Unsystematic Risk – this risk encompasses the nonmarket risk that can be prevented through carefully planned and meticulous portfolios. This risk is specific to an industry and can also affect heavily the investment if not properly catered for. The two salient factors of unsystematic risk are business risk and financial risk (Ameritrade 1999). Business risk, as its name outlines, is a risk relevant to the operations and economic environment in which the organization operates. Such risk can be evaluated by looking at management accounting data like product break-even point and margin of safety.
Equity investors normally are not provided such sensitive data, but with the help of the financial statements and an industry analysis they can attain good information on the underlying economic environment that the firm is operating in. The financial risk basically is pertinent to the capital structure of the organization. Particular attention is devoted to the debt capital of the company in order to assess the financial gearing when looking at this risk (Pike et al. 1999, pp 235-236). Standard Deviation – as already stated in previous explanations, all investments are subject to risk.
A definition of risk comprises the variability that the return on investment may have from what was actually envisaged. For instance, an investor invested $100,000, with the aim of attaining 15% return. However, the actual return received amounted to $12,000, which is $3,000 lower than expected. This variation in return portrays the risk element that led to a lower return received. Risk is normally highly associated with uncertainty, which is a common feature in the capital market leading investment decisions to be more elaborate despite the substantial improvements in financial management.
Standard deviation is a mathematical term resembling a measure of the dispersion of an investment return over a period of time in line with the expected value. It computes the deviation of each observation from the arithmetic mean of the observations at hand. Standard deviation is frequently used in investment decisions, because it is an accurate and reliable measurement of the total risk of an asset or a portfolio (Jones 2002, pp 144-145). The formula used to calculate the standard deviation encompasses the following:
Where: X comprises each value in the set x,? encompasses the mean of the observations n is the number of returns in the sample considered c) The Capital Asset Pricing Model was developed independently by Sharpe, Lintner and Mossin in the mid-60s. Even though considerable time has passed, such model is still very important and holds a central theory in modern financial economics. Like all models, it holds underlying presumptions, which comprise the following (Jones 2002, pp 531-532):
• Rests on Markowitz portfolio theory, by assuming that all investors diversify their portfolio in accordance to Markowitz model. This entails selecting a location on the efficiency frontier that matches the risk and return preferences of the investor; • Investors are homogenous in the probability distributions for future rates of return, expectations with regards to the three inputs of portfolios, expected returns, return variance and correlation matrix. These similar features lead to the utilization of the same information in the generation of the efficiency frontier;
• All investors are subject to a similar one period time frame; • All investors hold the ability to borrow/lend money at the risk-free rate of return; • Transaction costs are non-existent; • There is no personal taxation leading to indifference between dividends and capital gains stemming from tax advantages; • No inflation; • Investors are price takers and cannot influence the stock price in light of many investors in the capital market; and • Capital markets are in equilibrium.
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