08/02/2022

COVENANT UNIVERSITY
COLLEGE OF BUSINESS AND
SOCIAL SCIENCES
DEPARTMENT OF BANKING AND
FINANCE
ALPHA SEMESTER COURSE

BFN 111 - WEEK 9

Kehinde Adetiloye
 08/02/2022

Risks and Uncertainties in Finance

 Lecture Outlines are:
a. Distinction between risk and uncertainty
b. Sources of Risk
c. Attitude to Risk
d. Types of Risks
e. Classification of Risks
f. Relevance of Risk to Finance
g. Spreading of Risks
Kehinde Adetiloye
 08/02/2022

Introduction
 Successful finance managers understand the
subject of investment risk and realistic expectation
of return.
 There is also trade off between the return
expected and risk to be assumed.
 Returns is simply the yield from an investment
 Return comprise of Yield and Capital gain or loss

Kehinde Adetiloye
 08/02/2022

Definitions
 Risk is the possibility that the actual return (cash flow)
from an investment will deviate from the expected return.
It means that the investor cannot predict the future with
100% precision.
 It is the variance(or standard deviation) of the anticipated
return on investment. The greater the magnitude of the
deviation the greater the probability of its occurrence.
 Risks normally gives rise to probability distributions of
cash flows which are subjectively determined by the
investor
Kehinde Adetiloye
 Year cash flow probability 08/02/2022

 1 ₦5,000,000 0.5 0.3 0.2

 2 ₦6,000,000 0.4 0.5 0.1
3 ₦3,000,000 0.1 0.3 0.6
Uncertainty
This is a situation where it is not known what the future outcome will be
and where alternatives cannot be cannot be predicted based on the
knowledge of the past.

Risks and Uncertainty are interchangeably used but strictly do not

mean the same thing.

Kehinde Adetiloye
 08/02/2022
 Most investors are rationally risk averse and would prefer
certainty to uncertainty.
 There are different types of investment: from Treasury bills to
debenture and bonds and to ordinary shares.
 A rational investor will reduce risk to the minimum while he
maximizes return. A higher risk would normally be compensated
with high return, since rational investors do not like risks .
 Every investment must be assessed on the two parameters of risks
and return trade off

Kehinde Adetiloye
 08/02/2022

The graph below shows that high risks

is accompanied by high returns

ordinary shares

Bonds and debenture

Treasury Bills and Govt .

Rs 1 Rs 2 Rs3

Kehinde Adetiloye
 08/02/2022

Investors’ Attitude to Risk

 Two extremes are:

 Risk averter prefers the expected or average
outcome with certainty but will be willing to take
risk provided the expected return is adequate to
compensate for it.
 Risk Taker: loves takes risks
 Risk Neutral: He is indifferent to any of the two
extreme above. He is not bothered with risk analysis
but concerned only for return.
Kehinde Adetiloye
 08/02/2022

Sources of Risks
 Economic instability: risks thrive when this variable is not stable for
example the exchange rate.
 Political Instability: political disturbances and social unrests makes
the investor uncomfortable.
 Competition: competitive products brings competitive advantage and
weaker companies may not be able to survive the business
environment.
 Technological Development: brings in risk where the new technology
and inventions introduces new products.
 Market Conditions: General economic and market conditions may
change suddenly bringing in an element of risk that renders useless
earlier research
Kehinde Adetiloye
 08/02/2022

 Labor conditions: is a source of risk because, labor can be unionized though not educated,
and highly skilled ones are expensive.
 Natural occurrences; such as flood earthquake and other natural disaster.
 Unexpected disaster will normally make companies suffer setbacks: but this group is
insurable.
TYPES OF RISKS
Business risks is total risks associated with a company in operations it is the
factors that affect the total methods of operations.
Financial risks: Is the risk the that come with the way a company is
financed via debt and equity. The more debt financing a company has the
higher this risk is

Kehinde Adetiloye
 08/02/2022
 Purchasing Power Risks is the risks the t earned income or
investment may lose value overtime especially when inflation is
high.
 Interest rate risks where the prices of long-term bonds are
determined by the interest rate attached to substitutes and this
interest rate does not affect the short-term bonds.
 Liquidity Risks is the risks that the business may nor have cash
flow to run the business and meet its regular obligation.
 Moral, Political and Legal risks concerns dishonesty, actions
of the government of the day and possible changes in the legal
framework governing the industry respectively

Kehinde Adetiloye
 08/02/2022

Classification of Risks

 Systematic Risk: Risks that affect all the firms in

the industry and cannot be diversified. Investors in
securities in the market cannot avoid these risks.
 Non–systematic are unique risks that can be
diversified away. It is avoidable or diversifiable.

Kehinde Adetiloye
 08/02/2022

Relevance of Risk to Finance

 Recall the three finance decisions, Investment,
financing and dividend decisions:
 Investment decisions under certainty assure that
the investor knows the result from the beginning
and is risk free. However under uncertainty, the
concept of risk is fully integrated as there may be
return or otherwise in such investment.
 Financing decisions: involves the choice in who
finances the firm, by debt or equity.
Considerations is given to the equity /debt mix

Kehinde Adetiloye
 08/02/2022

 Dividend Policy decisions are affected by risk in the

choice of what to pay the providers of capital knowing
fully that there is a choice between retaining funds in
the company and paying the shareholders. This
normally impact on the prices of such securities.
Equally the government is regarded as good debtor and
can afford to pay regularly and this enables the
government to price cheaply. But this is not so
companies where the risk of non payment or delay
could be a challenge
Kehinde Adetiloye
 08/02/2022

Spreading the Risks

Investors normally embarks on the following in order to spread
risks:
a. Portfolio construction should include fixed and variable
income securities to derive the normal advantages
b. Size should be as small as possible in the total portfolio
c. Ease of Realization The more liquid the investment the better
d. Industrial and Geographical Spread involves not holding
the resources in a particular set of companies and in the same
area this include Overseas investment.
e. Investment in real property provides the best hedge against
inflation

Kehinde Adetiloye