Question

4. How do you define and measure financial risk? Discuss the relationship between risk and return when it comes to building an investment portfolio. Provide examples of how you would modify a portfolio to best fit an investor’s individual risk profile.

Answer 1

Financial risk means risk which is associated with investment in the financial markets that may result into losing the value of capital as well as the value of returns. Financial ratios can be measured by ratio analysis and other volatility tools which determine the derivation between the actual returns and the expected returns.

the most common ratios that are used by investors for determination of financial risk of a company are interest coverage ratios, debt equity ratio, degree of financial leverage, debt to Capital ratio.

Interest coverage ratios reflect the periodic debt repayment capability of company in form of interest to the bondholders.

Debt equity ratio is the ratio of total debt to the total equity of the company. if the debt is high than the equity it means that there is a lot of interest payment associated with the company,its profit will eventually decrease due to payment of interest.

Debt to Capital ratio is the ratio of debt to the overall capital of the firm. Higher debt to Capital ratio is not preferred by the investors at as it causes a lot of risk to solvency.

degree of financial leverage takes into account how leveraged the firm is. It helps in finding out the risk associated with solvency of the firm and how frequently it is paying out on its debt.

The relationship of risk to the return is directly related. It is often assumed that higher the risk, higher will be the return because the higher risk will expose to more deduction in capital and higher appreciation in capital as well . Similarly lower the risk exposure lower the return potential.

While building a portfolio I would look for proper asset allocation which will minimise the specific risk as well as the systematic risk associated with Investments . I'll also look for the risk taking ability of potential investor and then allocate his fund into different asset classes and securities.

I would look for matching portfolio according to the risk taking ability of an individual, I would look to allocate more of low beta stocks and debt into portfolio of a risk averse investor, while I would look for allocation of More of stable and high beta stocks as well as lesser into debt and gold for risk favourable investor.