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Risk vs Return0 - Risk versus Return Unlocking the...

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Risk versus Return 1 Risk versus Return Unlocking the Importance of Risk and Return for the Financial Manager
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Risk versus Return 2 Risk, Return, and SWM In order to achieve the goal of maximizing shareholder wealth, the financial manager must thoroughly comprehend the concepts of risk and the return and the relationship that exists between the two concepts. Failure to properly understand this may lead to decisions being made that inadequately compensate the shareholders for the level of risk to which they are being exposed To this extent it is necessary to have a solid provide a complete analysis of the concepts of risk and return.,
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Risk versus Return 3 Risk Too often, the word risk carries with it a negative connotation and thus risk is incorrectly defined as the likelihood of incurring a loss. More correctly, risk is the result of uncertainty and variability. To this extent risk expresses the likelihood of earning a loss or a gain about that which is expected. The different sources of risk that may affect firms and or shareholders include Business Risk, Financial Risk Interest Rate Risk, Liquidity Risk, Market Risk Event Risk, Exchange Rate Risk, Purchasing Power Risk, Tax Risk
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Risk versus Return 4 Return Return represents the gain or loss incurred on an investment over a period of time. The return on the stock measures the cash flows to the shareholder from dividends and capital gains relative to the level of investment. Mathematically this would be presented as: R t = [D t + (P t – P t-1 )]/P t-1 Where: R t = the Return for period t D t = the dividend paid in period t P t = the price of the stock at time t P t-1 = the price of the stock at time t-1
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Risk versus Return 5 Risk Averseness The reason such emphasis is placed on risk is that investors and managers are inherently risk averse. By this, we mean the generally, investors and managers will require higher rates of return in exchange for exposure to greater risk. Not all investors or managers, however, are equally risk averse. Furthermore, while some may be risk averse, some may be risk neutral where risk not play a role in dictating return and and some may even be risk loving whereby they higher levels risk is sought out despite lower returns.
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Risk versus Return 6 Risk Averseness By comparing the certainty equivalent to the expected return from the risky alternative one can determine whether the individual is risk averse, risk neutral, or risk loving. The certainty equivalent represents the guaranteed, riskless, or certain rate of return which the individual is indifferent to when compared to the expected rate of return from a risky alternative. By definition, an investor is considered to be: Risk averse if: Expected Return > Certainty Equivalent Risk neutral if: Expected Return = Certainty Equivalent Risk loving if: Expected Return < Certainty Equivalent
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Risk versus Return 7 Risk Averseness Consider an investor with an opportunity to invest in a risk free treasury security with return of 5% or a risky security.
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