Complete Guide To Corporate Finance


Risk Management And Options - Introduction To Risk Management

We tend to think of risk in predominantly negative terms, as something to be avoided or as a threat that we hope won't materialize. In the investment world, however, risk is inseparable from performance and, rather than being desirable or undesirable, is simply necessary. Understanding risk is one of the most important parts of a financial education. This section will examine ways in which we measure and manage risk in making investment decisions.

Tutorial: Managing Risk And Diversification
Risk - Good, Bad and Necessary
A common definition for investment risk is "deviation from an expected outcome." We can express this deviation in absolute terms or relative to something else like a market benchmark. Deviation can be positive or negative, and it relates to the idea of "no pain, no gain" - to achieve higher returns in the long run, you have to accept more short-term volatility. How much volatility depends on your risk tolerance - an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses. (To learn more, read Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)

Absolute Measures of Risk
One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. For example, during a 15-year period from August 1, 1992 to July 31, 2007, the average annualized total return of the S&P 500 Stock Index was 10.7%. This number tells you what happened for the whole period, but it doesn't say what happened along the way.

The average standard deviation of the S&P 500 for that same period was 13.5%. Statistical theory tells us that in normal distributions (the familiar bell-shaped curve) any given outcome should fall within one standard deviation of the mean about 67% of the time and within two standard deviations about 95% of the time. Thus, an S&P 500 investor could expect the return at any given point during this time to be 10.7% +/- 13.5% just under 70% of the time and +/- 27.0% for 95% of the time. (For more insight, read The Uses And Limits Of Volatility.)

Risk and Psychology
While standard deviation information may be helpful, it does not fully address an investor's risk concerns. The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion - they put more weight on the pain associated with a loss than the good feeling associated with a gain. (For more on this, read Behavioral Finance: Prospect Theory.)

Thus, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve. Value at risk (VAR) attempts to provide an answer to this question. The idea behind VAR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period of time. For example, the following statement would be an example of VAR: "With about a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-year time horizon is $200." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve. (To learn more, read Introduction to Value At Risk - Part 1 and Part 2.)

Of course, even a measure like VAR doesn't guarantee that things won't be worse. Spectacular debacles like that of hedge fund Long Term Capital Management (LTCM) in 1998 remind us that so-called "outlier events" may occur. After all, 95% confidence allows that 5% of the time results may be much worse than what VAR calculates. In the case of LTCM, the outlier event was the Russian government's default on its outstanding sovereign debt obligations, an event that caused the hedge fund's performance to be much worse than its expected value at risk. (To learn about LTCM and other similar events, read Massive Hedge Fund Failures and Pocket Change Or Prison: The Galleon Hedge Fund Scandal.)

Another risk measure oriented to behavioral tendencies is drawdown, which refers to any period during which an asset's return is negative relative to a previous high mark. In measuring drawdown, we attempt to address three things: the magnitude of each negative period (how bad), the duration of each (how long) and the frequency (how many times).

In short, risk is inseparable from return. Every investment involves some degree of risk, which can be very close to zero in the case of a U.S. Treasury security or very high for something such as concentrated exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs and costs involved with different investment approaches.

In the remainder of this section, we'll talk about a few investment products companies can use to manage some of the financial risks they face. (To learn more about the risks companies face, read Identifying And Managing Business Risks and The Evolution of Enterprise Risk Management.)

Options Basics
Related Articles
  1. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  2. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  3. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  4. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  5. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  6. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  7. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  8. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  9. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  10. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  1. Accountant

    A professional who performs accounting functions such as audits ...
  2. Rule Of 72

    A shortcut to estimate the number of years required to double ...
  3. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  4. Personal Finance

    All financial decisions and activities of an individual or household, ...
  5. Audit

    An unbiased examination and evaluation of the financial statements ...
  6. Put-Call Parity

    A principle that defines the relationship between the price of ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What’s the difference between the two federal student loan programs (FFEL and Direct)?

    The short answer is that one loan program still exists (Federal Direct Loans) and one was ended by the Health Care and Education ... Read Full Answer >>
  6. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center