There are many types of risks that are associated with business. The definition of a risk is the likelihood of pecuniary loss (Gitman, 2006, p. 226). Another definition is “the quantifiable likelihood of loss or less-than-expected returns” (Web Finance Inc., 2007b). Return can be defined as the whole gain or loss that occurred on an investment over a given interval (Gitman, 2006, p. 226). The types of risk include credit, systems, operations, reputation, strategic, financial, regulatory, information, technology, liquidity, market, legal, business, interest rate, event, purchasing-power, and tax risks (Gitman, 2006, p. 227; Colorado Technical University Online, 2007; “Risk Matrix Definitions,” n.d.).
Credit risk is defined as the chance that a borrower will not pay on time or pay at all (Colorado Technical University Online, 2007; “Risk Matrix Definitions,” n.d.). Systems risk is the risk associated with sustaining a loss which is a result of the malfunction of the computer system (Development Bank of Japan, 2007). Operations risk is the risk associated with the probability that operational problems will cause an unexpected loss (“Risk Matrix Definitions,” n.d.). Reputation risk is the risk that the negative public opinion of the company causes a reduction in customers whether it is the truth or not (“Risk Matrix Definitions,” n.d.). “Strategic risk is the current and prospective impact on earnings or capital arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes” (“Risk Matrix Definitions,” n.d.).
Financial risk is the risk of the company not being able to pay its liabilities to debtors (Gitman, 2006, p. 227). Regulatory risk is the risk associated with a change in the law relating to the business practices (Colorado Technical University Online, 2007). Information risk is the risk associated with data inaccuracies and the time it takes to obtain that information (“Glossary of Risk Management Terms,” 2006). Technology risk is the risk associated with technology problems, such as obsolete technology (Colorado Technical University Online, 2007). Liquidity risk is the possibility that the company cannot sell its assets at a price where they can profit (Gitman, 2006, p. 227). Market risk is the risk that an investment will lose value due to market factors (Gitman, 2006, p. 227). Legal risk is the risk that operations will be affected by legal judgments, lawsuits or contracts (“Glossary of Risk Management Terms,” 2006).
Business risk is defined as the risk that the company will not have the funds to pay their debts (Gitman, 2006, p. 227). Interest rate risk is the risk that comes from interest rate changes because when an interest rate increases, the value decreases (Gitman, 2006, p. 227). Event risk is the risk associated with the chance that an unexpected event will cause the company to lose the profitability of an investment (Gitman, 2006, p. 227). Purchasing-power risk is associated with price increases or decrease of the country’s financial system that will affect the company’s monetary stream and worth of investments (Gitman, 2006, p. 227). Task risk is the risk associated with a change in tax laws that will hurt the company (Gitman, 2006, p. 227).
Strident Marks must perform risk analysis in order to make proper decisions and remain profitable and open for business. In order to measure risk for Strident Marks, we use the Capital Asset Pricing Model (CAPM). The CAPM is a way of valuing stocks by connecting risk and expected return (Web Finance Inc., 2007a). The equation for CAPM is kj = RF + [bj * (km – RF)] (Gitman, 2006, p. 251). The required return on asset j is the kj (Gitman, 2006, p. 251). The risk-free rate of return is the RF (Gitman, 2006, p. 251). The beta coefficient for asset j is bj (Gitman, 2006, p. 251). The market return is the km (Gitman, 2006, p. 251).The CAPM is effective in determining risk when the following is true:
-“All investors are price takers” (“Development of the Capital Asset Pricing Model,” n.d.).
-All investors use the same phase of time (“Development of the Capital Asset Pricing Model,” n.d.).
-All investors have and use the same data in the same way (“Development of the Capital Asset Pricing Model,” n.d.).
-“Markets are ‘perfect'” (“Development of the Capital Asset Pricing Model,” n.d.).
-“All investors are risk averse” (“Development of the Capital Asset Pricing Model,” n.d.).
-“The market portfolio exists”, is measurable, and is included in the MVE frontier (“Development of the Capital Asset Pricing Model,” n.d.).
The risk of the company, Beta, is the comparison of the risk of the overall market relative to the assets (Sharpe, 2007).
“The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns” (Gitman, 2006, p. 236). The equation for the coefficient of variation is CV = ók/k, which is the standard deviation divided by the expected value of the return (Gitman, 2006, p. 233-236). When the CV is higher, the risk is higher; therefore the return potential is greater (Gitman, 2006, p. 236). The coefficient of variation can only be used when the standard deviation and expected value of return are known, because it will just be based on estimates and will not be true (Carlson, 1981).
References
Carlson, P.G. (1981, Autumn). An argument for ‘generalized’ mean-coefficient of variation analysis. Financial Management. 10(4), 87-88. Retrieved March 16, 2007, from Business Source Elite.
Colorado Technical University Online. (2007). Risks in everyday life. Retrieved March 16, 2007, from Colorado Technical University Online Web site: https://campus. ctuonline.edu/courses/FIN310/p3/FIN310_p3ar1.pdf
Development Bank of Japan. (2007). Systems risk management. Retrieved March 16, 2007, from Development Bank of Japan Web site: http://www.dbj.go.jp/english/ about/management/mf8.html
Development of the capital asset pricing model. (n.d.). Retrieved March 16, 2007, from http://www.financeprofessor.com/488/notes/capm.htm
Gitman, L.J. (2006). Principles of managerial finance (11th ed). Boston, Massachusetts: Pearson Addison Wesley
Glossary of risk management terms. (2006, Winter). Retrieved March 16, 2007, from http://post.queensu.ca/~sekalyg/repository/Glossary_of_Risk_Management_Terms.pdf
Risk matrix definitions. (n.d.). Retrieved March 16, 2007, from http://www.in.gov/dfi/ publications/RiskMatrixDef.pdf
Sharpe, W. F. (2007, February 28). CAPM-capital asset pricing model. Retrieved March 16, 2007, from Value Based Management Web site: http://www.valuebased management.net/methods_capm.html
Web Finance Inc. (2007a). CAPM. Retrieved March 16, 2007, from Investor Words Web site: http://www.investorwords.com/735/CAPM.html
Web Finance Inc. (2007b). Risk. Retrieved March 16, 2007, from Investor Words Web site: http://www.investorwords.com/4292/risk.html
