Question

Define risk, and explain how it is measured.

Identify a source of firm-specific risk. What is the source of market risk?

Explain what the coefficient of variation measures.

Answer 1

Risk is the uncertainty that the actual return from an investment will differ from the investor's expected return. There are a number of risk measurements but total risk is measured by standard deviation. Standard deviation is measured by the formula {[sum of (return - average return)]^2/n}^0.5. It basically measures how much the actual return varies from the average return, squares it, sums it up and divides it by the number of obsverations (for measuring the standard deviation of an entire population). This gives the variance, the square root of which is the standard deviation.

Firm-specific risk (unsystematic risk) can arise from the specific business in which the firm operates. For example, an FMCG company selling coffee/tea will be affected if due to some bad climate, production of coffee beans/tea leaves falls substantially. Companies operating in other businesses will not be affected by this.

Market risk (systematic risk) can arise from the macro-economic environment within which a firm operates. For example, if a country is undergoing recession then all companies operating in that country are affected by it.

Coefficient of variation is defined as the ratio of standard deviation to the average. It measures the extent of variation which is present in a data set with respect to the average or simply put, how much of variation is there vis-a-vis the average.