Friday, June 12, 2009

Define risk. What do you understand by ‘Diversification ‘ of risk?

Define risk. What do you understand by ‘Diversification ‘ of risk? Illustrate your answer with some examples.

Ans. The meaning of risk is that there is some possibility of advise happening . In other words risks in uncertainty of Income / capital appreciation or loss or both.

We can define risk as

“risks is that in which there is some chances of adverse happening whether it could be in the form of profits or in the form of loss”.

So, from the above definition it is now clear that risk means uncertainty of income, capital appreciation or loss or it can be both.
The two major types of risks are:

Systematic or market related risk and un-systematic risk ( or diversifying risk) or company related risks. The systematic risks are the market problems, raw material availability tax policy or any Government policy, inflation risks, interest rate risk and financial risk. The systematic risk or diversifying risk are like mismanagement, increasing inventory wrong financial policy, defective marketing.

Diversification of risks:

Risk is an uncertain thing. Risk can be minimized only if it is diversified in to few companies belonging to various industry groups, assets groups or different types of instruments like equity shares, bonds, debentures etc. Thus assets classes are bank deposits, company deposits, gold silver, land, real estate, equity shares etc. Industry groups are tea, sugar, paper, cement, steel electricity, electronics, computer software etc. Each of them have different risks-return characteristics and investments are to be made; based on individual risk preferences.

Diversification of risk can be of three type:

(1) Business Risk:-
(2) Financial Risk:-
(3) Default of Insolvency Risk:-

(1) Business Risk: This relates to the variability of business, sales, income, profits etc. Which in turn depend on the market conditions for the product mix, input supplies, strength of competitors etc. This business risk is sometimes external to the company due to the change of Government or in Govt. policies or strategies of competitors or unforeseen market conditions. They may be internal due to full in production, lab our problems, raw material problems or inadequate supply of electricity etc. The internal Business risks lead to fall in revenues and in profits of the company, but can be corrected by certain changes in the company’s policies.

(2) Financial Risk: This relates to the method of financing , adopted by the company, high leverage leading to large debt servicing problems or short-term liquidity problems due to bad debts, delayed receivables and fall in current assets or risk in current liabilities. These problems could no doubt be solved, but they may lead to fluctuations in earnings, profits, these may lead to fall in returns to investors or negative returns. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable.

(3) Default or insolvency Risk :- The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest installments or principal payments. The borrower’s credit rating might have fallen suddenly and he become default prone and in its extreme from it may be take to insolvency or bankruptcies. In such cases, the investor may get no return or negative returns. An investment in a healthy company’s share might turn out to be a waste paper, if within a short span, by the deliberate mistakes of management or acts of God, the company become risk and its share price tumbled below its face value.

Examples

There is two investors, I and II are being considered. Both investments require and initial cash outlay of Rs.100 and have a life of 5 year. The return on each depends on the rate of inflation over the 5 year period. Of course, the inflation rate is not known with certainty, but suppose that the collective judgment of economists is that the probability of moderate inflation is 0.5. and the probability of rapid inflation is 0.30 years. These outcomes for each state of nature (i.e rate of inflation ) for each investment are as

Probability distribution for Two Invt. Alternatives

State of Nature Probability(p1) Outcome(x1)

No inflation Investment I 100
Moderate inflation 200
Rapid inflation 400

No inflation Investment 11 150
Moderate inflation 200
Rapid inflation 250

Analysis of these investments can be made by calculating and comparing the three evaluation statistics for each alternative. The expected value U is an estimate of the expected return for the investment. Because risk has been defined in terms of the variability is outcomes, the standard deviation S is a measure of risk associated with the investment. The larger the U the greater is the risk. Risk per rupee of expected return is measured by the coefficient of variation.

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