Corporate Finance: Instructor\'s Manual Applied Corporate Finance

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Aswath Damodaran 68

The Importance of Diversification: Risk Types


Actions/Risk that
afifrfmect only one

Actions/Risk that
affect all investments

Firm-specific Market

dPor objeetcttes^ rm oary
worse than
expected

Competition
may be stronger
oanrt wiceipaakteerd than

Entire Sector
may be affected
by action

Exchange rate
and Political
risk
Interest rate,
Inflation &
neceownso amboyut

Figure 3.5: A Break Down of Risk

Affects few
firms

Affects many
firms

Freirdmuc cea bny Ionfv persotijnegct isn lots (^) cAocmqpueiritintogr (^) s Dacivroesrss isfeycintogr (^) s aDcirvoesrss cifoyiunngt (^) ries Cannot affect
Investors
cmainti (^) gate by
Diversifying across domestic stocks Diversifying across
asset classes
Diversifying globally


This is the critical second step that all risk and return models in finance take.


As examples,


Project-specific Risk: Disney’s new Animal Kingdom theme park: To


the degree that actual revenues at this park may be greater or less than


expected.


Competitive Risk: The competition (Universal Studios, for instance) may


take actions (like opening or closing a park) that affect Disney’s


revenues at Animal Kingdom.


Industry-specific risk: Congress may pass laws affecting cable and


network television, and affect expected revenues at Disney and ABC, as


well as all other firms in the sector, perhaps to varying degrees.


International Risk: As the Asian crisis deepened in the late 1990s, there


wasy be a loss of revenues at Disneyland (as tourists from Asia choose


to stay home) and at Tokyo Disney


Market risk: If interest rates in the US go up, Disney’s value as a firm


will be affected.


From the perspective of an investor who holds only Disney, all risk is relevant.


From the perspective of a diversified investor, the first three risks can be


diversified away, the fourth might be diversifiable (with a globally diversified


portfolio) but the last risk I not.

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