The relationship between risk and return appears

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not measurable could be thought of as uncertainty. The relationship between risk and return appears easier to examine with publicly traded securities. For example, consider fixed-income securities. Government bonds have less credit risk than corporate bonds in general, so the pricing takes into account that the yield spreads for government bonds are narrower than corporate bonds across various maturities. However, for a given maturity, the full relationship between risk and return goes further than merely credit risk (e.g., liquidity risks and taxation impacts may make the relationship less clear). Additionally, the risk tolerances (i.e., ability and willingness to take on certain risks) of market participants may change over time. When risk tolerances are high, the
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Page 6 ©2015 Kaplan, Inc. Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 spread between riskless and risky bonds may narrow to an abnormally low level, which again disguises the true relationship between risk and return. Examining the relationship between risk and return is made even more challenging when dealing with non-publicly traded securities because the pricing of such securities is less reliable compared to publicly traded securities (i.e., no market price validation). In practice, some entities have weak risk management and/or risk governance cultures, which allows for potential returns to be overstated because they are not adjusted for risk. Correlation risks may be ignored, which understate overall risk. Some risk measures may be computed in a misleading manner because the proper computation may result in lower reported profits for the entity. For example, for entities that have management bonuses based on reported profits, the use of mark to market accounting may result in inflated profits on the income statement (and overstated values for risky assets on the balance sheet) during a strong year in order to maximize the management bonuses paid. However, at the same time, there are usually no adjustments made to risk that considers the fact that those profits have not truly been earned because no cash has been received yet and, in fact, may never materialize if the investments subsequently lose significant value. Risk Classes LO 1.6: Describe and differentiate between the key classes of risks, explain how each type of risk can arise, and assess the potential impact of each type of risk on an organization. Market Risk Market risk considers how changes in market prices and rates will result in investment losses. There are four subtypes of market risk: (1) interest rate risk, (2) equity price risk, (3) foreign exchange risk, and (4) commodity price risk. Interest rate risk can be illustrated in simple terms by considering a bond earning a fixed rate of interest. If market interest rates rise, the value of the bond will decrease. Another form of interest rate risk is the hedging of bonds against a change in the shape of the yield curve (although it may be properly hedged against a parallel shift in the yield curve).
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