Risk and Return - How to Analyze Risks and Returns in Investing
The relationship between risk and required rate of return can be expressed as The rate of return required by investors in financial assets is determined in the. Risk-return tradeoff is a specific trading principle related to the inverse relationship between investment risk and investment return. The return of investment must refer to a particular period of time. Price change is the difference between the price at the end and the beginning of the period.
A very formal definition of risk is the likelihood that actual returns will be less than historical and expected returns. But to put it very simply, risk is the possibility of losing your money that is invested as principal. For example — You invest Rs 20, in stocks today. Next day, the markets go down and reduce the value of your investments to Rs 18, That is the primary risk when you invest in stocks. But stocks are not the only assets that have risk.
All investments have their own share of risks. The risks however vary in type and degree. So even when you keep you money in bank deposits offering 5. Your investment might not keep pace with inflation, which will reduce your purchasing power in future. Risk can come from many other factors too. Like volatility in stock markets, inflation, changes in currency exchange rates, changes in business dynamics, changes in economy, geo-political developments, etc. But generally, the investments that are considered to carry higher risks have the potential to deliver higher returns.
On the other hand, investments with lower expected returns like bank deposits ,carry lower risks. This is quite simple. Returns are simply the amount you get or lose on the invested amount.
Risk and Return
It is generally calculated on an annual basis. As mentioned earlier too, the asset, which gives higher returns, is generally expected to have higher levels of risk. Risk — Return Relationship There is a clear if not linear relationship between risk and returns.
Try finding an asset, where there is no risk. Chances are that you will end up with an asset giving very low returns. 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.Finance Lecture - Risk, Return and CAPM
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. 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. 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.
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.
Understanding the relationship of Risk & Return - Tradejini
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. 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.