Question

1)Explain risk and any three elements of risk

2) Explain diversification and and also hedging and spreading risk

Answer 1

1) Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. Risk focus only on the probability of an event occurring, more comprehensive definitions incorporate both the probability of the event occurring and the consequences of the event.The three-part definition helps with three important stages of the risk process:

The first source of risk is project-specific:-  An individual project may have higher or lower cashflows than expected, either because the firm misestimated the cashflows for that project or because of factors specific to that project. When firms take a large number of similar projects, it can be argued that much of this risk should be diversified away in the normal course of business.

The second source of risk is competitive risk:- Whereby the earnings and cashflows on a project are affected (positively or negatively) by the actions of competitors. While a good project analysis will build in the expected reactions of competitors into estimates of profit margins and growth, the actual actions taken by competitors may differ from these expectations. In most cases, this component of risk will affect more than one project, and is therefore more difficult to diversify away in the normal course of business by the firm.

The third source of risk is industry-specific risk:-   Those factors that impact the earnings and cashflows of a specific industry. There are three sources of industry-specific risk. The first is technology risk, which reflects the effects of technologies that change or evolve in ways different from those expected when a project was originally analyzed. The second source is legal risk, which reflects the effect of changing laws and regulations. The third is commodity risk, which reflects the effects of price changes in commodities and services that are used or produced disproportionately by a specific industry.

2) Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. It is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.

Hedging Risk Definition

Hedging is a strategy for reducing exposure to investment risk. An investor can hedge the risk of one investment by taking an offsetting position in another investment. The values of the offsetting investments should be inversely correlated.

Spreading Risk

Individual investors have their own, distinct attitude to risk. However, the same investment maxim applies to everyone - the higher the potential reward; the greater the risk attached. In other words, the extent to which an insurance company by selecting diversified and independent risks that are fairly uniform in size and sufficiently large in number can predict the losses thereon with reasonable accuracy by the law of averages.