Risk Management Techniques
Risk measurement is a necessary component of a successful and something that can be found in all parts of life, both in business and in personal life. There are many sources of risk that an organization must take into account before a decision is made. It is therefore important that these sources of risk are available, thus allowing the necessary identification, measurement and response to take place. Risks such as political, financial and legal may be specific to corporate level and needs to be measured before a project is sanctioned. Risk is an unavoidable feature of human existence and one of the reasons for the development of risk measurement has been the failure of projects to meet their budget. Some of the risk measurement techniques are expected return, standard deviation and capital asset pricing model.
Standard Deviation is used by companies to measure how dispersed a set of numbers are around the mean. In other words, by comparing the investment in the publishing firm against other investment, the attractiveness of a security with respect to its return and risk is where the standard deviation comes into the equation. A standard deviation technique is used in the risk measurement by computing the mean for the data set and then computes the deviation by subtracting the mean from each value. The individual deviation is squared and added up before dividing by one less sample size and finally take the square root to get the standard deviation. Although this can be a bit tedious, but the good thing about standard deviation is that it is very useful.
Expected return is another technique used measure risk in the sense that the expected returns or benefits an investment generated comes in the form of cash flows. Cash flows, not accounting profit are the relevant variable the financial manager uses to measure return. There is no guarantee that the expected rate of return and the actual return will be the same. Expected return is the average of a probability distribution of possible returns, calculated by using a particular formula. While there is a risk to expected return, what matters to investors is not the risk to returns on the security but the part of that volatility that correlates with the movements in the market. The impact on a portfolio of instability that is not correlated with the market fluctuations can be diluted to insignificant levels by modification. The expected return is found by multiplying the percentages by their respective probabilities and adding the results. An example would be in the case of an investment in stock in Ezzy Inc., presently trading at $20. This stock is expected to be trading at $20.50, 25% higher, within a year if the expected economy growth exceeds expectations; a probability of 30%; at $21.20, a 12% higher, if economic growth equals expectations, a probability of 50%; and, at $19.50, a 5% lower if the economy growth falls short of expectation- a probability of 20%. The formula for the expected return in the above scenario: (30 x 25) + (50 x 12) + (25 x -5) = 7.5 + 6+-1.25 = 12.25%, the expected rate of return.
Capital Asset Pricing Model
Capital asset pricing model or otherwise known as CAPM is used to determine the relationship between risk and expected return. The general idea being CAPM is that investor needs to be compensated by time value of money and risk. The time value of money is represented by the risk free rate and rewards the investors for placing their money in any investment over a period of time. Another formula or application to determine the risk measurement in the capital asset pricing model is the risk representation and calculates the amount being rewarded to the investors needs to any additional risk. This is actually calculated by taking a risk measure or beta that compares the returns of the asset to the market over a period of time and market premium. If the risk free rate is 3%, the beta of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17%. The CAPM is the mostly widely used single variation model as it can easily be applied to the most common types of investment.
In conclusion, although these three risk measuring technique are very similar and all needed to recognize risk in financial decision. Risk is an integral force underlying rates of return and the techniques are important concepts of return and risk measurement. Expected return is a return on a risky asset, given a probability distribution for the possible rates of return whereas the standard deviation is a statistical measurement of the variability of a distribution. An analyst may wish to calculate the standard deviation of historical returns on a stock or a portfolio as a measure of the investment’s riskiness. As opposed to Expected return, the higher the standard deviation of an investment returns, the greater the relative riskiness because of uncertainty in the amount of return. Investors in the CAPM all think in terms of a single holding period and have identical expectations as well as borrow or lend unlimited amounts at the risk-free rate.
Arthur J Keown, John D. Martin, J. William Petty The Meaning and Measurement of Risk and Return (ch. 6).
Merna, T., & AL-Thani, F. (2008). Typical Risks. In J. Wiley & Sons (Eds.), Corporate Risk Management, Second Edition (ch. 4). Retrieved from ISBN: 9780470518335.