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Cost of Capital^63

greater is the financial risk as it creates fixed interest payments due to debt or

fixed dividend payments on preference stock thereby causing the amount of residual

earnings available for common stock dividends to be more variable than if no

interest payments were required. It is avoidable to the extent that management

have the freedom to decide to borrow or not to borrow funds.

l Liquidity Risk. This risk is associated with the secondary market which the
particular security is traded in. A security which can be bought or sold quickly
without significant price concession is considered liquid. The greater the uncertainty
about the true element and the price concession , the greater the liquidity risk.
Securities that have ready markets like treasury bills have lesser liquidity risk.

Measurement of Total Risk

Risk is associated with the dispersion in the likely outcomes. Dispersion refers to
variability. If an asset's return has no variability, it has no risk. An investor analysing a
series of returns on an investment over a period of years needs to know something
about the variability of its returns or in other words the asset's total risk.

There are different ways to measure variability of returns. The range from the highest
possible to lowest possible rate of return is one measure, but the range is based only on
two extreme values.

A more popular way of measuring variability of returns is standard deviation. The
standard deviation is simply the square root of the variance of the rates of return.

[ ]

=

= -

n

i

Pi ki k

1

s ( )^2

where, s = standard deviation

Pi = probability associated with the ith possible outcome

ki = rate of return from the ith possible outcome

k = expected rate of return

n = number of outcomes

Portfolios and Risk

An investment portfolio refers to the group of assets that is owned by an investor.
When an investor invests all his funds in a single security, it is more in the nature of
speculation than of an investment, because the returns to the investor are based on the
future of the single asset, making it a very risky proposition. Generally, in order to
reduce risk, investors hold on to a diversified portfolio which might contain equity capital,