Question

Explain in detail the concept of risk and its importance how risk in the valuation of financial instruments

Answer 1

Risk is a very misunderstood concept

Risk should always be paired with returns. A risk is defined as the additional profit yield for an additional unit of standard deviation in expected returns

Risk can be classified as systematic and unsystematic along with idiosyncratic risk

An investor who has a good understanding of these risk concepts can become a very successful investor

Risk in the equity instruments is captured by the CAPM using the Beta":

Beta is the measurement of systematic risk

The higher the beta, the higher the risk of the firm

The higher the beta, the higher the cost of capital and hence the more discount your cash flows will recieve

So risk has a major impact on the financial models