Interpretation of the Risk Measures
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Written by Atila on September 22, 2008 – 1:31 pm
It is important to recognize that none of the risk measures discussed can be interpreted without some standard of reference. For example, suppose that Investors’ Healthcare, a for-profit company, is evaluating a project that has a 0.7 coefficient of variation of returns. Does the project have high, low, or moderate stand-alone risk?
We don’t know the answer without more information. However, knowing that Investor’s Healthcare has an average coefficient of variation of returns of 0.4 on all of its projects enables us to state that the project has more stand-alone risk than does the average project. Similarly, suppose the project under consideration has a corporate beta of 1.4.
We know that it has above-average corporate risk because any business in the aggregate, including Investors’ Healthcare, has a corporate beta of 1.0. This same project might have a market beta of 1.2.
This indicates that the project is riskier than the average project held in a large stock portfolio, but how does the project’s market risk compare to the market risk of Investors’ Healthcare? If the business (i.e., its stock) has a market beta of 0.9, the project also has above-average market risk as compared to the business as a whole. The point here is that risk is always interpreted against some standard because without a standard it is impossible to make judgments.
Which risk judgment is most relevant to Investors’ Healthcare? As discussed in the previous section, market risk is most relevant because the business taking on the project is investor owned, and hence managers should be most concerned about the impact of a new project on stockholders’ risk. However, as explained in the previous section, corporate and stand-alone risk might also have some relevance. The good news here is that the proposed project has above-average risk, when compared to the business’s average project, regardless of which risk measure is used.
