Risk and return - Basic understanding

Higher the risk higher the expected return.

Higher the risk higher the possible negative return.

Risk management involves taking up only those project whose negative returns do not effect the solvency and liquidity of the firm (Let us say chance of bankruptcy of 1 in 1,00,000). But globally there are a large number of companies and even with  this low probability some or other company goes into financial distress due to the adverse outcomes of risk.

Many people loosely talk of taking risk for the return. They do not understand the risk involved. Finance managers have to quantify the risk involved and show to the company managements the risk involved so that the more appropriate risk levels are chosen. The meltdown of investment banks in 2008 (Merrill Lynch, Citibank, UBS, Lehman is an example before everybody that risk catches up at some time or other).

The credit rating given by bond rating agencies is one indication of risk of an enterprise. Certain companies always plan to be in the AAA rating. They design or alter their policies to remain at AAA rated securities company.

Banks also do the rating of companies. Thus finance managers get the view of banks regarding the risk profile of their company.

Beta calculated from the behavior of share prices of a company with respect to value of a market share price index is another measure of the risk of the company.

Thus finance managers have external risk benchmarks.

References

Prasanna Chandra, Financial Management, 5^th Ed.,  Tata McGraw Hill, 2001
Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001

Risk - A Poem

I took the risk

and made my business brisk

I am eligible for bonus

My ranks are eligible for bonus

Thus danced and spoke a Merrill CEO

with a big EGO

The God of Risk listened with a smile on his face

and then showed his angry face

What is my duty?

What is my responsibility?

I do reward

But I also award

Penalty when greed becomes the need

and men pay no heed

The markets were down

The CEO became a clown

Risk does not mean only reward and capital gain

It also means loss and mental pain.

From Stock Market Poems By Narayana Rao K.V.S.S. (With Permission)