Essay Paper on Financial Risks
Financial Risk is the additional risk placed on the common stockholders as a result of using fixed income securities (debt & preferred stock) in a firm’s capital structure (financial leverage). There exist two common tools to evaluate possible financial risks – standard deviation and the coefficient of variation.
Standard deviation is the measure of uncertainty. Simply saying, it’s a measure of dispersal in a group of numbers. If the standard deviation is high, it indicates high volatility, i.e. increased riskiness of the investment, for instance. In contrary, low level of standard deviation will mean stability. Thus, the most consistent values are those, which have the lowest standard deviation. It means that investor trying to find the best objects of investment should consider those with the lowest level of deviation. Yet, this assumption is not always true, as it is commonly considered that securities with higher deviation are expected to have higher rate of return, i.e. higher profit.
In order to solve somehow the problem between the alternative of risk and return, the coefficient of variation is used. Coefficient of variation is a statistical measure of the dispersion of data points in a data series around the mean. It is calculated as:
Coefficient of variation = Standard deviation / Expected return
Thus, we see that CV actually depends on standard deviation. Thus, obviously it is better when the coefficient of variation is low. It means that even if we get extremely high level of standard deviation, our expected return might be even higher, which makes our investment risky, but very profitable.
It is difficult to say, which instrument – SD or CV—is better in measuring risks. Yet, standard deviation shows the nominal level of risk, while CV considers future expected profit. Thus, it is possible to say that CV is a little more accurate in measuring the risks. However, it is better to use both instruments in combination, as they actually complete each other and can show the best picture of the situation.
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