Risk is an important concept in financial
analysis, especially in terms of how it affects
security prices and rates of return.
ment risk is associated with the probability
of low or negative future returns.
The riskiness of an asset can be con-
sidered in two ways: (1) on a
where the asset’s cash flows are ana-
lyzed all by themselves, or (2) in a
where the cash flows from a number
of assets are combined and then the consolid-
ated cash flows are analyzed.
In a portfolio context, an asset’s risk can
be divided into two components:
sifiable risk component,
which can be diversi-
fied away and hence is of little concern to di-
versified investors, and (2) a
market risk com-
which reflects the risk of a general
stock market decline and which
cannot be eliminated by diversification, hence
does concern investors. Only market risk is
; diversifiable risk is irrelevant to most in-
vestors because it can be eliminated.
An attempt has been made to quantify
market risk with a measure called
. Beta is
a measurement of how a particular firm’s
stock returns move relative to overall move-
ments of stock market returns. The
Asset Pricing Model (CAPM),
concept of beta and investors’ aversion to risk,
specifies the relationship between market risk
and the required rate of return. This relation-
ship can be visualized graphically with the Se-
curity Market Line (SML). The slope of the
SML can change, or the line can shift upward
or downward, in response to changes in risk or
required rates of return.
With most investments, an individual or business spends money today with the expectation
of earning even more money in the future.
The concept of return provides investors with a
convenient way of expressing the financial performance of an investment.
One way of expressing an investment return is in
Dollar return = Amount received – Amount invested.
Expressing returns in dollars is easy, but two problems arise.
RISK AND RETURN
3 - 2
To make a meaningful judgment about the adequacy of the return, you
need to know the scale (size) of the investment.
You also need to know the timing of the return.
The solution to the scale and timing problems of dollar returns is to express investment res-
rates of return
Rate of return =
The rate of return calculation “normalizes” the return by considering the
return per unit of investment.
Expressing rates of return on an annual basis solves the timing problem.
Rate of return is the most common measure of investment performance.
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