Finance Theory And Risk Management

In this final article on finance we’re going to review some
finance theories There are plenty of them to go around
Finance theories themselves are the foundations for
understanding the role of finance in markets It is a way of
measuring investment value and risk and return on investment
Some of the theories include foreign currency transactions,
value at risk and portfolio theory, which is the basis of
investment analysis An example of investment analysis is the
CAPM model
CAPM stands for Capital Asset Pricing Model This is fundamental
to all finance theory The CAPM model tries to explain the
relationship between risk and return on investment This risk
includes both systematic and unsystematic risk
Systematic risk is the risk factor common to the whole economy
and the risk associated with investments in general These are
also non diversified risks, meaning they are invested in one
area
Unsystematic risk is the unique risk associated with a company
such as bad management, strike or disaster and with
diversification, can be eliminated or at least lessened
Only systematic risk is compensated for in regard to the
investor
Here is the CAPM formula for you mathematicians out there
re = rf + beta (rm – rf)
rf is the risk free rate This is the rate that the investor
gets for no risk rm is the risk of the market as a whole in
general re is the expected return incorporating the risk free
rate, market risk and beta value
In the ideal world you want to maximize your re while minimizing
the risk factor Sometimes this is not always easy or possible
But this is what you shoot for
Then there is the SML or Security Market Line
How does this relate to the CAPM formula? Actually, the SML is a
graphical representation of the CAPM This tells us that if a
security is priced accurately the expected return of the
security will meet the security beta at the securities market
line However, if it falls below the line then that means the
security is undervalued and overvalued if it falls above the
line In either case, adjustments have to be made
All of this leads to the theory of risk management itself, which
you could write several books on alone However, we won’t
attempt that here Instead we’ll just do a brief overview of
risk management
Risk management is trying to identify, control and minimize the
financial impact of events that cannot be predicted By
minimizing potential risk, a company can minimize the potential
loss associated with that risk
The ways that companies do this is through diversification of
investments A company might do any one of the following to
diversify and reduce risk including long term forward contracts,
currency swaps, cross hedging and currency diversification By
doing these things a company is placing it’s funds in various
areas so that if one area is hit hard by something unforeseen
the other areas should be unaffected So whatever
diversification is done should be done with careful planning to
ensure the areas invested in do not overlap each other This
makes it highly unlikely that multiple areas are affected by one
event
The above is simplified but should give you a start to the world
of finance theory and risk management Future articles will go
into more detail

Tags | asset, currency, foreign, market, model, risk, securities, systematic, theory, transactions