| In this final article on finance we're going to review | | | | for. |
| some finance theories. There are plenty of them to | | | | Then there is the SML or Security Market Line. |
| go around. | | | | How does this relate to the CAPM formula? Actually, |
| Finance theories themselves are the foundations for | | | | the SML is a graphical representation of the CAPM. |
| understanding the role of finance in markets. It is a | | | | This tells us that if a security is priced accurately the |
| way of measuring investment value and risk and | | | | expected return of the security will meet the |
| return on investment. Some of the theories include | | | | security beta at the securities market line. However, |
| foreign currency transactions, value at risk and | | | | if it falls below the line then that means the security |
| portfolio theory, which is the basis of investment | | | | is undervalued and overvalued if it falls above the line. |
| analysis. An example of investment analysis is the | | | | In either case, adjustments have to be made. |
| CAPM model. | | | | All of this leads to the theory of risk management |
| CAPM stands for Capital Asset Pricing Model. This is | | | | itself, which you could write several books on alone. |
| fundamental to all finance theory. The CAPM model | | | | However, we won't attempt that here. Instead we'll |
| tries to explain the relationship between risk and | | | | just do a brief overview of risk management. |
| return on investment. This risk includes both | | | | Risk management is trying to identify, control and |
| systematic and unsystematic risk. | | | | minimize the financial impact of events that cannot |
| Systematic risk is the risk factor common to the | | | | be predicted. By minimizing potential risk, a company |
| whole economy and the risk associated with | | | | can minimize the potential loss associated with that |
| investments in general. These are also non diversified | | | | risk. |
| risks, meaning they are invested in one area. | | | | The ways that companies do this is through |
| Unsystematic risk is the unique risk associated with a | | | | diversification of investments. A company might do |
| company such as bad management, strike or disaster | | | | any one of the following to diversify and reduce risk |
| and with diversification, can be eliminated or at least | | | | including long term forward contracts, currency |
| lessened. | | | | swaps, cross hedging and currency diversification. By |
| Only systematic risk is compensated for in regard to | | | | doing these things a company is placing it's funds in |
| the investor. | | | | various areas so that if one area is hit hard by |
| Here is the CAPM formula for you mathematicians | | | | something unforeseen the other areas should be |
| out there.re = rf + beta (rm - rf)rf is the risk free | | | | unaffected. So whatever diversification is done should |
| rate. This is the rate that the investor gets for no | | | | be done with careful planning to ensure the areas |
| risk. rm is the risk of the market as a whole in | | | | invested in do not overlap each other. This makes it |
| general. re is the expected return incorporating the | | | | highly unlikely that multiple areas are affected by one |
| risk free rate, market risk and beta value. | | | | event. |
| In the ideal world you want to maximize your re | | | | The above is simplified but should give you a start to |
| while minimizing the risk factor. Sometimes this is not | | | | the world of finance theory and risk management. |
| always easy or possible. But this is what you shoot | | | | Future articles will go into more detail. |