Risk and Return In Finance
Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street, investing, capital planning, or something else. An investor’s personality, lifestyle, and age are some of the top factors to consider for individual investment management and risk purposes. Each investor has a unique risk profile that determines their willingness and ability to withstand risk.
In general, as investment risks rise, investors expect higher returns to compensate for taking those risks. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways and investors need to be compensated for taking on additional risk.
For example, a U.S. Treasury bond is considered one of the safest investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return. Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk.
Standard deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk. Individuals, financial advisors, and companies can all develop risk management strategies to help manage risks associated with their investments and business activities.
Academically, there are several theories, metrics, and strategies that have been identified to measure, analyze, and manage risks. Some of these include: standard deviation, beta, Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM). Measuring and quantifying risk often allows investors, traders, and business managers to hedge some risks away by using various strategies including diversification and derivative positions.
This course provides an explanation of the relationship between risk and return. Every investment decision carries a certain amount of risk. Therefore, the role of the financial manager is to understand how to calculate the “riskiness” of an investment so that he or she can make sound financial and business decisions. For example, you are the financial manager for a large corporation and your boss has asked you to choose between two investment proposals. Investment A is a textile plant in a remote part of a third world country.
This plant has the capacity to generate ₦50 million in yearly profits. Investment B is a textile plant located in the United States, near a small Virginia Town with a rich textile industry tradition. However, investment B’s capacity for profits is only ₦30 million (due to higher start-up and operating costs).
You are the financial manager. Which option do you chose? While investment A has the capacity to yield significantly higher profits, there is a great deal of risk that must be taken into consideration. Investment B has a much lower profit capacity, but the risk is also much lower. This relationship between risk and return is explained in this course.
Specifically, you will learn how to compute the level of risk by calculating expected values and the standard deviation. Also, you will learn about handling risk in a portfolio with different investments and how to measure the expected performance of a stock investment when it is being affected by the overall performance of a stock market.
Completing this Course should take you approximately 3 hours. Upon successful completion of this course, you will be able to:
- Compute expected values when risk issues need to be considered in finance;
- Explain why the standard deviation is used in finance as a measure of risk;
- Explain how the financial manager makes financial investment decisions when confronted with issues of risk and uncertainty while considering different risk preferences; and
- Analyze an investment portfolio and apply market betas to the analysis.