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.
Prasanna Chandra, Financial Management, 5th 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.