Risk and return relationship in financial management

4 Main Sections of Risk and Return Relationship

risk and return relationship in financial management

Sep 26, The concept of financial risk and return is an important aspect of a financial manager's core responsibilities within a business. Generally, the. The risk-return relationship is explained in two separate back-to-back articles . The definition of risk that is often used in finance literature is based on the . equipment failure, R&D achievements, changes in the senior management team etc. Risk is associated with the possibility of not realizing return or realizing less .. analysts of financial securities and financial managers, it is not without critics.

There are obviously exceptions to this, as there are many examples of irrational risks that do not come with correspondingly high returns. Volatility Volatility refers to the way prices for certain securities change during a certain period of time. It is a statistical measurement that measures the average difference between prices and the average price in the given time period.

risk and return relationship in financial management

The greater the volatility of a security, the greater the uncertainty. Financial managers are often very concerned with the volatility of the stock of the company they work for as well as any stock they may have invested money into.

risk and return relationship in financial management

Risk Risk is closely tied to volatility. A volatile stock or investment is risky because of the uncertainty. 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.

Risk & Return in Financial Management | Bizfluent

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.

risk and return relationship in financial management

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. 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.

Risk & Return in Financial Management

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.

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. 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.

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. 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.

The Relationship between Risk and Return - National Financial Inclusion Taskforce

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: