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Financial management ((Types of risk, a) Systematic risk
A system…
Financial management
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a) Systematic risk
- A system risk is one that affects a wide range of assets/investments.
- Because this risk has a wide effect, it is sometimes called a market risk.
- This type of risk cannot be diversified.
- Inflation, interest rates, petrol price.
b) Unsystematic risk -Unsystematic risk affect a single asset/investment or only a small group of assets/investments.
- Because this risk is unique to individual companies or assets, it is sometimes called unique or asset-specific risk.
- This risk can be reduce by diversification.
- E.g Labour strike in a company/industry,
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- Help management invest in low risk investments.
- Low risk can be achieved by diversification.
- Help management invest in assets/investments with high return. So maximise investment return.
- Aim for a capital-structure with low debt.
- Minimize the cost of capital.
Maximise value when return on investment is more than cost of capital [cost of funding or financing].
Maximise shareholder wealth.
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- Tells us how much systematic risk an asset has relative to an average asset.
- It tells us the risk that influences a large number of assets.
- It shows us the volatility of an asset in relation to market fluctuations.
- A company has beta times the amount of systematic risk associated with the market portfolio/average asset.
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- Beta is a regression co-efficient expressing the relationship between an individual share and the market with the variance of the market. - Measure systematic risk, and tells us how much systematic risk an asset has in relation to an average asset. - It tells us the risk that influence a large number of assets. - It is the volatility of an asset in relation to the market,
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- Is the most common statistical indicator of total risk.
- It measures the dispersion of an asset around the expected return.
- In simple terms it shows how often an asset return deviates from the expected return.
- The more it deviates, the riskier the asset is.
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- It is the principle that investments with higher risk tend to yield higher returns, and the opposite is also true.
- A risk-reward ratio tells us how much return a share offers for every unit of systematic risk.
- (So, every unit of systematic risk produces return, or some return? Not really, offerers just award risk, systematic risk more.)
- A share with a higher risk-to-reward is more appealing, there will be more demand for it, because for more risk, it has more return.
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- Diversification is the process of spreading an investment across assets (Thereby forming a portfolio).
- The principle of diversification tells us that when we spread an investment across assets, we eliminate some risk.
- With diversification, we expose ourselves to only a percentage of the risk associated with one asset, while exposing ourselves to only a percentage of the benefit associated with another asset.
- If we held investment only in one asset, our investment would fluctuate based on factors that are specific to that industry.
- If we held a large portfolio, some of the assets will increase in value based on positive company specific events, and some of the assets will go down in value based on negative events.
- The net effect on the overall value of the portfolio will be relatively small.
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- The term risk implies that probabilities can be assigned to a finite number of possible outcomes.
- It is therefore possible to identify a range of possible outcomes and to identify the most likely outcome and the level of certainty that surrounds that probability.
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- With uncertainty, it is not possible to assign probabilities to future possible outcomes.
- In such instances it is therefore not possible to quantify the uncertainty and so it remains an abstract concept.
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Used to determine which investment between two, three or more is the best one.