
optimal capital structure and uses debt financing without excessively increasing the firm’s financial risk.

Business and financial risk are firm specific and are the source of unsystematic, diversifiable risk. As
illustrated later in this chapter, the construction of a diversified portfolio reduces diversifiable risk. This
reduction occurs because the events that decrease the return on one asset may increase the return on
another. Notice there is little relationship between returns in the individual assets; hence the name
“unsystematic risk”.

The possible beneficial effect of combining different assets in a portfolio may be intuitively grasped by
considering the purchase of the stocks of an airline and an oil driller (for example, Continental Airlines
and Schlumberger). Higher oil prices may reduce the earnings of an airline but increase the profits of the
drilling operation. Lower oil prices may have the opposite impact; thus, combining the stocks of these
two firms will reduce the risk associated with the portfolio. Of course, the risk associated with each
individual asset remains the same, but from your perspective, the risk associated with the portfolio is what
matters and not the risk associated with the individual asset.

Even though a firm may seek a broader mix of products, diversification primarily remains the
responsibility of investors. Firms cannot achieve as diversified mix of assets as is possible in an
individual’s portfolio, which can include real estate, savings accounts, collectibles, and shares in mutual
funds as well as the stocks and bonds issued by a variety of firms and governments.

2. Nondiversifiable (systematic risk)

Refers to those sources that are not reduced through the construction of a diversified portfolio.
These include fluctuations in securities prices, changes in interest rates, reinvestment rates, inflation, and
fluctuations in exchange rates.

3. Market risk
Refers to the risk associated with movements in securities prices, especially stock prices. If you
buy a stock and the market as a whole declines, the price of the specific stock will probably fall.
Conversely, if the market increases, the price of the stock will probably also tend to increase.

4. Interest rate risk

Refers to the risk associated with fluctuations in interest rates. Suppose that a financial manager
borrows funds under one set of terms only to have interest rates subsequently fall. If the financial
manager had waited, the cost of these borrowed funds would have been lower. Movements in interest
rates also affect securities prices, especially the prices of fixed income securities, such as bonds and
preferred stock. As explained in Chapter 13, there is an inverse relationship between changes in interest
rates and securities prices. Thus, a rise in interest rates will drive down securities prices and inflict a loss
on investors in fixed income securities.

5. Reinvestment rate risk

Refers to the risk associated with reinvesting funds generated by an investment. If you receive
interest or dividends, these funds could be spent on goods and services. For example, individuals who live
in pension consume a substantial portion, and perhaps all, pf the income generated by their assets. Other
investors, however, reinvest their investment earnings in order to accumulate wealth.

6. Purchasing power risk

The risk associated with inflation. A conservative investor may deposit funds in a savings
account that pays a modest rate of interest. If the rate of inflation exceeds the rate of interest, the investor
sustains a loss.
 The rate of inflation has varied perceptibly. During the 1980’s, the annual rate of inflation rose
over to 10 percent, and purchasing power risk becomes a major concern of financial managers and
investors. These individuals were forced to take actions designed to reduce the impact of inflation.
Variable interest rate bonds and variable rate mortgages are examples of two debt instruments that were
developed in response to the risk associated with the loss of purchasing power. Subsequently, the rate of
inflation declined and the impact of purchasing power risk diminished. However, the inflation has not
disappeared. The risk still exists and must be considered when making financial decisions.

Although the rate of inflation has declined, another source of risk has become more prominent:
fluctuations in the value of dollar relative to other currencies.
7. Exchange rate risk
The risk associated with fluctuations in the prices of foreign moneys. Many firms make, and
receive payments in foreign countries, and making payments on foreign currencies. In addition, many
individuals and financial managers make foreign investments. Any foreign investment subjects the
investor to risk from the changes in the value of the foreign currency. The dollar value of a foreign
currency can rise, thus increasing the return when the funds are converted back to dollars. The value of
the foreign currency can also fall, however, reducing the return on the investment when converted back to
dollars.
These various sources of risk appear repeatedly throughout this text, since risk is an integral part
of financial decision making. Neither the financial manager nor the investor can stop fluctuations in stock
prices or interest rates. Nor can they stop inflation or fluctuations in exchange rates. They will, however,
seek to earn a return that compensates them for bearing a nondiversifiable risk.

THE STANDARD DEVIATION AS A MEASURE OF RISK

As was stated earlier, risk is concerned with the uncertainty that the realized return will not equal
the expected return.
Standard deviation
This is a measure of risk which emphasizes the extent to which the return differs from the
average or expected return.

The standard deviation measures the dispersion around an average value. As applied to
investments, it considers average return and the extent to which individual returns deviate from the
average. If there is very little difference between the average return and the individual returns, the
dispersion will be small. If there is a large difference between the average return and the individual
returns, the dispersion will be large. The larger the dispersion, the greater the risk associated with the
investment.
 This measurement is perhaps best illustrated by a simple example. Consider the returns on two
stocks over a period of nine years:

The average return over the 9 years is the same for both stocks, 15%, but annual returns differ.
Stock A’s individual returns were close to the average return. The worst year generated a 13.5% return
while the best year generated a 16.5% return. None of the individual returns deviated from the average of
more than 1.5%. Stock B’s individual returns differ from the average return ranging from a low 11% to a
high of 19%. With the exception of year 5, all the returns deviate from the average by more than 1.5%.

Even though both stocks achieved the same average return, common sense suggests that B was
riskier than A. The individual returns are more dispersed around the average return and this implies
greater risk. The larger dispersion means these were periods with smaller returns (or larger losses, if
applicable) from the investment. Of course, there were periods when the returns were greater, which
could be expected if the risk were greater, but even so, the average return from B only matched the
average return of A.

Dispersion can be measured by means of standard deviation. Since the standard deviation measures
the tendency of the individual returns to cluster around the average return, it may be used as a measure of
risk. The larger the dispersion, the greater the standard deviation and the larger the risk associated with
the particular investment.

The standard deviation for stock A’s returns is calculated as follows:

1.Subtract the average return from the individual observations
2.Square the difference
3.Add these squared differences
4.Divide this sum by the number of observations less 1
5.Take the square root.
For stock A the standard deviation is determined as follows:

The sum of the squared differences divided by the number of observations less 1:

The investor must then interpret this result. Plus and minus one standard deviation has been shown
form normal distribution to encompass approximately 68% of all observations (in this case, that is 68% of
the returns). The standard deviation of stock A is 1.01 which means that approximately two-thirds of the
returns fall between 13.99% and 16.01%. There returns are simply the average return (15%) plus 1.01 and
minus 1.01% (that is, plus and minus the standard deviation).

For stock B the standard deviation is 3.30, which means that approximately 68% of the returns fall
between 11.7% and 18.3%. B’s returns have a wider dispersion from the average return, and this fact is
indicated by a greater standard deviation.

In the previous example, historical returns were used to illustrate the standard deviation as a
measure of risk. The same concept may be used to measure the risk associated with expected returns.
Consider stock A: An investor believes there is a 20% chance of a 15% return, a 60% chance of a 10%
return, and a 20% chance of a 5% return. The expected average return is 10%. However, there is
dispersion around that expected return, and once again this dispersion may be measured by the standard
deviation. In this case, the standard deviation is 3.162, which is calculated as follows:

The larger the dispersion around the expected return implies that the investment is riskier, because
you are less certain of the return. The larger the dispersion, the greater is the chance of a smaller gain (or
larger loss). Correspondingly, there is a greater chance of a larger return. However, this potential for
increased gain means you will be bearing additional risk. Stock A involves less risk; it has the smaller
dispersion. Because the expected returns on both investments are the same, obviously stock A is to be
preferred since it has less risk.

A portfolio also has an average return and dispersion around that return. While you are concerned
with the return and the risk associated with each investment, the return and risk associated with the
portfolio as a whole is more important. This aggregate is the result of the individual investments and of
each one’s weight in the portfolio (the value of each asset, in proportion to the total value if the portfolio).

Consider a portfolio consisting of the following three stocks:

If 25% of the total value of the portfolio is invested in stocks 1 and 2 and 50% is invested in stock 3, the
return is more heavily weighted in favor of stock 3. The return is a weighted average of each return times
its proportion in the portfolio.
The return is the sum of these weighted averages.

The previous example which states that the return on a portfolio r p is a weighted average of the
returns of the individual assets [(r1) … (rn)], each weighted by its proportion in the portfolio (w1 … wn):

Rp = w1(r1) + w2(r2) + … wn(rn)

Thus, if a portfolio has 20 securities, each one plays a role in the determination of the portfolio’s
return. The extent of that role depends in the weight that each asset has in the portfolio. Obviously those
securities that compose the largest part of the individual’s portfolio have the largest impact in the
portfolio’s return.

Unfortunately, an aggregate measure of the portfolio’s risk (or the portfolio’s standard deviation) is
more difficult to construct than the weighted average of the returns. This happens because securities
prices are not independent of each other. However, although securities prices do move together, there can
be a difference in these price movements. In more advanced texts, these inner relationships among stocks
are called covariation.

RISK REDUCTION THROUGH DIVERSIFICATION – AN ILLUSTRATION

In effect, a diversified portfolio reduces unsystematic risk. The risk associated with each individual
investment is reduced by accumulation a diversified portfolio of assets. Even if one company fails (or
does extremely well), the impact on the portfolio as a whole is reduced through diversification.
Distributing investments among industries, however, does not eliminate the other sources of risk.
 This reduction is unsystematic risk is illustrated above. The vertical axis measures units or risk, and
the horizontal axis fives the number of securities. Since market risk is independent of the number of
securities in the portfolio, this element of risk illustrated by a line, A B that runs parallel to the horizontal
axis. Regardless of the number of securities that an individual owns, the amount of market risk remains
the same.

Portfolio risk
(or the sum of systematic and unsystematic risk) is indicated by land C D. The difference between
line A B and line C D is the unsystematic risk associated with the specific securities in the portfolio. The
amount of unsystematic risk depends on the number of securities held. As the number increases,
unsystematic risk diminishes; the reduction in risk is illustrated above, in which line C D approaches line
A B. for portfolios consisting of 10 or more securities, the risk involved is primarily systematic.

Such diversified portfolios do not consist of 10 public utilities but of a cross section of businesses.
Investing 20, 000 in 10 stocks (2,000 for each) may achieve a reasonably well diversified portfolio.
Although such a portfolio may cost more in commissions that two10, 000 purchases, the small investor
achieve a diversified mixture if securities, which should reduce the risk of loss associated with investment
in a specific security. Unfortunately, the investor must still bear the systematic risk associated with the
investing