Summary - Business Finance - ثاني ثانوي

SUMMARY Risk is the uncertainty of an event or outcome and every business faces potential risks. With a pure risk there is no opportunity for financial gain but only loss. A speculative risk has the possibility of either financial loss or gain. Investments have speculative risk. Uncontrollable business risks can be the result of geographic, economic, cultural, and political factors, while controllable risks relate to the business operations of an enterprise. Investments are made in anticipation of a return, which is a flow of income and/or price appreciation. Individuals and financial managers make investments in anticipation of a return, but the realized return may differ from the expected return. That is the element of risk; the future is uncertain. Several sources of risk exist. These include the risk associated with the specific asset (diversifiable, unsystematic risk) and the undiversifiable, systematic risk from fluctuations in securities prices, changes in interest rates, reinvestment rates, inflation, and fluctuations in exchange rates. Risk may be measured by an asset's (or portfolio's) standard deviation, which measures the dispersion around the realized return (in the case of historical returns) or the expected return (in the case of anticipated returns). The larger the dispersion of the returns, the greater the risk. An alternative measure of risk determines the responsiveness of an asset's return relative to the market performance as a whole. This measure, called a beta coefficient, is an index of the systematic risk associated with the asset. The larger the beta coefficient, the greater the systematic risk associated with the security, since its return has risen or fallen more rapidly than the return on the market as a whole. Beta coefficients are used to determine an investor's required rate of return. This capital asset pricing model specifies the required return and includes: (1) the risk-free rate that may be earned on very safe investments plus (2) a risk premium. The risk premium includes a premium for purchasing risky assets instead of the risk-free asset, plus an adjustment for the systematic risk associated with the particular investment. The process of systematically identifying potential risks and making plans to reduce the impact of risk is known as "risk management". Risk specialists have the responsibility of planning and coordinating risk management programs. Risk management most often involves pure rather than speculative risk and the four risk management methods commonly used are risk avoidance, risk reduction, risk transfer, and risk assumption. The construction of a diversified portfolio reduces the risk associated with the particular asset. By owning a variety of assets whose returns. are not highly positively correlated, the investor reduces unsystematic وزارة التعليم CHAPTER 6 Risk and Its Measurements 253

p254Business Finance risk without necessarily reducing the potential return on the portfolio as a whole, Unfortunately, the construction of a diversified portfolio does not reduce the other sources of risk. PROBLEMS 1. List four different types of risk. 2. Describe the expected, and required returns. 3. Explain the difference between the following risks: geographic risk, economic risk, cultural risk, and political risk. 4. Briefly describe risks you have observed throughout your daily life. 5. Differentiate the standard deviation and the beta coefficient as measures of risk.

6. Explain why larger standard deviations indicate increased risk. 7. Explain why higher beta coefficients indicate increased risk. B. How is the required return calculated using the capital asset pricing model (CAMP)? 9. Illustrate the relationship between beta coefficient and the required return. 10. Describe a situation in which a company might use each of the following methods: a. risk avoidance b. risk reduction Crisk transfer d. risk assumption حرارة التعليم CHAPTER 6 Risk and Its Measurements 255

P256Business Finance 11.Why might an investor wish to invest in two uncorrelated industries? 12. What are the four most commonly used risk management methods? EXERCISES 1. You are considering purchasing Stock A. What is your expected return on your investment given the range of economic outcomes and returns shown below? Rapid growth Declining economy slow growth Probability Returns 15% 30% 20% -20% 65% 6% 2. Two stocks, A and B, have beta coefficients of 0.8 and 1.4, respectively. If the expected return on the market is 10% and the risk-free rate is 5%, what is the risk premium associated with each stock?

3. What is the expected return of Stock A, assuming that it has a beta coefficient of 0.57, a risk free investment yields 2.3% and the expected return on the market is 8.1%7 4. What is the expected return on an investment with a beta coefficient of 1.3 if the risk-free rate is 2% and the return on the market is B.1%? If the required return on the investment is 11.2%, what should you do? ASSESSMENT QUESTIONS Choose the correct answer. 1. An earthquake can create a situation with a a. speculative risk. b. human c. natural d. controllable 2. The uncertainty that the realized return will not equal the expected return is called risk. True/False 3. Unsystematic risk is the tendency for stock prices to move together. True/False 4. The capital asset pricing model specifies the required return adjusted for systematic risk. True/False وزارة التعليم CHAPTER 6 Risk and Its Measurements 257

علم M 5. The risk-adjusted required rate of return excludes: a. the stock's standard deviation. b. the stock's beta coefficient. c. the risk-free rate. d. the anticipated return on the market. 6. Buying insurance is an example of risk avoidance. True/False 7. The final step in the risk management program is to implement the program. True/False KEY TERMS Match the terms listed with their definitions. Write the letters of the correct definitions. Term Your choice Definition 1. Beta coefficient 2. Capital asset pricing model (CAPM) 3. Capital gain 4. Controllable risks 5. Correlation 6. Diversifiable risk (Unsystematic risk) 7. Dividends 8. Economic risk 9. Expected return 10. Human risks a. Unexpected possibilities that can be avoided or whose negative effects can be reduced by careful actions b. A period payments to a stock shareholder in cash or other shares of stock c. Uncertainty resulting from the actions of individuals, groups, or organizations d. Uncertainty with no opportunity for financial gain, only a potential loss e. Uncertainty with a potential financial impact f. Uncertainty resulting from natural events or phenomena g. A method of calculating the relationship between systematic risk and the expected return on assets, particularly stock h. The amount that investors need to get back in order for them to be induced to make an investment i. What is earned on an investment, the sum of income and capital gains generated by an investment j. The process of systematically identifying potential uncertainties and making plans to reduce the impact of those uncertainties 258 Business Finance

Term 11. Natural risks 12. Portfolio nsk 13. Pure risk 14. Required return 15. Return 16. Risk 17. Risk management 18. Self-insurance 19. Speculative risk. 20. Standard deviation 21. Uncontrollable risks 22. Undiversifiable risk (Systematic risk) Your choice Definition k. A situation with the possibility of either financial loss or gain 1. The increase in the value of the asset, based on the asset's original price m. Uncertainties associated with fluctuations in secunties prices and other non firm-specific factors: market uncertainty that is not reduced through the construction of diversified portfolios n. Uncertainties that cannot be influenced by human action o. A measure of dispersion around an average value: a measure of risk p. Uncertainties associated with individual events that affect a particular asset; firm-specific uncertainty that is reduced by diversifying investment portfolios q. The degree of uncertainty about whether an anticipated return will be achieved r. A measure of systemic risk; an index of the risk of a stock's return relative to changes in the return on the market s. The relationship between two or more financial variables over time t. The financial or other incentive for accepting risk by investing u. Uncertainty associated with making a range of investments which involve both systematic and unsystematic risk v. Setting aside money to cover a potential financial loss KEY FORMULAS Weighted Average Return - (probability of event 1 x return on event 1) + (probability of event 2 x return on event 21+... CAPM risk-adjusted required return (k) = risk-free rate + risk premium Risk premium=(market return (-risk free return (n)) x beta وزارة التعليم NO CHAPTER 6 Risk and Its Measurements 259

260 Business Finarice M MINI CASE 6.1 Investment Decisions Amina likes to make her own investments for her long-term retirement portfolio. She is seeing considerable systemic risk in the investment environment. Amina hos decided to evaluate her investment portfolio given the risks she has identified. She doesn't want to be too conservative in her approach in case there is a sudden growth in the equities market. Task 1. List the types of systemic risks Amina may be identifying. 2. Which methods. can Amina use to evaluate and readjust her investment portfolio? 3. Use the risks you identified to recommend which financial tools Amina should be using. Justify your response.

MINI CASE 6.2 Risk Management and Insurance One of the goals of Saudi Vision 2030 is to create paths for business success for small and medium enterprises and large corporations. As new enterprises develop and existing companies expand, an increased knowledge of risk management strategies will be needed. Sahar and several business partners have started a small manufacturing company to produce components for generating solar energy. The company has a production facility, warehouse and office space. Currently, 14 people are employed by the company involved in research, production, distribution, office activities, and administration. The company works with eight suppliers providing materials used in production, and has five main customers, which are companies that create solar panels and solar energy installations. Task 1. Explain how Sahar and her business partners might use risk avoidance, risk reduction, risk transfer, and risk assumption to create a risk management plan for their company. 2. Recommend various types of insurance the company might consider to protect itself. حرارة التعليم CHAPTER 6 Risk and Its Measurements 261

pul 262 Business Finance M MINI CASE 6.3 Capital Asset Pricing Model (CAPM) As commodity companies ottempt to attract investors, managers realize that a higher rate of return may be required due to various risks associated with the investments. An investor will only buy a company's stock if rewarded for taking the risk. The expected return of an investor must exceed the required return based on a risk premium. The capital asset pricing model (EAPM) may be used to determine that risk premium. With CAPM the risk premium is based on: (1) an additional return above the risk-free rate, and (2) the unpredictability of the commodity company's stock compared to the market, measured by the beta coefficient of the stock. The risk premium using CAPM is calculated with this equation: Risk premium=r-r) x beta The components of the equation include: (1) the expected market return (..). (2) the risk-free rate (r.), and (3) beta coefficient. Task 1. Explain possible risks a commodity company might encounter to use the capital asset pricing model (CAPM) to determine the risk premium. 2. Using the CAPM formula, calculate the risk premium for the following situation: beta: 1.2 risk-free rate: 5% average market rate: 11%.

CASE STUDY: INVESTMENT CONSULTING The supervisor of the retiree's personal finance section of a large Saudi bank has given Khalid and Fatima their project assignment. Khalid and Fatima are both recent college graduates with degrees in finance. They have been instructed to devise à plan to attract young Saudi professionals to open a retirement investment account with the bank. Their plan will need to be presented the following week to the bank executive management. The bank has primarily served older Saudis with their business and personal banking. Khalid and Fatima start their meeting. "I think we need a two-step approach. The first thing I think we need to do is paint out to the executive management that one of the goals under Saudi Vision 2030 is to promote greater financial independence for individuals and retirement options. Then we need to design an investment strategy for our Saudi young professionals," Fatima says. "That's true," replies Khalid, "but we need to present some data to show the potential of this plan. Let's do some research and meet tomorrow." The graduates gather their research and meet the following morning. Khalid starts, "Saudi Arabia's General Organization for Social Insurance fund has been doing very well earning returns of over 14% last year." Fatima replies, "True, but how long will that fund last? The long-term population trends for Saudi Arabia suggest that by 2050, a large proportion of the population will be either in retirement or approaching retirement. Saudi life expectancies are also increasing. Individuals need to start retirement planning now so they will have retirement funds from the government, their workplace, and private savings and investments. That is where we come in." "I think we have a strong case for starting retirement investment products for the bank, but what should we recommend for investors?" asks Khalid. "The bank's management is somewhat conservative, and they may not approve of investments for individuals who are willing to take on higher growth strategies with lower risk. "We also have the issue of our targeted young investors. Many of them will be new to investing and their views may be based on what they hear from online sources about great investments," Fatima says. "We will most likely need to have an educational program for investors. We will also need to determine if we will use existing Saudi investment products found on the Tadawul exchange or if we should work with our international branch to offer investment opportunities outside of Saudi Arabia, "Our bank already has licensed brokers and relationships with investment banks and their market maker dealers. Younger investors may want a portfolio that expands beyond Saudi investment opportunities" Khalid points out. وزارة التعليم NO CHAPTER 6 Risk and Its Measurements 263

p264 Business Finance M Fatima replies, "I think we need to look at the current beta coefficient of our bank's investment products. These may be on the conservative side. Younger investors who have a long-term investment horizon and may be willing to take more risk. They may also want to use other investment strategies such as margin purchases and short selling." Khalid replies, "We will need to devise a portfolio Investment strategy for young professionals to present to executive management for their approval. We will need to convince bank management to develop the technical platform for investment. Younger investors want to use their cell phones for monitoring their portfolios." Fatima comments, "Let's put together our initial presentation for executive management and show it to the supervisor for comments." Study Questions 1. To help Khalid and Fatima inform young Saudi professionals about their project in an educational program, create a list of uncontrollable risks that could influence business performance. 2. Khalid and Fatima need to explain financial risk beta coefficients to young Saudi professionals. Write a short explanation of beta coefficients. how these are determined and how they should be used in making investment decisions. 3. Khalid and Fatima are concerned that young Saudi professionals may not see a reason to invest for retirement. Write an explanation of how Investing for retirement should fit into a risk management strategy for young Saudi professionals.

Online Activity Research Saudi banks that are offering retiree personal finance plans. Identify the types of investment products and services they are offering. Determine how well these offerings meet the needs of young Saudi professionals and present your findings. حرارة التعليم CHAPTER 6 Risk and Its Measurements 265