In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk?
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In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk? |
Explanation
Stand-alone risk refers to the firm's specific undiversified risk of a project. Such risk can be controlled internally. Reasons to use stand-alone risks are:
Stand-alone risks are generally linked to market risk and are directly proportional to market risk.
Market risk is the most difficult to calculate, whereas stand-alone risk can be easily calculated with the help of scenario analysis, sensitivity analysis, or the Monte Carlo simulation.
To determine the total risk, it is easier to first determine the stand-alone risk through quantitative means and then apply subjective judgements to determine corporate risk and market risk.
Sample Response
Theoretically, market risk is the most relevant risk to investors. Market risk is estimated with the help of beta. However, companies also focus on project-specific risks, which are measured through stand-alone risks. Stand-alone risks are calculated as standard deviations of a project's expected returns. If the project's return is also highly correlated with the economy condition, the stand-alone risk is sufficient to represent the market risk.
