Question

From chapter 8, please describe and discuss the concept of risk and diversification in your own wrds, and ensure you include a discussion on dispersion risk and systemic risk.

Book title is higgins Analysis for financial management 12th edition

Answer 1

Risk diversification consists of spreading risk out into numerous areas to ensure that the potential negative effects of exposure to any one variable are limited.

Diversifying risk is done in order to protect a company’s financial position. If a company does not protect itself through diversification and instead leaves itself exposed to one variable, it could lead to potentially costly consequences.

For example: a clothing chain based in the eurozone places an annual order with an American supplier for monthly delivery of goods with payment made every month. The total annual cost is $12 million. At the beginning of the year, once the order is placed, the company wishes to protect its financial position and maximise profits as much as possible.

Given the inherent volatility in currency markets, the company decides to diversify the risk of paying later in the year or paying now, should there be a decrease in the value of the euro against theU.S. dollar, an example of currency risk. So, the company elects to formulate a strategy based on holding a portion of cash, purchasing a forward contract and purchasing an options contract.

Different types of hedging products offer different advantages. Therefore, although it is more expensive to buy more hedging products, it covers more potential eventualities. If the company goes unhedged, without purchasing any hedging products or formulating a management strategy, it leaves itself at the mercy of the markets.

Risk diversification is seen as absolutely essential to ensure that profit losses are minimised and to protect a company’s bottom line.

In finance, dispersion is used in studying the effects of investor and analyst beliefs on securities trading, and in the study of the variability of returns from a particular trading strategy or investment portfolio. It is often interpreted as a measure of the degree of uncertainty and, thus, risk, associated with a particular security or investment portfolio.

Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be asystemic risk are called "too big to fail."