Risk in Financial Management

Meaning of Risk:- Risk is defined in financial terms as the chance that an outcome or
investment's actual gains will differ from an expected outcome or return. Risk includes the
possibility of losing some or all of an original investment

Types of Risk:- The two major components of risk systematic risk and unsystematic risk,
which when combined results in total risk. The systematic risk is a result of external and
uncontrollable variables, which are not industry or security specific and affects the entire
market leading to the fluctuation in prices of all the securities. On the other
hand, unsystematic risk refers to the risk which emerges out of controlled and known
variables that are industry or security specific.

Systematic risk cannot be eliminated by diversification of portfolio, whereas the

diversification proves helpful in avoiding unsystematic risk.

BASIS FOR
SYSTEMATIC RISK UNSYSTEMATIC RISK
COMPARISON

Meaning Systematic risk refers to the hazard Unsystematic risk refers to the risk
which is associated with the associated with a particular security,
market or market segment as a company or industry.
whole.

Nature Uncontrollable Controllable

Factors External factors Internal factors

Affects Large number of securities in the Only particular company.

market.

Types Interest risk, market risk and Business risk and financial risk
purchasing power risk.

Protection Asset allocation Portfolio diversification

Systematic Risk

By the term ‘systematic risk’, we mean the variation in the returns on securities, arising due
to macroeconomic factors of business such as social, political or economic factors. Such
fluctuations are related to the changes in the return of the entire market. Systematic risk is
caused by the changes in government policy, the act of nature such as natural disaster,
changes in the nation’s economy, international economic components, etc. The risk may
result in the fall of the value of investments over a period. It is divided into three categories
that are explained as under:

 Interest risk: Risk caused by the fluctuation in the rate or interest from time to time
and affects interest-bearing securities like bonds and debentures.
 Inflation risk: Alternatively known as purchasing power risk as it adversely affects
the purchasing power of an individual. Such risk arises due to a rise in the cost of
production, the rise in wages, etc.
 Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall
consistently over a period along with other shares of the market.

Unsystematic Risk

The risk arising due to the fluctuations in returns of a company’s security due to the micro-
economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The
factors that cause such risk relates to a particular security of a company or industry so
influences a particular organization only. The risk can be avoided by the organization if
necessary actions are taken in this regard. It has been divided into two category business risk
and financial risk, explained as under:

 Business risk: Risk inherent to the securities, is the company may or may not
perform well. The risk when a company performs below average is known as a
business risk. There are some factors that cause business risks like changes in
government policies, the rise in competition, change in consumer taste and
preferences, development of substitute products, technological changes, etc.
 Financial risk: Alternatively known as leveraged risk. When there is a change in the
capital structure of the company, it amounts to a financial risk. The debt – equity ratio
is the expression of such risk.
Difference between Profit Maximization and Wealth Maximization

Financial Management is concerned with the proper utilization of funds in such a manner that
it will increase the value plus earnings of the firm. Wherever funds are involved, financial
management is there. There are two paramount objectives of the Financial Management:
Profit Maximization and Wealth Maximization. Profit Maximization as its name signifies
refers that the profit of the firm should be increased while Wealth Maximization, aims at
accelerating the worth of the entity.

COMPARISON PROFIT MAXIMIZATION WEALTH MAXIMIZATION

Concept The main objective of a concern The ultimate goal of the concern is
is to earn a larger amount of to improve the market value of its
profit. shares.

Emphasizes on Achieving short term objectives. Achieving long term objectives.

Consideration of Risks No Yes

and Uncertainty

Advantage Acts as a yardstick for computing Gaining a large market share.

the operational efficiency of the
entity.

Recognition of Time No Yes

Pattern of Returns