Question
In: Finance
Explain how risk affects investment decisions of the firm and the trade-off with expected return.
Explain how risk affects investment decisions of the firm and the trade-off with expected return.
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Expert Solution
Every investment opportunity carries some risks or the other. In some investments, a certain type of risk may be predominant, and others not so significant. A full understanding of the various important risks is essential for taking calculated risks and making sensible investment decisions.
Risks that affects investment decisions
Market risk
The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.
Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
Foreign investment risk
The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.
Longevity risk
The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.
Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers.
Risk-Return trade off
Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.
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