Risk There Are Many Sources

Risk

There are many sources of risk in financial management, and these are measured using a number of different techniques. Sources of risk can generally be divided into two categories -- firm-specific and systematic. The former relates to risk factors inherent to the firm, such as its abilities, its resources, its credit, its leadership and any other factor that is either within the firm's control or is related to their business. In contrast, systematic risk refers to risks inherent in the overall market that cannot be diversified away. There are different measures used to evaluate financial risk, including standard deviation and the beta coefficient.

The beta coefficient is used to evaluate firm-specific risk. The beta is a measure of movement in the firm's stock price relative to the movements of the broad market, and is calculated using a regression of daily changes for an extended period (Investopedia, 2013). The beta is most typically used in the capital asset pricing model. In this model, the constituents of expected return are the risk-free rate, the market risk premium and the beta coefficient. The market risk premium and risk-free rate represent the systematic risk in the broad market, and the beta the firm specific risk in this model. The beta relates the risk of the firm to the risk of the market, which makes for an easy understanding of how risky the investment is compared with the broader market, using the assumption that the beta is sufficiently robust as to act as a predictor based on past performance.

The standard deviation is another measure of risk that can be used in financial management. It highlights the degree to which a series of numbers revolve around the average for that series. It is used, for example, to evaluate mutual funds or other investments against their historic performance (Morningstar, 2010). As with the beta, the standard deviation reflects the volatility of the returns. The major difference between standard deviation and the beta is that the former measures the volatility against the asset's own mean, whereas beta measures the asset's volatility against the market. Standard deviation, therefore, allows the user to understand the asset's specific risk on its own, and can use this information to compare returns against historical average returns. This is valuable because the risk profile of an investment can be significantly different than that of the market, so the returns will be expected to be significantly different as well.

Standard deviation can also be used to measure against other means, for example against historic market returns. However, the beta coefficient is more effective as a measure against the market. Standard deviation and beta are both often used as measures on their own, without any model, because they communication the information clearly. In the capital asset pricing model, for example, the systematic factors are going to be equal among all stocks anyway, so differences in the expected returns of securities will reflect differences in the betas of those securities. The standard deviation, which is often used for mutual funds but can be used for any asset, is also used as a standalone risk measure. Many firms incorporate standard deviation into proprietary risk modeling software that evaluates portfolios.