The purpose of this paper is to explain corporate investing in terms of risk and return and their inherent relationship. First, there will be an explanation of risk and return and the importance in deciding the right approach to match the appropriate risk tolerance to the expected return for an investment. There will be an explanation of how one can calculate an expected return and its variance. There will be a discussion on diversification to minimize risk while maximizing returns with portfolios and their effects associated with systematic and unsystematic factors. Also, there will some brief details on the security market line and on the capital asset pricing model. Finally, there will be ...view middle of the document...
The phrase “risk and return” is defined as the amount of money invested in securities such as common stocks, corporate or government bonds, and Treasury bills with a chance of losing the investment with the expectation of gaining a profit (Hillstrom, 2014). The term “risk” is defined by Webster as a chance that an investment (as a stock or commodity) will lose its value (Merruan-Webster, 2014). The term “return” is defined as the percentage amount of money that you get back for every unit invested (Reeves, 2013). The rule with investment strategies is the higher the risk or volatility the greater the expected return or reward for the investment. The reward is given to the investor for their willingness to assume the risk. There are no absolutes in risk only relativity depending on the type of investment. If one invests in a company just starting out then there is going to be a higher degree of risk assumed with hopes of a greater return to be realized. A well seasoned “blue chip” company will have a lesser degree of risk with a lower expected return. When making a decision on what investment is best, the investor should make sure to lay out the comparables of each option to capitalize on the best risk and return suited for their degree of tolerance.
In order for an investment like stock in “Robotics” (asset i) to be a viable option, one must calculate the expected return for an investment – E(Ri) – to see if it meets the rate of return needed to willing assume the risk. Our text demonstrates this calculation by realizing a return of 30 percent for the first half of the year followed by 10 percent in the second half of the year in the example below (Ross, Westerfield, & Jordan, 2011):
E(Ri) = .50(1st half) x 30% + .50(2nd half) x 10% = 20 %
In comparing the overall market to the “Robotics” stock, there is a tool investors can use to determine the amount of expected returns by calculating the expected return or “risk premium.” This is done by taking the expected return of an investment – E(Ri) – of 20 percent from a higher risk investment like “Robotics” and subtracting a certain return from a “risk-free” – Rf – of an 8 percent investment in the market known as a risk premium (Ross, Westerfield, & Jordan, 2011). The problem below will help illustrate the calculation:
Risk premium = Expected return – risk free rate
= E(Ri) - Rf
= 20% - 8%
This informs the investor of a 12 percent greater risk with the “Robotics” stock above the risk-free investments of 8 percent in the market to potentially realize a greater expected return.
After evaluating the risk premium, the variance of the “Robotics” stock should be calculated to see how it compares with other stock option variances in the market. Using the same previous example, take the expected return of 30 percent for the first half of the year and subtract the...