Risk And Return Essay

1724 words - 7 pages

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.
Expected Return
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 %
Risk Premium
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%
= 12%
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.
Variance
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...

Find Another Essay On Risk And Return

The portfolio theory in minimizing the risk and maximizing the return

1910 words - 8 pages Introduction:Portfolio theory founded by Markowtz (1952) is a revolutionary theory changed finance profession from 'arts' to 'science'. It gives direction of how to minimize risk at a given return or maximize return at a given return. A portfolio is a bundle of assets with different levels of return and risk. The constituent assets are combined with relative weights. Portfolio theory studies how the characteristics (e.g. risk and return) of

Discuss these titles about the ASX: risk and return, aims of investment, considerations for setting up a portfolio, shares & alternative investment. Make reference to the profiles!

1739 words - 7 pages The principles of risk and return:Fundamentally, the greater the return the greater the risk; in other words there is a direct relationship between risk and return. An investor acting in rational self interest would only invest in a speculative investment if the investor is compensated by a greater return. For instance, gambling has the greatest risk attached, and also it potentially has the greatest return. However, government bonds have little

Peachtree Securities Case

874 words - 3 pages expected return. 3. The standard deviation provides a measurement of the total risk by examining the tightness of the probability distribution associated with the different possible outcomes whereas the coefficient of variation measures risk per unit. The coefficient of variation is a better measure when investments have different expected returns and different levels of total risk. When risk is considered, the best alternative depends on

Portfolio Analysis and Investment

984 words - 4 pages portfolios; as well their relevance to investment theory. Furthermore, given the nature of the assignment, avoid bringing the brokerage industry into your discussion. In other words, assume you can invest directly in the stock market and do not need any financial intermediaries like brokerage houses. Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time. In

Application of the C.A.P.M. on NYSE & NASDAQ Stocks: Toyota in NYSE

545 words - 2 pages IntroductionIn order to analyze and apply the C.A.P.M. on the stock of Toyota, one must know what the C.A.P.M. is. This is a formula which is actually an abbreviation of Capital Asset Pricing Model and is used in order to find the appropriate price of an asset. If we analyze the C.A.P.M., we can find the expected return of a stock, such as is demanded in this case. The C.A.P.M. consists of the risk-free rate, the beta of the stock (the risk

Financial theory and Corporate Policy

2126 words - 9 pages index from the 1st of January 2009 all up to the 1st of February 2014. Furthermore, the risk free rate data over this period of time would be used in the analysis. The business and sector in which each company is involved in is highlighted so that the return and the risk involved will be evaluated based on the following criteria, which include the average return, standard deviation, Capital Asset Pricing Model (CAPM) Beta, Sharpe ratio, the

Investment Policy Statement

4725 words - 19 pages in evaluation.1.3ScopeThis report provides an overview of an investment policy statement, the methodology used (excel solver) and also provides a critical evaluation of the portfolio. The scope also includes the process of setting a portfolio strategy, and expected yield in line with the risk return preferences.1.4LimitationsThis report is based on historical data. Investments are made on the basis of preset risk profiles; the movement of stock

Capital Asset Pricing Model

979 words - 4 pages in 1990 (Watson & Head, 2006). The theory is giving the investors the ability to avoid desultory risk by choosing variety of portfolios which contain different number of shears. Markowitz's first point is to build the envelope curve which is giving the maximum return or minimum risk for a giving stage of return, this shows the investors a group of portfolio available choices when investing in a set of risky assets and it is advising the investors

capital asset pricing model

1150 words - 5 pages , 1972, p1). The CAPM is used to measure risk and the ties between variance of risk (market beta) and the expected rate of return (reward) (Fama & French, 2004). And it mainly deal with two problems, one is how to choose a portfolio, the other is to utilize diversification investment to reduce the risk. This essay is about the CAPM, it will begin by the fundamental feature of the CAPM , this will be followed by the description of the relationship

Merrill Finch Inc. Case Study

2116 words - 8 pages the concept of Risk. Three different measurements of risk are discussed and calculated for each of the investment alternatives. The risk measurements discussed are the Standard Deviation, Coefficient of Variance, and Beta Coefficient.Section 2 discusses some scenarios of different investment options. The first is of a 2-stock portfolio consisting of the investment of $50,000 into both High Tech and Collections. The expected return, standard

Key Issues Relative to Portfolio Analysis and Investment

1777 words - 7 pages , 2006).MPT is defined, according to investorwords.com (2005), as an overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially measured by alpha, beta, and R². MPT utilizes several basic statistical measures to develop a portfolio plan (Gitman, et al, 2005). Included are expected returns and standard deviations of returns for both securities and portfolios, and

Similar Essays

Risk And Return Tradeoff Memo Essay

1036 words - 4 pages The process of portfolio construction can be quite complex. Analysts go through reams of statistics - past performance, future potential, and industry knowledge and rely on personal insights into the market to arrive at the final list (UOP, 2008). This memo will be based on the Constructing and Managing a Portfolio Simulation which details the fundamentals of portfolio construction in relation to the risk-return tradeoff and the relationship

Risk And Return Trade Off Memo

978 words - 4 pages with minimal risk and the highest yield possible. At that time the following capital market information was true.Market Risk 15%Risk-Free Rate4.88%Market Return 11%Additionally, the following eight companies were provided as options for investments; the financial team was asked to chose the four stocks that would best suit Casa Bonita's investment goals and risk tolerance.1.Desktop, Inc.; the largest seller of office supplies worldwide. Products

Rpl Mrpl Assessing Risk And Return Essay

1726 words - 7 pages have negative or positive beta coefficient. The magnitude of beta gives an indication how great an impact a systematic risk has on a stock's return. For example if two stocks have beta of 2 and 3, this implies that second stock is more responsive to fluctuation in risk factor compared to first one. Or the second stock is more risky than the first one. A positive beta means that the return will rise or fall with the increase or decrease in market

He Risk And Return Of Human Capital Investments

945 words - 4 pages Title: The Risk and Return of Human Capital Investments (2013) Kristen Koerselman & Roope Uusitalo This paper looks at investment in human capital and the level of risk involved. The aim of this paper is to show how moments in lifetime income can be estimated from a shorter panel. The paper uses a 22-year panel (based on Finnish registers). Some of the techniques used in this short paper are mean and variance in lifetime earnings and