Question

Discuss the profound impact risk has on financial decisions. Most financial instruments and the pricing of those instruments reflect this uncertainty. Loans get turned down due to uncertainty, or are priced higher to compensate for the percentage expected to fail. Stock prices rise and fall due to uncertainty. Debt contracts have reporting and collateral provisions because of uncertainty. Reference Ecclesiastes 8:7.

Answer 1

Risk significantly impacts financial decision making. Risk, in the context of financial decisions, is the possibility or the danger that the capital involved in the decision making may be lost either partially or completely. The different types of risks which affect financial decision making are credit risk, liquidity risk, as well as operational risk.

For instance suppose that a company has applied for a loan to a bank for expansion purposes. The company will use the loan proceeds to expands its manufacturing facilities. Suppose that the financial condition of the company, as indicated by its financial ratios like interest coverage ratio, leverage ratio, free cash flows etc., is below the industry average. As such there is a credit risk involved for the bank providing the loan. The bank will factor in this risk when considering whether to disburse or not disburse the loan to the company. It may decide to disburse the loan but at a higher rate of interest to compensate itself for taking additional risks.

Similarly investment decisions are also affected by risk. Risk element is higher with regards to equities than with regards to debt instruments. But higher risk also means possibility of higher returns. So an investor with better risk appetite will invest in equities while an investor with low appetite for risk will invest in debt instruments.