Relationship between financial risk and return

The Relationship between Risk and Return - National Financial Inclusion Taskforce

relationship between financial risk and return

Risk and return are opposing concepts in the financial world, and the tradeoff between The tradeoff between risk and return, then, is the balance between the lowest We can see a visual representation of this association in the chart below . 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 relationship between financial decision making and risk and return is simple. The more risk there is, the more return on the investment is expected. Not all.

In turn, you get back a set amount of interest once or twice a year. 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.

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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.

relationship between financial risk and return

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.

Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares. The additional return for holding shares rather than safe government debt is known as the equityEquity Two meanings: Two yield curves for U. Note the different shapes of the two yield curves.

The yield curve for August is downward sloping, indicating that the longer the time to maturity, the lower the required return on the security. The yield curve for April is upward sloping, indicating that the longer the time to maturity, the higher the required return on the security.

In general, the yield curve has been upward sloping more often than it has been downward sloping. For example, in Aprilthe yield on 3-month U.

In contrast, the yield on year U. Treasury Securities A number of theories have been advanced to explain the shape of the yield curve, including the expectations theory, liquidity or maturity premium theory, and market segmentation theory. According to the expectations theory, long-term interest rates are a function of expected future that is, forward short-term interest rates.

If future short-term interest rates are expected to rise, the yield curve will tend to be upward sloping. In contrast, a downwardsloping yield curve reflects an expectation of declining future short-term interest rates.

Risk and Return - How to Analyze Risks and Returns in Investing

According to the expectations theory, current and expected future interest rates are dependent on expectations about future rates of inflation. Many economic and political conditions can cause expected future inflation and interest rates to rise or fall.

These conditions include expected future government deficits or surpluseschanges in Federal Reserve monetary policy that is, the rate of growth of the money supplyand cyclical business conditions. The liquidity or maturity premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer-term securities.

relationship between financial risk and return

As we shall see in Chapter, the value of a bond tends to vary more as interest rates change, the longer the term to maturity. Thus, if interest rates rise, the holder of a long-term bond will find that the value of the investment has declined substantially more than that of the holder of a short-term bond.

In addition, the short-term bondholder has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate.

The long-term bondholder must wait much longer before this opportunity is available. Accordingly, it is argued that whatever the shape of the yield curve, a liquidity or maturity premium is reflected in it.

The liquidity premium is larger for long-term bonds than for short-term bonds.

The risk-return relationship

Finally, according to the market segmentation theory, the securities markets are segmented by maturity. If strong borrower demand exists for long-term funds and these funds are in short supply, the yield curve will be upward sloping.

Risk and return in hindi

Conversely, if strong borrower demand exists for short-term funds and these funds are in short supply, the yield curve will be downward sloping. Several factors limit the choice of maturities by lenders. One such factor is the legal regulations that limit the types of investments commercial banks, savings and loan associations, insurance companies, and other financial institutions are permitted to make.

Another limitation faced by lenders is the desire or need to match the maturity structure of their liabilities with assets of equivalent maturity. For example, insurance companies and pension funds, because of the long-term nature of their contractual obligations to clients, are interested primarily in making long-term investments. Commercial banks and money market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the form of deposits that can be withdrawn on demand.

At any point in time, the term structure of interest rates is the result of the interaction of the factors just described. All three theories are useful in explaining the shape of the yield curve.

The Default Risk Premium U. In contrast, corporate bonds are subject to varying degrees of default risk.

relationship between financial risk and return

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. In mid, the spread narrowed to 0. The spread expanded to 0.