Sri Sharada Institute Of Indian Management - Research(A unit of Sri Sringeri Sharada Peetham, Sringeri)

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DEVELPOMENT DAY PROJECT REPORT

FINANCIAL RISK MANAGEMENT

SUBMITTED TO SUBMITTED BY:

PROF.HARPREET SINGH KARISHMA GUPTA

(20090127)

SHILPA JAISWAL

(20090156)

ACKNOWLEDGEMENT

I am deeply indebted to Prof. HARPREET SINGH. He gave me an opportunity to express my sincere appreciation and deep sense of gratitude for their esteemed guidance invaluable and inspiring suggestion, constructive criticism and keen sustained interest in preparation of this report.

I also forward my sense of gratitude to my parents for their cooperation and encouragement in completing my project

INTRODUCTION

Financial Risk Management

Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them.

Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.

In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.

When to use Financial Risk ManagementFinance theory (i.e., financial economics) prescribes that a firm should take on a project when it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost.

When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the hedging irrelevance proposition: In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets.

This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management.

The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. Research by many, including Raj Aggarwal has started to disclose much of the decisions and impacts firms must make when operating in many countries. Research has specifically identified three kinds of foreign exchange exposure for various future time horizons, transactions exposure[1], accounting exposure[2], and economic exposure.

Megaprojects (sometimes also called "major programs") have been shown to be particularly risky in terms of finance. Financial risk management is therefore particularly pertinent for megaprojects and special methods have been developed for such risk management.

WHAT IS RISK

R ISK has been know to man ever since he first faced adversity. It is an integral part of the evolution of man. Risk has been encountered primarily in his physical environment, later on in his social environment. With time, risk has evolved alongwith man. The main risk Neolithic man faced was an attack by a wild animal. This was mitigated with the discovery of fire. Note: Mitigated not eliminated. Risk can rarely, if ever, be completely eliminated. This mitigation has now take the form hedging sales of currencies in the future using forward contracts or options. It is risk, but i t has changed with man and his society.

R ISK is essentially, the probability that the outcome maybe damaging or result in a loss. With risk, the outcomes of an event are thrown open to uncertainty. Tossing a dice, is at a basic level a risky endeavor, that has uncertain outcomes. If you were to be shot depending on the outcome of a dice roll (say prime number you live, non-prime number you die), you would have a 50% chance of survival. A risky outcome with a level of uncertainty involved.

WHAT are the standard types of risk?

1. Pure v/s Speculativea. Pure Risk: The situation in which a gain will not occur. The best

possible outcome is that of no loss occurring. E.g.: A pilot flying an airplane will be happy with not crashing the airplane. He has not gained anything, but avoiding the catastrophe is the best possible outcome.(This is an extreme example, intended to clarify the concept).

b. Speculative Risk: A risk in which either a gain or a loss may occur.E.g.: You commit to sell a bag of wheat 3 months into the future at $10. Three months down if the price of wheat is $5 you make a profit of $5; if it is $15, you incur a loss of $5 by not being able to sell i t at the market price. You speculated on the price of wheat 3 months into the future.

2. Diversifiable v/s Non-diversifiableEssentially diversifiable risk is that which can be mitigated through a process of pooling risks. Vice versa for non-diversifiable. E.g.: This is best exemplified through the theory of portfolio diversification. Buying one stock (portfolio of 1 stock) exposes you to 2 types of risk. Risk of the market (Systematic risk) and risk of the firm specific stock (Non-systematic risk). Increasing the number of stocks in your portfolio would be a form of pooling that mitigates non-systematic risk of the whole portfolio. But the portfolio is implicit ly exposed to the systematic risk of the market.

R ISK averse individuals tend to be willing to pay the expected value of the loss rather than face the risk of the loss. This can be explained by the fact that the value of the loss, if incurred, is greater than the amount sacrificed by the individual to cover that loss.E.g.: If your house has a 20% chance of catching a fire and being destroyed. The loss you would incur on this would be $20,000. This the absolute amount you would lose given the house caught fire. The expected value of this is (.2)*($20,000) + (.8)*(0) = $4,000 * . So the risk averse person would be will ing to pay $4,000 to avoid a loss of $20,000 with a 20% probability. The amount a risk averse person is willing to pay depends on the degree of risk aversion . This also depends on the amount of init ial wealth that is at risk. Due to the declining marginal uti lity of wealth (each additional unit of wealth is less useful, as the level of wealth increase), a larger loss has a greater impact than a smaller loss. The effect of a larger loss is to set back the initial level of wealth, inverting the marginal util ity of wealth. Though, the fact that a larger loss sets you back is something very obvious, and would not need an explanation.

RISK IN FINANCIAL TERMS

IN a financial context risk can be mitigated in two ways. One, by hedging using the correlations of stocks (CAPM), secondly using derivatives. Investors normally use both, though their applications are different. In a portfolio, the demand for any financial asset rests on the correlation between all the assets in the portfolio. In a portfolio, if two assets are

* This is a pure risk; hence the opposite of the loss $20,000 is “no gain”.

negatively correlated (a loss in one results in a simultaneous gain in the other) then they have naturally hedged themselves against each other. Financial models are used to evaluate returns on portfolios. The CAPM is the most popular model.

CAPM

CAPM or the Capital Asset Pricing model is the most frequently used financial model to enable portfolio diversification. If returns on risky assets have less than perfect correlation, i.e., they do not naturally hedge against each other, risk averse individuals diversify risk in their holding of assets. A well diversified portfolio would have less fluctuation than returns on individually held financial assets.

SO how does this work? Assume that you have a portfolio of financial assets (in this case, equity securit ies). Each stock as explained in the types of risk, has two elements of risk. These are systematic and non-systematic risks. The non-systematic risk of individual securities can be mitigated through a well-diversified portfolio. Theoretically i t can be completely negated by holding a diversified portfolio that is identical to the market. This normally does not happened since

a) This would be a very very large portfolio.b) People would make money only based on the entire market moving

up or down. (i .e., if your portfolio is a perfect substitute for the DJIA, then you will make money only if the entire market moves up). Most people who do hold real portfolios would like to make money regardless of the market movements.

Given that non-systematic risk is virtually nullified by a large portfolio (CAPM assumes such a large portfolio), the only risk that remains is the systematic risk. Thus, the only type of risk for which and investor would earn a return would be the systematic risk. This systematic risk is measured as Beta . Beta (β) calculates the volatil ity/exposure of a security’s return to the entire market (CAPM) portfolio.

MATHEMATICALLY this is how it is understood. A security ‘a’ has i ts βa = σam / σ2m. βa is the beta of the security ‘a’, σam is the covariance between the return on security ‘a’ and the CAPM portfolio (m since the ideal CAPM would be identical to the market portfolio) and σ2m is the variance of the return on this CAPM (market) portfolio. The covariance σam can also be expressed as a function of the correlation coefficient (ρam) and the standard

deviations of the individual security and the market portfolio. σam = ρamσaσm. Thus the beta is βa = ρamσa / σm.

FINANCIAL ASSETS

EXPOSURE of financial assets is a vast topic and very detailed to get into. This is intended to provide a brief overview. A simple illustration of risk in financial terms is as follows. You are issue a loan to another person. The risk you are exposed to is that of the interest rates on loans rising after you issued the loan. This means that the amount of money you lent could have been invested to earn a higher return. The issued person is conversely exposed to the risk of interest rates dropping after he borrows from you. In the case of a company that issues debt this changes slightly. Companies would prefer issuing debt when interest rates are low and vice versa for the debtholders.

F INANCIAL assets are unique, as they do not necessarily convey rights to specific tangible assets to the holder. Financial assets can entit le the holder to a certain income or the right to buy another asset at a pre-specified price in the future. For instance common stock is a financial asset. The holders of common stock are the owners of the corporation; but they do not exercise direct control over the physical assets of the corporation. Their ownership role is restricted to that of a principle with the management and the board of directors as their agents. Hence, often firms have employees as shareholder, so that their interests are aligned with that of the non-employee shareholders.

A financial asset has one or more of the three following characteristics:1. Ownership rights of a corporation or asset.2. Single or Multiple series of payments.3. Right to buy or sell another asset, subject to certain changes in

price, interest rates, volati lity, time horizons.

TYPES of financial assets .

Stock: In the form of a single share, this certifies an individuals ownership of a certain percentage of the corporation. Individuals rarely own 1 or 2 shares of a corporation. More often than not they own, a block of shares. This can range from 100 to 100,000. These

ownership rights are valid as long as the corporation does not become insolvent or not pay any contractual obligations. The return on common stock comes in the form of dividends that are paid out of the net income after all the obligations to other creditors and debtholders are made. The board of directors/management is not compelled to declare dividends out of the residual net income. This money can be re-invested by the firm, if the deem that there are better investment opportunities. To mitigate the conflict of interest between shareholders and management/directors, companies more often than not insist on employee compensation scheme based partially on stock based compensation. In this case the management/directors are more certain to make more prudent investment decisions.

Deb t: This is basically a series of promised payment to be made by the borrower to the lender. Often the debt obligation is called a bond . A 3-year $100 bond with a 5% coupon rate would provide 6 semi-annual payments of $2.5 (bonds normally pay the interest in semi-annual installments) and $100 after 3 years. Debt can have these additional features.

Call feature: This allows the issuer to recall the bond before its maturity date. Early retirement of the bond would require the payment of premium over the bonds value by the issuer.

Secured debt: Debt that has another asset pledged as collateral. In which case the debtholder can claim the asset pledged as a collateral in case of a default by the issuer.

Subordinated debt: Also known as junior debt. The basic implication of this is that in case of default, the subordinated debtholders have a secondary claim on the firms assets, as opposed to senior debtholders. Note: Junior/Subordinated debtholders are stil l senior to shareholders in terms of laying claim to a firms assets.

The present value of a stream of bond payments of a 4 year annual bond is with interest payments of I1-I4 is:

PV of bond =

Assessing the risk of debt is done mainly through the duration of the bond. Duration measure the time-weighted average ti ll payments are received from bonds.

I1 + I2 + I3 + I4

(1+ I)1 (1+I)2 1+I)3 (1+I)4

The duration (D) is therefore:

D =

Duration conveys that the longer the stream of cash flow payments, the

more susceptible the bond is to a change in the interest rates. This concept of duration is comparable to the systematic risk portion of a security.

Future and Forward Contracts: Futures and forwards are financial derivatives . They are referred to as such since their value is derived from an underlying asset. Options are another type of derivative. Derivatives allow the investor to protect himself against the risk of a price variation while at the same time not owning the asset. An Arab Sheikh, disturbed by world events can choose to enter into a future or forward contract with a Dutch oil development company, by promising to deliver a mill ion barrels of crude oil at 3 months into the future @$21/barrel. He is the writer/seller of the contract. Futures also enables a company to possess assets, without physically storing them. In the above example, the Dutch company owns $21 million of oil in assets. While the exchange will take place later, the contract has guaranteed them these assets in the future. It is a form of artificially storing the asset for this period. The price is determined at the time of the transaction but the actual payment is not made at that t ime. The futures contract has a daily “marking to market” where the exchange posts gains and losses on the contract to either parties’ account. Futures are traded in standardized sizes and on organized exchanges. Forwards on the other hand are private agreements that are not traded on exchanges and unlike futures they are not marked to market.

Options : An option provides the holder with a right to buy or sell an asset at an exercise price . A put option is the right to sell and a call is the right to buy the financial asset. The holder has the right, but not the obligation, to buy or sell the asset at a specific expiration date (European Option) or by a specified expiration date. If the option is not exercised by a specific date, then i t expires without value. Options are available on financial assets such as common stock, foreign currencies and even on futures themselves. Options are conceptually the hardest financial assets to

   

  (1 x I1) + (2 x I2) + (3 x I3) + (4 x I4)  

  (1+ I)1 (1+I)2 1+I)3 (1+I)4  

1

P

understand but they do provide the best insurance at a small premium (as opposed to futures and forwards which have no premium). But options have a greater upside potential and no downside risk.

RISK /RETURN TRADEOFF

The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12% - 6%). 

Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors. 

Return On Investment - ROI

What Does Return On Investment - ROI Mean?

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio. 

ROI = Gain on Investment- Cost of InvestmentsCost of Investment

In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest.  Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.

IN FINANCIAL TERM

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on aninvestment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principle, or the cost basis of the investment. ROI is usually expressed as a percentage rather than a fraction.

Calculation

The initial value of an investment, Vi, does not always have a clearly defined monetary value, but for purposes of measuring ROI, the expected value must be clearly stated along with the rationale for this initial value. Similarly, the final value of an investment, Vf, also does not always have a clearly defined monetary value, but for purposes of measuring ROI, the final value must be clearly statedalong with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an average over multiple periods.

Single-period

Arithmetic return

The arithmetic return is:

rarith is sometimes referred to as the yield. See also: effective interest rate, effective annual rate (EAR) or annual percentage yield (APY).

Logarithmic or continuously compounded return

The logarithmic return or continuously compounded return, also known as force of interest, is defined as:

It is the reciprocal of the e-folding time.

Multiperiod average returns

Arithmetic average rate of return

The arithmetic average rate of return over n periods is defined as:

Geometric average rate of return

The geometric average rate of return, also known as the time-weighted rate of return, over n periods is defined as:

The geometric average rate of return calculated over n years is also known as the annualized return.

Internal rate of return 

The internal rate of return (IRR), also known as the dollar-weighted rate of return, is defined as the value(s) of   that satisfies the following equation:

where:

NPV = net present value of the investment Ct = cashflow at time t

When the rate of return r is smaller than the IRR rate  , the investment is profitable, i.e., NPV > 0. Otherwise, the investment is not profitable.

Comparisons between various rates of return

Arithmetic and logarithmic return

The value of an investment is doubled over a year if the annual ROR rarith = +100%, that is, if rlog = ln(200% / 100%) = ln(2) = 69.3%. The value falls to zero when rarith = -100%, that is, if rlog = -∞.

Arithmetic and logarithmic returns are not equal, but are approximately equal for small returns. The difference between them is large only when percent changes are high. For example, an arithmetic return of +50% is equivalent to a logarithmic return of 40.55%, while an arithmetic return of -50% is equivalent to a logarithmic return of -69.31%.

Logarithmic returns are often used by academics in their research. The main advantage is that the continuously compounded return is symmetric, while the arithmetic return is not: positive

and negative percent arithmetic returns are not equal. This means that an investment of $100 that yields an arithmetic return of 50% followed by an arithmetic return of -50% will result in $75, while an investment of $100 that yields a logarithmic return of 50% followed by an logarithmic return of -50% it will remain $100.

Comparison of arithmetic and logarithmic returns for initial investment of $100

Initial investment, Vi $100 $100 $100 $100 $100

Final investment, Vf $0 $50 $100 $150 $200

Profit/loss, Vf − Vi −$100 −$50 $0 $50 $100

Arithmetic return, rarith

−100% −50% 0% 50% 100%

Logarithmic return, rlog

−∞ −69.31% 0% 40.55% 69.31%

Arithmetic average and geometric average rates of return

Both arithmetic and geometric average rates of returns are averages of periodic percentage returns. Neither will accurately translate to the actual dollar amounts gained or lost if percent gains are averaged with percent losses A 10% loss on a $100 investment is a $10 loss, and a 10% gain on a $100 investment is a $10 gain. When percentage returns on investments are calculated, they are calculated for a period of time – not based on original investment dollars, but based on the dollars in the investment at the beginning and end of the period. So if an investment of $100 loses 10% in the first period, the investment amount is then $90. If the investment then gains 10% in the next period, the investment amount is $99.

A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss and gain occurs does not affect the result. A 50% gain and a 50% loss is a 25% loss. An 80% gain plus an 80% loss is a 64% loss. To recover from a 50% loss, a 100% gain is required. The mathematics of this are beyond the scope of this article, but since investment returns are often

published as "average returns", it is important to note that average returns do not always translate into dollar returns.

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average at End of Year

5% 5% 5% 5%

Capital at End of Year $105.00 $110.25 $115.76 $121.55

Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55

Compound Yield 5% 5.4%

Example #2 Volatile Rates of Return, including losses

Year 1 Year 2 Year 3 Year 4

Rate of Return 50% -20% 30% -40%

Geometric Average at End of Year

50% 9.5% 16% -1.6%

Capital at End of Year $150.00 $120.00 $156.00 $93.60

Dollar Profit/(Loss) ($6.40)

Compound Yield -1.6%

Example #3 Highly Volatile Rates of Return, including losses

Year 1

Year 2 Year 3 Year 4

Rate of Return -95% 0% 0% 115%

Geometric Average at End of Year

-95%-

77.6%-

63.2%-42.7%

Capital at End of Year $5.00 $5.00 $5.00 $10.75

Dollar Profit/(Loss) ($89.25)

Compound Yield -22.3%

]Annual returns and annualized returns

Care must be taken not to confuse annual and annualized returns. An annual rate of return is a single-period return, while an annualized rate of return is a multi-period, geometric average return.

An annual rate of return is the return on an investment over a one-year period, such as January 1 through December 31, or June 3, 2006 through June 2, 2007. Each ROI in the cash flow example above is an annual rate of return.

An annualized rate of return is the return on an investment over a period other than one year (such as a month, or two years) multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be stated as an annualized rate of return of 12%. Or a two-year ROI of 10% could be stated as an annualized rate of return of 5%. **For GIPS compliance: you do not annualize portfolios or composites for periods of less than one year. You start on the 13th month.

In the cash flow example below, the dollar returns for the four years add up to $265. The annualized rate of return for the four years is: $265 ÷ ($1,000 x 4 years) = 6.625%.

Uses

ROI is a measure of cash generated by or lost due to the investment. It measures the cash flow or income stream from the investment to the investor, relative to the amount invested.Cash flow to the investor can be in the form of profit, interest, dividends, or capital gain/loss. Capital gain/loss occurs when the market value or resale value of the investment increases or decreases. Cash flow here does not include the return of invested capital.

Cash Flow Example on $1,000 Investment

Year 1

Year 2 Year 3 Year 4

Dollar Return $100 $55 $60 $50

ROI 10% 5.5% 6% 5%

ROI values typically used for personal financial decisions include Annual Rate of Return and Annualized Rate of Return. For nominal risk investments such as savings accounts or Certificates of Deposit, the personal investor considers the effects of reinvesting/compounding on increasing savings balances over time. For investments in which capital is at risk, such as stock shares, mutual fund shares and home purchases, the personal investor considers the effects of price volatility and capital gain/loss on returns.

Profitability ratios typically used by financial analysts to compare a company’s profitability over time or compare profitability between companies include Gross Profit Margin, Operating Profit Margin, ROI ratio, Dividend yield, Net profit margin, Return on equity, and Return on assets.

During capital budgeting, companies compare the rates of return of different projects to select which projects to pursue in order to generate maximum return or wealth for the company's stockholders. Companies do so by considering the average rate of return, payback period, net present value, profitability index, and internal rate of return for various projects.[3]

A return may be adjusted for taxes to give the after-tax rate of return. This is done in geographical areas or historical times in which taxes consumed or consume a significant portion of profits or income. The after-tax rate of return is calculated by

multiplying the rate of return by the tax rate, then subtracting that percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25%0.05 x 0.15 = 0.00750.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5%0.10 x 0.25 = 0.0250.10 - 0.025 = 0.075 = 7.5%

Investors usually seek a higher rate of return on taxable investment returns than on non-taxable investment returns.

A return may be adjusted for inflation to better indicate its true value in purchasing power. Any investment with a nominal rate of return less than the annual inflation rate represents a loss of value, even though the nominal rate of return might well be greater than 0%. When ROI is adjusted for inflation, the resulting return is considered an increase or decrease in purchasing power. If an ROI value is adjusted for inflation, it is stated explicitly, such as “The return, adjusted for inflation, was 2%.”

Many online poker tools include ROI in a player's tracked statistics, assisting users in evaluating an opponent's profitability.

]Cash or potential cash returns

Time value of moneyInvestments generate cash flow to the investor to compensate the investor for the time value of money.

Except for rare periods of significant deflation where the opposite may be true, a dollar in cash is worth less today than it was yesterday, and worth more today than it will be worth tomorrow. The main factors that are used by investors to determine the rate of return at which they are willing to invest money include:

estimates of future inflation ratesestimates regarding the risk of the investment (e.g. how likely it is that investors will receive regular interest/dividend payments and the return of their full capital)

whether or not the investors want the money available (“liquid”) for other uses.

The time value of money is reflected in the interest rates that banks offer for deposits, and also in the interest rates that banks charge for loans such as home mortgages. The “risk-free” rate is the rate on U.S. Treasury Bills, because this is the highest rate available without risking capital.

The rate of return which an investor expects from an investment is called the Discount Rate. Each investment has a different discount rate, based on the cash flow expected in future from the investment. The higher the risk, the higher the discount rate (rate of return) the investor will demand from the investment.

Compounding or reinvesting

Compound interest or other reinvestment of cash returns (such as interest and dividends) does not affect the discount rate of an investment, but it does affect the Annual Percentage Yield, because compounding/reinvestment increases the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual interest rate of 4%, compounded quarterly, the CD would earn 1% interest per quarter on the account balance. The account balance includes interest previously credited to the account.

Compound Interest Example

1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

Capital at the

beginning of the period

$1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the period

$10 $10.10 $10.20 $10.30

Account Balance at end of the

period

$1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly ROI

1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the beginning of the year, the investor took $1,000 out of his pocket (or checking account) to invest in a CD at the bank. The money was still his, but it was no longer available for buying groceries. The investment provided a cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the investor got $1,040.60 back from the bank. $1,000 was return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves reinvestment of capital; the interest earned during each quarter is reinvested. At the end of the first quarter the investor had capital of $1,010.00, which then earned $10.10 during the second quarter. The extra dime was interest on his additional $10 investment. The Annual Percentage Yield or Future value for compound interest is higher than for simple interest because the interest is reinvested as capital and earns interest. The yield on the above investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital. Investors/Depositors lend money to the bank, and the bank is obligated to give investors back their capital plus all earned interest. Because investors are not risking losing their capital on a bad investment, they earn a quite low rate of return. But their capital steadily increases.

Summary: overall rate of return

Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While compound interest and dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the investor), Return on Investment is a percentage return based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the greater the potential investment loss.

Achieving A Balance Between Risk And Return

Because risk management is costly, many health plans and providers practice risk avoidance by transferring risk to other entities. Risk-bearing healthcare organizations can improve their return on assets, but to do so they need complete information about patients' health status and the availability of effective medical treatment.

To improve their return on assets, providers can use risk-management strategies such as growth, designing incentives to encourage providers and health plans to reduce or eliminate

unnecessary variations in resource use, and improving information about the reasons for variations in resource use and controlling those variations when possible. Providers need data to analyze why variations in resource use occur and to evaluate the efficiency of their resource use.

Uncertainty, or risk, pervades the healthcare industry. This uncertainty is attributable to two factors: the randomness with which illness occurs and progresses, and inadequate information about health status and the capacity of medical technology to change that health status.

Effective healthcare financial management requires effective risk management. Often, however, both providers (hospitals and physicians) and health plans equate risk management with risk avoidance because uncertainty tends to increase costs. Hospitals, for example, maintain excess capacity because they cannot know what their census will be on any given day and do not want to turn patients away. More uncertainty leads to maintaining more excess capacity which in turn increases the average cost per patient day. According to this logic, higher costs lead to smaller margins. The best strategy, therefore, is to shift the uncertainty elsewhere.

Many recent developments in healthcare financial arrangements can be interpreted in terms of this risk-transfer paradigm. For example, inpatient prospective payment systems shift the risk of variations in resource use for hospital stays from the insurer to the provider. The decision to adjust per case or per diem payments for case mix is actually a decision to shift risk related to case mix from the provider to the payer. Similarly, capitation and subcapitation arrangements move risk of variations in resource use per enrollee from the payer to the capitated provider.

It is tempting to conclude that risk transfers benefit the entity transferring risk to the detriment of the risk-bearing entity. As obvious as this conclusion may seem, however, it is not necessarily correct.

The capital asset pricing model (CAPM) demonstrates that assuming more risk can lead to higher rates of return. In its simplest version, the CAPM predicts that the return on an asset (R) is related to the return on risk-free assets ([R.sub.risk-free]) and the returns currently prevailing in the market ([R.sub.market]) as follows:

R = [R.sub.risk.free] [beta] ([R.sub.market] - [R.sub.risk-free])

In this equation, beta ([beta]) measures the financial risk of an asset on the basis of the amount of variation in its expected return in relation to marketwide rates of return. If [beta] = 1, the asset bears average risk, and its rate of return will equal the market rate of return over time (R = [R.sub.market]). If [beta] [less than] 1, the asset has below-average risk, and its return is expected to be below the market rate of return. If [beta] [less than] 1, the asset has above-average risk, and its return is expected to be above the market average.

Given the assumptions of the CAPM model, providers and insurers can increase their rates of return by assuming risk, rather than attempting to transfer risk to other entities. Still, risk avoidance seems to dominate behavior in the healthcare industry. A combination of factors appears to explain why.

Many health plans and providers work to avoid large variations in utilization. The lesson of the CAPM is that average returns increase with the variability of those returns. Despite increasing consolidation, however, the healthcare industry still is characterized by relatively small, independent providers that have a limited capacity to absorb variations in rates of return. Such providers tend to be risk averse and inclined to shift risk to other entities, when possible.

A substantial portion of the risk that health plans and providers face is due to inadequate information rather than random fluctuations in returns. Historically, health plans have depended upon providers to assess the resource requirements of their insured population. Health plans that are in fee-for-service arrangements, for example, are entirely at risk for variations in resource use. Health plans responded to this uncertainty by transferring risk onto providers and thereby imposing financial penalties for excess resource consumption.

Health plans and providers rarely operate in a true competitive market. The CAPM is founded in the economist's notion of a competitive marketplace, in which no buyer or seller is so large as to affect the prevailing price or rate of return appreciably Large health plans and health systems, however, often have sufficient market power, especially in defined geographic areas, to shift risk onto other entities without recognizing the full economic value of that shift. Health plans, for example, may implement per diem or per case payment systems without factoring risk or a case-mix adjustment into the payment amount.

CONCLUSION

The relationship between financial risk and return is the gain or lose of from investments or securities. The "risk" denotes that the investor could lose money and the "return" is the profit the investor obtains. If the investors chooses to invest in security that is a low risk then the return will be small. If the security is high risk factor the investor has the potential to get higher returns. The return on an investment can be measured by a real rate which is what is earned after inflation has been figured into the value.

Risk-bearing healthcare organizations can improve their return on assets, but to do so they need complete information about patients' health status and the availability of effective medical treatment.

To improve their return on assets, providers can use risk-management strategies such as growth, designing incentives to encourage providers and health plans to reduce or eliminate unnecessary variations in resource use, and improving information about the reasons for variations in resource use and controlling those variations when possible. Providers need data to analyze why variations in resource use occur and to evaluate the efficiency of their resource use.

Uncertainty, or risk, pervades the healthcare industry. This uncertainty is attributable to two factors: the randomness with which illness occurs and progresses, and inadequate information about health status and the capacity of medical technology to change that health status.

So, This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management.