Diversifiable Risk and Non-Diversifiable Risk - Assignment Example

Risk Student’s Name Institution Affiliation What is a Risk? According to the Oxford dictionary (1971), risk is denoted as a danger or hazard exposure. Thus, when putting oneself at risk implies participating either voluntarily or unwillingly in an occasion that would end up causing a loss, injury or damage. Involuntarily risk denotes the risks related to situations that happen without prior awareness. Exemplars include natural phenomenon such as fire, lightning, floods as well as exposure to environmental contaminants. On the other hand, voluntary risks denotes the occurrences related to the activities which individuals are involved in; for instance, riding motorbike, racing, smoking and skydiving (Jorion, 1996). The risks result in disruptions, low quality of work, time overruns, and cost overruns. Nonetheless, these risks are inevitable and call for different risk management techniques. The ability to manage the risk throughout operations has become an important means of preventing unwanted consequences. In other terms, risk can be described as statistically non-verifiable or verifiable. For the risks, which can be verified statistically, there are involuntary or voluntary activities, which are established from a direct scrutiny and be contrasted. Risks that cannot be verified statistically denote the risks caused by automatic occurrences, which are founded on limited information as well as arithmetical equations. For instance, it is known that there is a low risk of a meteorite hitting an individual, but because no record has been kept of a similar event ever taking place, hence, it is referred as statistically nonverifiable. Statistically verifiable as well as the nonverifiable risks are said to be similar to oranges and apples because both are fruits, but are different in that, comparison cannot be made among the two (Ready Ratios, 2011). Risks concerned with different activities vary greatly, and those individuals have very little control over are involuntary risks. Contrarily, voluntary are highly concerned with controllable. Arguably, risk is part of life; consequently, individuals evaluate daily encountered risks constantly. Individuals may be unconscious of the assessment because it is often ingrained in the thinking process. However, one has to consider risks more so those related to voluntary activities to enhance personal safety and for those near you. A good example is when leaving home in the morning; one should consider whether it could rain to avoid the possibility of being soaked while going to work by carrying an umbrella (Rais, 2013). Numerous activities may present severe risks; for instance, transportation is among them and taken regularly. While driving a car or riding a motorbike, there is more risk of being injured from eventualities. Obviously, majority of people depend on driving cars to get to their working places as well as other destinations; everyone is willing to take the risk because of the convenience it offers. To reduce accidents and injuries, safe guards like antilock brakes and airbags should be standard features of all vehicles. In addition, risk safety measures; for instance decreasing speed as well as raising the distance between the adjacent car in poor driving circumstances and putting on seat belts can help in reducing the occurrence of the risk (Jorion, 1996). Public risks are computed through direct observation or through application of mathematical frameworks as well as assumptions related to animal risks study, which may result in the same risk as those human beings may face. Regardless of how risks can be defined, they are conveyed as a probability of outcomes concerned about a given undertaking. Risk is usually conveyed as a part with no units included and range from 0-1.0 indicating certainty of an event or result that will take place. Scientific notation is normally used to present information on quantities risk. With regard to organizations, business risks can be broadly influenced by two major risk factors internal risks and external risks. Internal risks are caused from activities operating within the business for instance strikes, machine failure or theft. Internal risks vary from one organization to another depending on its size and levels of operations. Large firms are prone to more internal risks as compared to smaller and middle sized firms. On the other hand, external risks may arise due to events happening outside the business space where the management has no control. Examples of external business risks indicators include government regulations, market prices and natural event like earthquakes. External risks are unavoidable hence what matters is how a business manager handles them. Three major types of business risks are common in any business venture. The first one is operational risks, which are associated with operative and administrative measures in a particular line of business. These risks vary from one line of business to the other due to differences in their operations. The second type of risk is the financial risk, which is associated with the financial composition and structure of a business. This type of risk determines how the company raises its capital and how best to utilize it in their day-to-day transactions. The last type of business risk is the legal risk. This type of risk comes with the requirement to comply with certain rule and regulations set by either the government or regulatory authorities. All these risks affect the overall performance of a company; therefore, they can determine the success or failure of a company. Diversifiable Risk and Non-Diversifiable Risk Diversifiable risk denotes a risk that is specific to a given security or a sector, and thus has a limited impact on a diversified portfolio. A good example of diversifiable risk is a risk by a particular company, which will end up losing its market share. This risk does not affect other companies in a diversified portfolio, hence great loss goes to the investor who holds shares in the company who losses that share. However, an increase in interest rates will decrease the value of all shares as well as bonds; this means that it is impossible to diversify away the interest rate risk. For a national level risk, it becomes diversifiable if one buys shares outside the boundaries of a given country, some equities risks can be diversified through buying commodities or bonds. Some models like CAPM outline risk as diversifiable and not in a particular universe context of securities. For the CAPM framework, the market is used in the calculation of the expected market return (Ready Ratios, 2011). On the other hand, non-diversifiable risk denotes a risk that is regular to an entire class either assets or liabilities. The value of the investment may reduce over a given time because of economic transformations only or any other event affecting vast market sections. Nevertheless, asset allocation as well as diversification offers security for non-diversifiable risks because diverse market sections seem to have a tendency of underperforming. Non-diversifiable risk is as well termed systematic risk or market risk. Simply, risk associated with investment asset, which is difficult to mitigate or eliminate by bringing more assets to an expanded investment portfolio may be categorized as non- diversified risk. In addition, this risk is highly exposed to an investment owned individually; this type of risk is almost involved in almost all investments, that is, the uncertainty whereby markets move either up or down as well as the specific investment’s movement (Rais, 2013). Non-diversifiable risks cannot be avoided and lacks compensation for the exposure. It is an important part of asset risk, which is attributed to factors affecting firms. The basic reason for this kind of risk includes war, political occasions, inflation as well as global happenings. Furthermore, it is hardly eliminated through expansion. Non- diversification risk occurs because of dynamics that influence the entire market, which includes changes in the investment policy, transformations in taxation clause, as well as threats of security globally among others. Investors’ do not control non-diversifiable risk; therefore, mitigating it is hard. However, these risks are usually recognized by analyzing and estimating statistically; these are the associations between diverse asset portfolios of a firm using varying techniques, for instance, principal components analysis (Ready Ratios, 2011). In summary, investors make diverse viewpoints regarding whether to agree or disagree with diverse investments concerning risk entailed in the specific investment. If a non- diversifiable risk occurs, which can consist of inflation or war, investors choose to invest in portfolios like real estates, which entail a lower risk (Ready Ratios, 2011). What are the Various Methods to Compute the Risk? Many methods can be used to compute risk. One is the delta-normal method. This method considers that all asset returns are distributed normally. Portfolio return is distributed and taken as a linear combination of normal variables. The method involves going back in terms of time; for example, for over the past five years and variance computation is done as well as correlation of all the risk factors. Portfolio risk is thus generated through combination of linear exposure to the many factors which are assumed to be normally distributed. The second method is historical stimulation. Here, the method considers going back in time; for example, for the past 5 years. It applies the present weight to the time series of asset returns historically. The return does not necessarily represent an actual portfolio, but instead, reconstruct a hypothetical portfolio history using the current position. In case all the asset returns are normally distributed, the value at risk obtained through this method should be similar to the delta-normal method. Requirements for this method include position on different securities and for every risk factor, there is a specified stochastic procedure a provision of time series of the actual movements. The third method is Monte Carlo. This method take place in two steps: first, the risk manager has to specify a stochastic process for the financial variables, a process parameter, the distribution choice as well as parameters like correlation and risk can be taken from historical data. The second step is where factious cost paths are stimulated for the entire variables of interest (Rais, 2013). Any horizon considered may take r a day or months, the portfolio is normally marked-to market through a full valuation. Each of the “pseudo” realized is used in compiling distribution of returns, which can help measure the value at risk. Requirements for this method include, for every risk factor, there should be a specification of a stochastic process. Second is the valuation of models for all the assets included in the portfolio and last is the position on several securities. Finally is the comparison method. The simplest method for implementation is the delta-normal method; however, the disadvantages include the assumptions of normal distribution for all the risk factors and are taken to be that all the securities are linear in the risk factors. Secondly, historical stimulation method is relatively simple to implement as well because it is only a matter of keeping records on the previous price changes. Here, securities can only be non-linear. One disadvantage is that, only one sample path can be used, which may end up not giving adequate future distributions. Third is the Monte Carlo method which is the most sophisticated method. It paves way for any given distribution as well as non- linear securities. Unfortunately, in this method one ought to have good understanding of the process used and enough time for using a computer (Jorion, 1996). What are the Instruments That Can Be Used For Risk Management? Risk management refers to “a continuing plan to establish and perform evaluation analysis while minimizing losses that occur because of harm and damage to company’s property, personnel or the surrounding environmental life.” Risk management entails appropriate assessment, organization of various structures, and identification of impending perils and subsequent analysis of different ways to curb or minimize the close at hand risks. Any organization operating in the business environment faces myriad of risks in its day-to-day activities. Business managers are responsible for deciding whether a company takes on a risk or avoids it at all costs. Business managers are classified into two risk takers and risk averse. Risk taking managers assume that the more risk they take, the more returns they expect to receive. On the other hand, risk averse managers shy away from risks since they believe that they bring along dangers and uncertainties. Various instruments are used in risk management. These instruments range from risk identification tools to risk response and planning tools. These tools include risk identification tools.ls, risk impact assessment tools, risk prioritization tools and risk planning, mitigation and progress monitoring tools. These are the most cardinal and significant risk management components. Risk identification is the initial and most crucial tool required in any risk assessment and proper management plan. Risk identification involves proper gathering of information relating to the impeding perils. Numerous techniques are employed in risk identification. These techniques involve use of effective tools in information gathering and in assessment of the root cause of the risk. Several risk identification techniques are essential in risk management. The process of risk identification begins with information gathering. Information gathering involves application of various techniques such as brainstorming; interviewing, Delphi technique and root cause analysis. Brainstorming technique is a group problem-solving technique in which members spontaneously share ideas and solutions. In this risk identification technique, a group of expert carrying out identification of a certain risk meets in a forum where they share ideas and solutions that concern the risk to be identified. Upon brainstorming Delphi technique, is employed by the experts in bid to reach consensus. In Delphi technique, a facilitator administers questionnaires to experts in the forum. In this step, every response made is summed up and re-circulated to the group in the forum for comment. Delphi technique is essential as it ensures consensus among the expert in the brainstorming forum. The technique also aids in attainment of precise and unbiased data from the experts. Through this strategy, external influence that may affect the outcome of the brainstorming forum is hindered. Interviewing process may also be employed in this step to help in information gathering. In this step, root cause analysis is applied in problem identification and in discovering the risk causes and in development of risk preventive measures. Thereafter checklist analysis follows. This entails analyzing various factors that were considered during the information gathering. After checklist analysis, assumption analysis follows. This technique involve uncovering of various problematic suppositions that were made during information gathering stage. Upon assumption analysis, diagrammatic representations are employed in defining the risk. Diagram techniques involve development of cause and effect plots, flow charts, and influence diagrams. Influence diagrams entail representations of variables and outcomes in graphs. SWOT analysis and expert perspicacity culminate the process of risk identification. The second tool of risk management is risk analysis. According to Clarizen Team (2013), risk analysis entails application of versatile techniques such as risk probability, risk categorization, risk urgency assessment, risk impact assessment, and expert judgment. Risk probability focuses on identification of probable root causes of a risk. Risk analysis involves risk probability and impact assessment. This stage involves investigating possibility of occurrence of a particular risk and the probable effects of the risk. It evaluates the effects of the risk through interviewing of pertinent stakeholders. Risk analysis stage also involves development of probability and impact matrix as well as risk urgency evaluation and categorization. Several risk analysis and modeling proficiencies are employed in both event and project oriented analysis of the risk. Sensitivity assessment is also carried out to determine the risks that may have increased potential effects on projects. In sensitivity assessment, the analyst focuses on impacts of varying mathematical model inputs on various output of the model. At this stage, expected monetary value assessment technique is applied in calculation of mean outcomes of the impeding. These outcomes may be positive or negative values. The result obtained in this step is used in decision-making. Simulation and modeling are other important statistical quantitative risk assessment techniques used in this stage. Cost and schedule analysis are other crucial techniques employed by risk assessors at this stage. Upon risk analysis, expert opinion based on the experiences of the expert analyzing the risk is fundamental as it aids in proper planning on various models to eliminate or minimize the risk. The third tool centers on risk prioritization analysis. These techniques involve data gathering models and representation techniques. This may involve interviewing, risk modeling techniques, risk probability distribution, and cost analysis techniques. The main objective of risk prioritization is to aid in ranking of the risk. Risks can be ranked from most to least critical by use of various decision analytic tools. Finally, risk response planning tool is employed in determination of various strategies to control or minimize the risk. This involves application of various techniques to aid in risk mitigation, planning, implementation, as well as risk advancement monitoring. Mitre Organization (2013) suggests that it is necessary to select the right tools to employ in management of various different risks. It is important to identify proper tools that are accessible, aligned to a particular risk as well as those that can be effectively used in decision-making and risk integration program. Conclusion Risk is denoted as a danger or hazard exposure. Similarly, risk can be classified as statistically non-verifiable or verifiable. Diversifiable risk denotes a risk that is specific to a given security or a sector, and thus has a limited impact on a diversified portfolio. Contrarily, non-diversifiable risk denotes a risk, which is common to a whole class either assets or liabilities. In terms of business, all organizations are faced with risky situations at some point in the operations; therefore, it is the duty of the manager in charge to take the right decision to avoid or face the risk. Many methods can be used to compute risk including delta-normal method, historical stimulation, Monte Carlo, and comparison method. Risk management entails appropriate assessment, organization of various structures, and identification of impending perils and subsequent analysis of different ways to curb or minimize the close at hand risks. A number of instruments are used to mitigate risks including identification tools.ls, risk impact assessment tools, risk prioritization tools, and risk planning, mitigation and progress monitoring tools among others. Risk should be minimized at all cost to avoid losses. References Clarizen Team (2013). Risk Management - Useful Tools and Techniques. Retrieved from https://success.clarizen.com/entries/24127786-Risk-Management-Useful-Tools-and-Techniques. Jorion, P. (1996). Methods to compute VAR. Retrieved from http://merage.uci.edu/~jorion/oc/case4.html Ministry for Environment (1998). Aquaculture Risk Management Options - 5 Risk Mitigation Instruments | Ministry for the Environment. Retrieved from http://www.mfe.govt.nz/publications/oceans/aquaculture-risk-management/html/page7.html Mitre Organization (2013). Risk Management Tools. Retrieved from http://www.mitre.org/publications/systems-engineering-guide/acquisition-systems-engineering/risk-management/risk-management-tools. Oxford University Press (1971), The Oxford English Dictionary Rais (2013). The Risk Assessment Information System. Retrieved from http://rais.ornl.gov/tutorials/whatisra.html Ready ratios (2011). Non-diversifiable Risk. Retrieved from http://www.readyratios.com/reference/analysis/non_diversifiable_risk.html Read More