The relationship between financial risk and return

The Relationship between Risk and Return - National Financial Inclusion Taskforce

the relationship between financial risk and return

There are two primary concerns for all investors: the rate of return they can expect on their investments and the risk involved with that investment. While investors. Diversification enables you to reduce the risk of your portfolio without on amounts up to $, if your financial institution goes bankrupt. As a general rule, investments with high risk tend to have high returns and vice versa. Another way to look at it is that for a given level of return, it is human nature .

The Default Risk Premium U.

Understanding the relationship of Risk & Return - Tradejini

In contrast, corporate bonds are subject to varying degrees of default risk. Investors require higher rates of return on securities subject to default risk. Over time, the spread between the required returns on bonds having various levels of default risk varies, reflecting the economic prospects and the resulting probability of default.

For example, during the relative prosperity ofthe yield on Baa-rated corporate bonds was approximately. By lateas the U.

The risk-return relationship

In mid, the spread narrowed to 0. The spread expanded to 0. Seniority Risk Premium Corporations issue many different types of securities. A partial listing of these securities, from the least senior that is, from the security having the lowest priority claim on cash flows and assets to the most senior, includes the following: Generally, the less senior the claims of the security holder, the greater the required rate of return demanded by investors in that security.

For example, the holders of bonds issued by ExxonMobil are assured that they will receive interest and principal payments on these bonds except in the highly unlikely event that the company faces bankruptcy. In contrast, ExxonMobil common stockholders have no such assurance regarding dividend payments.

Also, in the case of bankruptcy, all senior claim holders must be paid before common stockholders receive any proceeds from the liquidation of the firm. For example, there is very little marketability risk for the shares of stock of most companies that are traded on the New York or American Stock Exchange or listed on the NASDAQ system for over the counter stocks.

For these securities, there is an active market. Trades can be executed almost instantaneously with low transaction costs at the current market price. In contrast, if you own shares in a rural Nebraska bank, you might find it difficult to locate a buyer for those shares unless you owned a controlling interest in the bank.

When a buyer is found,that buyer may not be willing to pay the price that you could get for similar shares of a largerbank listed on the New York Stock Exchange. The marketability risk premium can be significantfor securities that are not regularly traded, such as the shares of many small- and medium-size firm.

The risk-return relationship | Understanding risk |

Business and Financial Risk11 Within individual security classes, one observes significant differences in required rates of return between firms. For example, the required rate of return on the common stock of US Airways is considerably higher than the required rate of return on the common stock of Southwest Airlines. The difference in the required rate of return on the securities of these two companies reflects differences in their business and financial risk.

Over the decade from tothe operating profit margin ratio for Southwest Airlines was consistently higher and much less variable from year to year than for US Airways. As a stronger, and more efficient firm, Southwest Airlines can be expected to have a lower perceived level of business risk and a resulting lower required return on its common stock all other things held constant.

Risk and Return

In addition, as debt financing increases, the risk of bankruptcy increases. For example, US Airways had a debt-to-total-capitalization ratio of By AugustUS Airways was forced to enter Chapter 11 bankruptcy as a way of reorganizing and hopefully saving the company.

Although it emerged from bankruptcy init faced renewed bankruptcy riskin In comparison, the debt-to-total-capitalization ratio was This difference in financial risk will lead to lower required returns on thecommon stock of Southwest Airlines compared to the common stock of US Airways, all other things being equal.

Indeed, because of the bankruptcy filing, common stock investors in US Airways lost virtually all of their investment value in the firm.

Risk and Required Returns for Various Types of Securities illustrates the relationship between required rates of return and risk, as represented by the various risk premiums just discussed.

As shown in Figure 6. All other securities have one or more elements of additional risk, resulting in increasing required returns by investors. The order illustrated in this figure is indicative of the general relationship between risk and required returns of various security types.

the relationship between financial risk and return

There will be situations that result in differences in the ordering of risk and required returns. For example, it is possible that the risk of some junk high-risk bonds may be so great that investors require a higher rate of return on these bonds than they require on high-grade common stocks. The relationship between risk and return can be observed by examining the returns actually earned by investors in various types of securities over long periods of time. Finance professionals believe that investor expectations of the relative returns anticipated from various types of securities are heavily influenced by the returns that have been earned on these securities over long periods in the past.

the relationship between financial risk and return

They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year.

the relationship between financial risk and return

If you hold bonds until the maturity date, you will get all your money back as well. As a shareholderShareholder A person or organization that owns shares in a corporation.

May also be called a investor. But if the company is successful, you could see higher dividends and a rising shareShare A piece of ownership in a company. But it does let you get a share of profits if the company pays dividends. Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested.

DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not. May include stocks, bonds and mutual funds. The equity premium Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free.

The government is unlikely to default on its debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date. At the other extreme, common shares are very risky because they have no guarantees and shareholders are paid last if the company is in trouble or goes bankrupt.

the relationship between financial risk and return

Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares.