Risk There Are Many Sources Essay

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This is equity risk. Equity risk can be measured -- either with standard deviation or more typically with the beta coefficient. This risk must be addressed, because the upside movement of the stock was something that was paid for with the lower rate of interest payments.

Diversification of any equity portfolio can be done on a number of other variables. The diversified portfolio will contain exposure to a wide range of firms and industries, and preferably a high level of geographic diversification as well. Modern portfolio theory holds that as few as three companies can result in a diversified portfolio but ideally the portfolio would have at least thirty. The portfolio should include a wide range of types of instruments as well, so that the risk inherent in the convertible is offset by the performance of other instruments, companies and products in the portfolio. With the market, the CAPM beta is usually measured in terms of U.S. markets, but the portfolio can gain even higher levels of diversification with securities from international markets as well, and also with assets that are not exchange-traded (currencies, commodities, real estate, etc.

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Through diversification, risks can be all but eliminated. This is even the case with convertible bonds. The major risk, however, is default risk, and that is not as easy to address. There is a loss associated with default that is difficult to counter with other securities, unless the convertible represents a miniscule portion of the total portfolio. Thus, it is important to understand the degree of risk that one is taking on with a convertible bond, because the risk characteristics of bonds are substantially different from those with equities, and convertible bonds are not normally designed to provide downside risk in the case of insolvency at the company.

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