Risk in Financial Context - Essay Example

Risk in a Portfolio Context By Lecturer’s and In financial context, risk is a situation where one takes an alternative whose results are uncertain. It is one of the most important traits that investors look into when evaluating different decision or a course of action. These decisions include such issues as accepting new technology, choosing a career or financial decision. The actual meaning of the word ‘risk’ is difficult to explain despite the different definitions by different scholars as in their definition risk meant different things in their situation. It is worth noting that risks and preference are negatively related to preference when all things are held constant especially the level of returns. In this context, the greater the risk, the more that alternative is unfavourable while if the risk is lower the alternative is the best for an individual to take a course of action into it (ALEXANDER, 2008). In my work I will examine the risks in relation to financial assets. Probability can be defined as the possibility that a given event will occur or take place; therefore, it is the possibility of an event coming to pass. For example, probability of a woman given birth to a boy child or a girl is 0.5. This means that there is a possibility of a girl or boy child being delivered. In this manner, is the method that is used to define and measure likelihood distribution of possible outcomes, and taking into consideration variables of its distributions at different occurrences (CONNOR, GOLDBERG & KORAJCZYK, 2010)? Due to different understanding of term risk many scholars are of other takes that measure risks especially those that emphasizes on negative results or that are below some known referent points. Different scholars have also defined risks in terms of how risky it is to take certain alternatives. In this scholars view risk as a perceptual variable. For example taking participants with a pair of gambles and asking them which gamble appear riskier to them. In addition one can assess individual’s sensitivity on riskiness by putting up a scale of 1(not at all risky) to 50 (extremely risky). This will give results on how individual view risks in a given situation. The major concern of such ratings or models is to have a grasp of individual perception on risks (ALEXANDER, 2008). In their perception on a given risk people judge risks and feel that their judgment is significant. Risks judgment is a routine carried out in the day to day activities. Managers approximate the riskiness of various courses of action and implement these actions with a lot of care and due diligence to avoid any consequential outcome. In addition, in relation to our relationship in our society, in reality we judge risk associated to an individual decision in accordance to our social morals and norms. Risk judgment is normal in our daily life and more so risk perception. In different researches conducted, risk judgment and attractiveness judgment are related and distinct too. First, the two judgments are significantly negatively correlated. Secondly, the two types of judgments are having qualitative differences and therefore discrete, quantifiable, and significant constructs (CONNOR, GOLDBERG & KORAJCZYK, 2010). Researches carried out by different scholars on risk judgment do not take into consideration perception on the expected return i.e. when chances and payoffs are clear, expected returns is not a perceptual variables. There before, researches conducted to examine risk judgment were shallow and not precise since first, it just gave a risk but the probabilities are not clearly stated. Second is that majority of the risks are controlled by trade-offs between chance and return (VERHELPEN, 2011). Today the study tries to outdo above drawbacks by first, exploration of both the risk and return judgments. Second is to study out the construct strength of these judgments within the risk return viewpoint which gives a clear relation between risks and return judgments. Third is that they investigate risk and return judgments of uncertain option whose chances and outcomes are not clearly stated. Why Investors Might Differ in Their Pricing of Risk Investors tend to expect high returns when they engage in an investment that they feel it’s of high risk. This means that an investment or an asset considered risky should be valued at relatively low price so that at the end one reap maximum from such an investment (HACKEL, 2011). However, the risk of any investment depends on the risk judgment of the investors. For example an investor who want to contribute $1 million for a risky latest venture. He has a probability of 0.9 that the new venture will fail and end up losing everything while on the other hand there is probability of 0.1 that the business venture will succeed in lone year’s time and have $4o million. In this, expected values of this business venture will be $ 4 million in only one year (AVEN, 2012). From the above explanation, if an investor who knows to analyze risks comes and fund the investment with his $ 1 million, the investment would yield very high levels of returns, for example 100%. To be on such a situation whereby an expected return is 100% of which the investment was $1 million, the investor would have to sell to an entrepreneur 50% stake: 500,000shares at a price per share of $2. In a second case from the above explanation, if the money was to be raised from someone who has many portfolios and want to diversify, the returns would be lower. For example an investor having $100 million to put in 100 projects with the same pay-offs and probabilities as the above investor and that all returns from each investment are independent of the other. From this perspective, probability of an investor undergoing too much loss is low. For example, probability that all the 100 ventures will fail is 0.9 to power 100 and that he may be satisfied by getting only about 10%. If this is his target he will therefore be required to give a stake of 27.5% equivalence of ($1.1 million/$4million) for him to raise the same amount of cash. The above two cases differ relation to the extent in which an investor has a wide range of portfolios in which he has invested into, stand alone risk and expected rate of returns in a given venture (ALEXANDER, 2008). An investor who has put his investment in many portfolios or diversified is likely to face less risk than who has just invested in one project and are willing to pay more and get lower rates of return. Risks therefore should be viewed in relation to other risks that investor is exposed to during the investment period. Diversification, Correlation and Risk Diversification was viewed as a way of spreading wealth across many independent projects or investment so that at in case of loss they can council each other. Risks across all assets are correlated to some degree. Therefore, investor cannot do away with all risks by diversifying into various portfolios. Diversification depends on correlation in that correlation between returns of two asset measure the extent to which they rise and fall together. Correlation coefficient range between -1.0 and 1.0, and therefore, two assets are perfectly positively correlated if the correlation is 1.0. This means that they progress in the identical direction and in fixed ratios. In such a situation one asset is a subset of the other. However, returns are perfectly negatively correlated when correlation is -0.1 and the assets therefore can insure one another since when return one asset goes up the other one goes down and the vice versa. For example to demonstrate how correlation affects individual security returns in a portfolio risk, think of two uncertain assets A and B. For these, risk is measured in standard deviation of return and that of A will be denoted by σA and that of B as σB. ρ denotes the correlation between the returns on assets A and B; x is the fraction invested on asset A, therefore y (1-x) representing the remaining fraction invested in B (AVEN, 2012). Therefore, returns on assets invested in the portfolio are perfectly correlated i.e. (ρ=1). The portfolio risk is weighted averages of all risks of a given asset in a portfolio. That can be represented as σρ=xσA+yσB. On the other hand, when there is non linear relation in a portfolio (ρ Read More