The Risk - Return Relationship

Another fundamental relationship in the study of finance is the relationship between expected return and the expected level of associated risk. The nature of the relationship is that as the level of expected risk increases, the level of expected return also increases. The opposite is true as well. Lower levels of expected risk are associated with lower expected returns. This risk-return relationship is characterized as being a direct relationship or a positive relationship. Business firms operate and invest in risky environments. Since these risks impact the level of returns from business investments, they directly affect the economic value of both individual investment projects and the firm as a whole. Because of this, the potential risks associated with project investments must be taken into account when making investment decisions.

The "expectational" nature of the relationship

It should be noted that the risk-return relationship is stated in expectational terms. That is, it focuses on expected risk and expected returns. When an investment decision is made, the decisions reflect expectations about future performance. After the investment has been made, actual returns and actual risks may be different from what was originally anticipated. The important point, however, is that when investment decisions are made, greater levels of expected risk should be compensated for by greater expected returns on the investment.

A general definition of risk

In its most general definition, risk is nothing more than the possibility of something unexpected happening. These unexpected occurrences could either have a positive or a negative effect on our personal financial well-being or the financial well-being of our company. In its broadest sense, then, risk is essentially the unknown or uncertainty. Finance related risks can then be thought of as the impact of the unknown on an individuals economic wealth or a business firms economic value. Note that risk of the unknown could work either in your favor (upside risk) or against you (downside risk).

Risk = the possibility of something unexpected happening or Risk = the possibility of an unexpected outcome occurring

The importance of the risk-return relationship The risk-return relationship has implications for many of the areas of finance. If, for example, two different alternative investments are being considered by a business, the existence of the risk-return relationship dictates that the comparison of alternative investments has to take both expected risks and expected returns into account. The decision cannot be made solely on the basis of the expected return. If two investments have differing risk levels associated with their future cash flows, the risk must be accounted for in the investment decision process. There are a number of different methods that can be used to incorporate risk into the project

investment decision. These will be discussed in the advanced Capital Budgeting modules.

The risk-return relationship also has implications for the pricing of various financial assets. If two sets of identical cash flows with the same risk levels are available, the risk-return relationship dictates that the two investments must have the same market value and market price. If the prices differ, the opportunity exists for arbitrage activities and the earning of riskless profits. This aspect of the risk-return relationship is the basis of one of the fundamental asset pricing concepts in finance and economics; the Law of One Price. Risk is a fundamental, underlying, concept that has to be taken into account during any financial decision making process.

Risk Aversion
Risk aversion refers to the aspect of human nature that causes people to avoid unnecessary risk. In general, people tend to be risk averse. In order to overcome this risk aversion, the investor must be adequately compensated. This concept of risk aversion carries over into the business and financial world as well.

In business, people also tend to be risk averse. If they choose to expose themselves to higher levels of risks, they do so only if they are going to be compensated in some financial way for taking on the additional risk. In finance, since risk and return are positively related, the taking on of greater expected levels of risk is always associated with a higher expected financial return. This is the basis for the direct risk-return relationship.

CONCEPT OF RETURN AND RISK

There are different motives for investment. The most prominent among all is to earn a return on investment. However, selecting investments on the basis of return in not enough. The fact is that most investors invest their funds in more than one security suggest that there are other factors, besides return, and they must be considered. The investors not only like return but also dislike risk. So, what is required is: i. ii. iii. Clear understanding of what risk and return are, What creates them, and How can they be measured?

Return
The return is the basic motivating force and the principal reward in the investment process. The return may be defined in terms of (i) realized return, i.e., the return which has been earned, and (ii) expected return, i.e., the return which the investor anticipates to earn over some future investment period. The expected return is a predicted or estimated return and may or may not occur. The realized returns in the past allow an investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return can be measured as the total gain or loss to the holder over a given period of time and may be defined as a percentage return on the initial amount invested. With reference to investment in equity shares, return is consisting of the dividends and the capital gain or loss at the time of sale of these shares.

Risk
Risk in investment analysis means that future returns from an investment are unpredictable. The concept of risk may be defined as the possibility that the actual return may not be
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same as expected. In other words, risk refers to the chance that the actual outcome (return) from an investment will differ from an expected outcome. With reference to a firm, risk may be defined as the possibility that the actual outcome of a financial decision may not be same as estimated. The risk may be considered as a chance of variation in return. Investments having greater chances of variations are considered more risky than those with lesser chances of variations. Between equity shares and corporate bonds, the former is riskier than latter. If the corporate bonds are held till maturity, then the annual interest inflows and maturity repayment are fixed. However, in case of equity investment, neither the dividend inflow nor the terminal price is fixed. Risk should be differentiated with uncertainty: Risk is defined as a situation where the possibility of happening or non happening of an event can be quantified and measured: while uncertainty is defined as a situation where this possibility cannot be measured. Thus, risk is a situation when probabilities can be assigned to an event on the basis of facts and figures available regarding the decision. Uncertainty, on the other hand, is a situation where either the facts and figures are not available, or the probabilities cannot be assigned.

Types of Risk
Systematic Risk
It refers to that portion of variability in return which is caused by the factors affecting all the firms. It refers to fluctuation in return due to general factors in the market such as money supply, inflation, economic recessions, interest rate policy of the government, political factors, credit policy, tax reforms, etc. these are the factors which affect almost all firms. The effect of these factors is to cause the prices of all securities to move together. This part of risk arises because every security
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has a built in tendency to move in line with fluctuations in the market. No investor can avoid or eliminate this risk, whatever precautions or diversification may be resorted to. The systematic risk is also called the non-diversifiable risk or general risk. Types of Systematic Risk 1. Market Risk: Market prices of investments, particularly equity shares may fluctuate widely within a short span of time even though the earnings of the company are not changing. The reasons for this change in prices may be varied. Due to one factor or the other, investors attitude may change towards equities resulting in the change in market price. Change in market price causes the return from investment to very. This is known as market risk. The market risk refers to variability in return due to change in market price of investment. Market risk appears because of reaction of investors to different events. There are different social, economic, political and firm specific events which affect the market price of equity shares. Market psychology is another factor affecting market prices. In bull phases, market prices of all shares tend to increase while in bear phases, the prices tend to decline. In such situations, the market prices are pushed beyond far out of line with the fundamental value. 2. Interest-rate Risk: Interest rates on risk free securities and general interest rate level are related to each other. If the risk free rate of interest rises or falls, the rate of interest on the other bond securities also rises or falls. The interest rate risk refers to the variability in return caused by the change in level of interest rates. Such interest rate risk usually appears through the change in market price of fixed income securities, i.e., bonds and debentures. Security (bond and debentures) prices have an inverse relationship with the level of interest

rates. When the interest rate rises, the prices of existing securities fall and vice-versa. 3. Purchasing power or Inflation Risk: The inflation risk refers to the uncertainty of purchasing power of cash flows to be received out of investment. It shows the impact of inflation or deflation on the investment. The inflation risk is related to interest rate risk because as inflation increases, the interest rates also tend to increase. The reason being that the investor wants an additional premium for inflation risk (resulting from decrease in purchasing power). Thus, there is an increase in interest rate. Investment involves a postponement in present consumption. If an investor makes an investment, he forgoes the opportunity to buy some goods or services during the investment period. If, during this period, the prices of goods and services go up, the investor losses in terms of purchasing power. The inflation risk arises because of uncertainty of purchasing power of the amount to be received from investment in future.

Unsystematic Risk
The unsystematic risk represents the fluctuation in return from an investment due to factors which are specific to the particular firm and not the market as a whole. These factors are largely independent of the factors affecting market in general. Since these factors are unique to a particular firm, these must be examined separately for each firm and for each industry. These factors may also be called firm-specific as these affect one firm without affecting the other firms. For example, a fluctuation in price of crude oil will affect the fortune of petroleum companies but not the textile manufacturing companies. As the unsystematic risk results from random events that tend to be unique to an industry or a firm, this risk is random in nature. Unsystematic risk is also called specific risk or diversifiable risk.
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Types of Unsystematic Risk 1. Business Risk: Business risk refers to the variability in incomes of the firms and expected dividend there from, resulting from the operating condition in which the firms have to operate. For example, if the earning or dividends from a company are expected to increase say, by 6%, however, the actual increase is 10% or 12 %. The variation in actual earnings than the expected earnings refers to business risk. Some industries have higher business risk than others. So, the securities of higher business risk firms are more risky than the securities of other firms which have lesser business risk. 2. Financial Risk: It refers to the degree of leverage or degree of debt financing used by a firm in the capital structure. Higher the degree of debt financing, the greater is the degree of financial risk. The presence of interest payment brings more variability in the earning available for equity shares. This is also known as financial leverage. A firm having lesser or no risk financing has lesser or no financial risk.

Measurement of risk
No investor can predict with certainty whether the income from an investment increase or decrease or by how much. Statistical measures can be used to make precise measurement of risk about the estimated returns, to gauge the extent to which the expected return and actual return are likely to differ. The expected return, standard deviation and variance of outcomes can be computed as

Variance is Where, R = expected return 2= variance of expected return = standard deviation of expected return P = Probability O = Outcome n = total number of different outcomes Beta Coefficient There is another measure of risk known as which measures the risk of one security/portfolio in relation to market risk. The market risk is represented by fluctuation in the market benchmark, i.e., market index, e.g., SENSEX. Shares whose factor is more than 1 are considered less risky. It may be noted that is a measure of systematic risk which cannot be diversified away. The total risk of an investment consists of two components: diversifiable (unsystematic) risk and non diversifiable (systematic) risk. The relationship between total risk, diversifiable risk, and non diversifiable risk can be expressed by the following equation: Total risk = Diversifiable risk + Non Diversifiable risk
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SOURCES OF RISK
What makes a financial asset risky? Traditionally, investors have talked about several sources of total risk, such as interest rate risk and market risk, which are explained below, because these terms are used so widely, Following this discussion, we will define the modern portfolio sources of risk, which will be used later when we discuss portfolio and capital market theory. 1. Interest Rate Risk: The variability in a security's return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. Interest rate risk affects bonds more directly than common stocks, but it affects both and is a very important consideration for most investors. 2. Market Risk: The variability in returns resulting from fluctuations in the overall market that is, the aggregate stock market is referred to as market risk. All securities are exposed to market risk, although it affects primarily common stocks. Market risk includes a wide range of factors exogenous to securities themselves, including recessions, wars, structural changes in the economy, and changes in consumer preferences. 3. Inflation Risk: A factor affecting all securities is purchasing power risk, or the chance that the purchasing power of invested dollars will decline/With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand additional inflation premiums to compensate for the loss of purchasing power. 4. Business Risk: The risk of doing business in a particular industry or environment is called business risk.
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For example, AT&T, the traditional telephone powerhouse, faces major changes today in the rapidly changing telecommunications industry. 5. Financial Risk: Financial risk is associated with the use of debt financing by companies. The larger the proportion of assets financed by debt (as opposed to equity), the larger the variability in the returns, other things being equal. Financial risk involves the concept of financial leverage, which is explained in managerial finance courses. 6. Liquidity Risk: Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered to be liquid. The more uncertainty about the time element arid the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small over-the-counter (OTC) stock may have substantial liquidity risk. 7. Exchange Rate Risk: All investors who invest internationally in today's increasingly global investment arena face the prospect of uncertainty in the returns after theyconvert the foreign gains back to their own currency Unlike the past when most U.S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. For example, a U.S. investor who buys a German stock denominated in marks must ultimately convert the returns from this stock back to dollars. If the exchange rate has moved against the investor, losses from these" exchange rate' movements can partially or totally negate the original return earned.

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8. Country Risk: Country risk, also referred to as political risk, is an important risk for investors today probably more important now than in the past. With mote investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a country's economy need to be considered. The United States arguably has the lowest country, risk, and other countries can be judged on a-relative basis using the United States as a benchmark. Examples-of countries that needed careful monitoring in the 1990s because of country risk included the, former Soviet Union ^and Yugoslavia, China, Hong Kong, and Smith Africa. In the-early part of the twenty-first century, several countries in South America, Turkey, Russia, and Hong Kong, among others, require careful attention.

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