Risk Management Analysis

2172 words - 9 pages

This assignment will discuss the theoretical basis of financial risk, because managers need to be aware that financial risk its present in all sectors of activity so that they can run business efficiently and take advantageous investment choices, considering the different types of financial risk relevant to the current economic climate, as well as evaluating the methods available to business for managing, and by observing a case study where risk management has possibly failed.
Risk is the doubt about future gains or losses, thus such doubts reveal that some future expectation and their impact cannot be predicted Chorafas (2008). Markowitz cited in Brigham, Gapenski and Ehrhardt (1999), argues that the portfolio theory can get high expected returns on investment with low levels of risk. therefore, risk can be spread and consequently eradicated so does not concern investors, thus the only worrying risk for managers , is the market risk which cannot be eliminated. However, Arnold (2002), suggest that this fails to assert that portfolio risk does not need to be considered, thus resulting with a problem with the theory, because it uses historic data returns to support decision making about potential investments, and as risk is about uncertainty is difficult to calculate future events, therefore this theory may have gaps.
Alternatively Brigham et al. (1999), argues that the CAPM model establishes a causal relation between risk and return on assets, where investors have the same expectations about the expected return and there are no transaction costs and taxes. However, Pike and Neale (1999) suggest that some concerns may occur related to the validity of this model because there are transaction costs and taxes which are sources of revenue for many institutions. Thus the CAPM suppositions do not reflect the reality. According to Crouhy, Galai, and Mark (2006), Black-Scholes model is rapid and exact thus still widely used today. However Arnold (2002), argues that, it can only be used for European Options, that the share does not pay dividends, and the share price does not vary, although the model´s assumptions may be adaptable. Modigliani and Miller as cited in Damodaran (2001), created a model arguing that if the market is efficient, no matter how the firm finances itself, with debts or equity, the value of the firm will remain the same, because both firm and shareholders will have same the value for rate of return, thus the unique factor capable of influencing the capital structure is the cash flow generated. However Arnold (2002), suggests that Modigliani & Miller have created a model that might be based in assumptions, which in reality might not work, because there exist costs affecting the capital structure of a firm, as paying taxes. Additionally high gearing levels may increase risk of failing, thus it lies a need to have a pro-active thought about its assumptions before place it...

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