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Strategic Financial Management

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RISK AND RETURN


Topic # 5

This topic is very interesting to note in this subject STRATEGIC FINACIAL


MANAGEMENT, why?
Simply because The concept of financial risk and return is an important
aspect of a financial manager's core responsibilities within a business.
Generally, the more financial risk a business is exposed to, the greater its
chances for a more significant financial return.
Whether it is investing, driving or just walking down the street, everyone of us
exposes ourselves to risk. Right? Our personality and lifestyle play a big role in
how much risk we are comfortably able to take on.
First, let me begin with definition of terms:
Boglehead.org defines risk and returns as the chance that an investment's
actual return will be different than expected. This includes the possibility of
losing some or all of the original investment.
And in other definition
investopedia.com states is the uncertainty that an investment will earn its
expected rate of return.
When it comes to financial matters, we all know what risk is -- the possibility of
losing your hard-earned cash. And most of us understand that a return is what
you make on an investment. But we tend to forget and understand, the
relationship between the two.
The relationship between risk and return is often represented by a trade-off. In
general, the more risk you take on, the greater your possible return. To
visualize it further I have downloaded a graph from investopedia.com to show
their relationship. Their relationship is a fundamental concept in finance
theory, and is one of the most important concepts for investors to understand.
To illustrate it further, think of lottery tickets, for example. They involve a very
high risk (of losing your money) and the possibility of an extremely high
reward. On the other end of the line, try to think of savings account on your
banks, theyre quite low-risk, but the reward is to low.
If you are a rational investor will not seek to take more risk without the
expectation of a higher return. Since the early 1950s, an enormous amount of
theoretical and empirical research has been done to characterize and quantify
the relationship between risk and return.
William Sharpe and others to develop asset valuation models, such as the

Capital Asset Pricing Model, or CAPM. CAPM introduced the concept of


combining a risk-free asset with a portfolio of risky assets to construct a
complete portfolio that resulted in an efficient trade-off between risk and
return. It also enabled a more straightforward way to quantify the risk of
individual assets by comparing the relationship of their returns with the return
of a broad market portfolio. Another important contribution of CAPM was to
extend the theoretical foundation distinguishing between the systematic risk
inherent in investing in risky assets, which cannot be eliminated, and the
unsystematic risk specific to individual firms, which can be eliminated
through sufficient diversification.
The CAPM says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium. If this expected return does
not meet or beat the required return, then the investment should not be
undertaken. The security market line plots the results of the CAPM for all
different risks (betas).
Using the CAPM model and the following assumptions, we can compute the
expected return of a stock in this CAPM example: if the risk-free rate is 3%, the
beta (risk measure) of the stock is 2 and the expected market return over the
period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
In finance, the beta () of an investment is a measure of the risk arising from
exposure to general market movements as opposed to idiosyncratic factors. The
market portfolio of all investable assets has a beta of exactly 1. A beta below 1
can indicate either an investment with lower volatility than the market, or a
volatile investment whose price movements are not highly correlated with the
market. An example of the first is a treasury bill: the price does not go up or
down a lot, so it has a low beta. An example of the second is gold. The price of
gold does go up and down a lot, but not in the same direction or at the same
time as the market.
A beta greater than one generally means that the asset both is volatile and
tends to move up and down with the market. An example is a stock in a big
technology company. Negative betas are possible for investments that tend to go
down when the market goes up, and vice versa. There are few fundamental
investments with consistent and significant negative betas, but some
derivatives like equity put options can have large negative betas.
Beta is important because it measures the risk of an investment that cannot be

reduced by diversification. It does not measure the risk of an investment held


on a stand-alone basis, but the amount of risk the investment adds to an
already-diversified portfolio. In the capital asset pricing model, beta risk is the
only kind of risk for which investors should receive an expected return higher
than the risk-free rate of interest.
Security Market Line (SML)
What Does Security Market Line (SML) Mean?
A line that graphs the systematic or market risk versus the return of the whole
market at a certain point in time. SML shows all risky marketable securities.
Also referred to as the characteristic line.
Investopedia explains Security Market Line (SML)
The SML essentially graphs the results from the capital asset pricing model
(CAPM) formula. The x-axis represents the risk (beta), and the y-axis
represents the expected return. The market risk premium is determined from
the slope of the SML. The security market line is a useful tool in determining
whether an asset being considered for a portfolio offers a reasonable expected
return for its risk. Individual securities are plotted on the SML graph. If a
security's risk versus expected return is plotted above the SML, it is
undervalued because the investor can expect a greater return for the inherent
risk. A security plotted below the SML is overvalued because the investor would
be accepting less return for the amount of risk assumed.
It should be on a high regard to consider what the kinds of risk are. Before we
can measure it.
1. Economic risks are risks that something will upset the economy as a
whole. The economic cycle may swing from expansion to recession, for
example; inflation or deflation may increase, unemployment may
increase, or interest rates may fluctuate. These macroeconomic factors
affect everyone doing business in the economy. Most businesses are
cyclical, growing when the economy grows and contracting when the
economy contracts.
2. Industry risks usually involve economic factors that affect an entire
industry or developments in technology that affect an industrys markets.
An example is the effect of a sudden increase in the price of oil (a
macroeconomic event) on the airline industry. Every airline is affected by

such an event, as an increase in the price of airplane fuel increases


airline costs and reduces profits. An industry such as real estate is
vulnerable to changes in interest rates. A rise in interest rates, for
example, makes it harder for people to borrow money to finance
purchases, which depresses the value of real estate.
3. Company risk refers to the characteristics of specific businesses or firms
that affect their performance, making them more or less vulnerable to
economic and industry risks. These characteristics include how much
debt financing the company uses, how well it creates economies of scale,
how efficient its inventory management is, how flexible its labor
relationships are, and so on.
4. Market risk changes in a market can affect an investments value. When
the stock market fell unexpectedly and significantly, as it did in October
of 1929, 1987, and 2008, all stocks were affected, regardless of relative
exposure to other kinds of risk. After such an event, the market is
usually less efficient or less liquid; that is, there is less trading and less
efficient pricing of assets (stocks) because there is less information
flowing between buyers and sellers. The loss in market efficiency further
affects the value of assets traded.
Standard deviation. The investment industrys primary measure of risk is
standard deviation. Standard deviation really tells you how much an
investment will fluctuate from the average return
Chance of loss. Chance of loss measures how often a fund loses money versus
makes money. Ultra-conservative investments make money 100% of the time
and never lose. At the other extreme, some Far East funds lose money as much
as 60% of the time and make money only 40% of the time. The more often a
fund loses money, the greater the patience required by the investor.
The magnitude of loss. When an investment loses money, how much could a
fund lose in any given year? Measuring this will tell us the tolerance we have
for loss.
Draw down. According to Levi Folk of Fundlibrary.com, A draw down is the
loss incurred in a fund from any high point in the funds value until the fund
recovers that value. Drawdowns are typically expressed as a percentage from a
previous high.

Beta ratios. Beta ratios are used to measure the risk of an investment relative
to the risk of a comparable market benchmark

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