Corporate Finance Theory and Practice, Third Edition

Chapter 18

RISK AND RETURN

The spice of finance

Investors who buy financial securities face risks because they do not know with certainty the future selling price of their securities, nor the cash flows they will receive in the meantime. This chapter will try to understand and measure this risk, and also examine its repercussions.

Section 18.1

SOURCES OF RISK

There are various risks involved in financial securities, including:

• Industrial, commercial and labour risks, etc.

  There are so many types of risk in this category that we cannot list them all here. They include: lack of competitiveness, emergence of new competitors, technological breakthroughs, an inadequate sales network, strikes and so on. These risks tend to lower cash flow expectations and thus have an immediate impact on the value of the stock.

• Liquidity risk

  This is the risk of not being able to sell a security at its fair value, as a result either of a liquidity discount or the complete absence of a market or buyers.

• Solvency risk

  This is the risk that a creditor will lose his entire investment if a debtor cannot repay him in full, even if the debtor's assets are liquidated. Traders call this counterparty risk.

• Currency risk

  Fluctuations in exchange rates can lead to a loss of value of assets denominated in foreign currencies. Similarly, higher exchange rates can increase the value of debt denominated in foreign currencies when translated into the company's reporting currency base.

• Interest rate risk

  The holder of ...