Meaning of Risk and Uncertainty Risk: In Common Parlance, risk means a low probability of an expected outcome. From business decision-making point of view, risk refers to a situation in which a business decision is expected to yield more than one outcome and the probability of each outcome is known to the decision makers or can be reliably estimated. For example, if a company doubles its advertisement expenditure, there are three probable outcomes: i)Its sales may more than double ii)It may just double or iii)It may less than double.
The company has the knowledge of these probabilities or has estimated the probabilities of the three outcomes on the basis of its past experience as: i)More than double – 10% (or 0. 1) ii)Almost double – 40% (or 0. 4) and iii)Less than double – 50% (or 0. 5) It means that there is 90% risk in more than doubling of the sales, and in doubling the sale, the risk is 60%, and so on. Uncertainty: Uncertainty refers to a situation in which there is more than one outcome of a business decision and the probability of no outcome is known or can be meaningfully estimated.
The unpredictability of outcome may be due to lack of reliable market information, inadequate past experience, and high volatility of the market conditions. For example, if an Indian firm, highly concentrated with population burden on the country, meant an irreversible sterility drug, the outcome regarding its success is completely unpredictable. Consider the case of insurance companies. It is not possible for them to predict the death of insured individual, a car meeting an accident or a house catching fire e. t. c. Measurement of Risk
Risk in an investment can be quantified by using standard deviation of its returns. The calculations can be based on either. -Expected values, or -Information about the returns. The returns can be represented by a classic normal distribution curve, in which, 95% of result are within 1(one) standard deviation either side of the mean. The same technique can be applied to all investments. Example An investment in wise Ltd has a 50% chance of producing a 15% return, but there is a 25% of a 10% return and of a 20% return. The expected values are as follows: Probability (Px)Return % (x)x. pr (x) 0. 5102. 5 0. 5157. 5 0. 25205. 0 Expected return E (x) = Ex. Pr (x) = 15% = Mean approach Using the standard deviation approach for the same question, we have. PrX-E(X-E)2Pr (X – E)2 0. 255256. 25 0. 5000 0. 255256. 25 12. 5 Standard deviation (? ) = ? Pr (x –E)2 =12. 5 = 3. 54% Using co-efficient of variation for same illustration (-CV) = Standard deviation (? ) Expected Value(E(x0 CV = 3. 54=0. 236 15 REDUCING RISK WITH PORTFOLIO THEORY The Portfolio theory deals with investment in assets. However, it brings to the fore – the techniques of optimizing Portfolio of several assets.
The idea of the possibility of diversifying away specific risk (available risk) is the basis of Portfolio theory, developed by Markowitzs (1952). After the risk has been measured the investor can decide to diversify his portfolio among less risky assets and or returns from the assets, depending on the nature of investor; whether risk taker, risk averter or risk neutral. The Portfolio theory helps to reduce risk from an investment in a risky asset or where there is a high level of uncertainty. The capital Asset pricing model The model is based on the capital market line.
The point at which the efficiency meets the capital market lines point M, is the Return 2 Y Risk Market portfolio. The investor is concerned to evaluate an investment and will look at returns, risk and the relationship of the security to the portfolio at M. This, it was Beta (B) values, where = (? 1) / ? m) Gm ?1 and ? m are the measures of the specific risks in the security 1 and in the market and GM is the coefficient of correlation between the returns of I and the returns of the market. The beta risk of the market is 1, so if a share has a beta value of