Are Managers Measuring the Financial Risk in the Right Manner - Article Example

Conversely, bankruptcy risk denotes a situation where the price of a security, for example, shares plummet without any optimism that it will improve. As such, the investor faces an imminent loss. The author explores at lengthy how different models treat bankruptcy risk differently. For instance, the CAPM model treats bankruptcy risks as unsystematic risks (Srinivas, 2013). The author subsequently verifies it by calculating its correction with future returns. The correlation is a negative figure, which is a characteristic of unsystematic risks.

The author identifies the weakness of Adjusted Present Model (APV), which integrates bankruptcy in the calculation of the value of a corporate entity. As per this model, bankruptcy risk only arises due an increase in debt. However, in the corporate world companies go bankrupt due to a myriad of reasons, which include poor management, rivalry and loss of market. The article seeks to chart a new way forward in the calculation of risk by managers. However, to understand what the article proposes with regard to calculation of risk, it is vital to understand the weaknesses of the present methods of risk evaluation.

Most methods such as CAPM and APV calculate risks after classification into either systematic or unsystematic risk. In the calculation of the total risk of a firm or a company, unsystematic risk is overlooked. To understand why it is overlooked, it is vital to define systematic and unsystematic risks. Systematic risk denotes the decrease or increase in returns from an investment or a security owing to events or factors, which afflict all firms unfavourably. Unsystematic risk refers to decrease or increase in the earnings from an investment or a security due to reasons particular to a single firm (Damodaran, 2010).

The models only consider factors that afflict all the firms (systematic) as unsystematic risks may be addressed through diversification of the