In this final article on finance we’re going to review some finance theories. There are plenty of them to go around.
Finance theories themselves are the foundations for understanding the role of finance in markets. It is a way of measuring investment value and risk and return on investment. Some of the theories include foreign currency transactions, value at risk and portfolio theory, which is the basis of investment analysis. An example of investment analysis is the CAPM model.
CAPM stands for Capital Asset Pricing Model. This is fundamental to all finance theory. The CAPM model tries to explain the relationship between risk and return on investment. This risk includes both systematic and unsystematic risk.
Systematic risk is the risk factor common to the whole economy and the risk associated with investments in general. These are also non diversified risks, meaning they are invested in one area.
Unsystematic risk is the unique risk associated with a company such as bad management, strike or disaster and with diversification, can be eliminated or at least lessened.
Only systematic risk is compensated for in regard to the investor.
Here is the CAPM formula for you mathematicians out there.
re = rf + beta (rm – rf)
rf is the risk free rate. This is the rate that the investor gets for no risk. rm is the risk of the market as a whole in general. re is the expected return incorporating the risk free rate, market risk and beta value.
In the ideal world you want to maximize your re while minimizing the risk factor. Sometimes this is not always easy or possible. But this is what you shoot for.
Then there is the SML or Security Market Line.
How does this relate to the CAPM formula? Actually, the SML is a graphical representation of the CAPM. This tells us that if a security is priced accurately the expected return of the security will meet the security beta at the securities market line. However, if it falls below the line then that means the security is undervalued and overvalued if it falls above the line. In either case, adjustments have to be made.
All of this leads to the theory of risk management itself, which you could write several books on alone. However, we won’t attempt that here. Instead we’ll just do a brief overview of risk management.
Risk management is trying to identify, control and minimize the financial impact of events that cannot be predicted. By minimizing potential risk, a company can minimize the potential loss associated with that risk.
The ways that companies do this is through diversification of investments. A company might do any one of the following to diversify and reduce risk including long term forward contracts, currency swaps, cross hedging and currency diversification. By doing these things a company is placing it’s funds in various areas so that if one area is hit hard by something unforeseen the other areas should be unaffected. So whatever diversification is done should be done with careful planning to ensure the areas invested in do not overlap each other. This makes it highly unlikely that multiple areas are affected by one event.