Question

Is business risk the same as financial risk and interest rate risk? How about real return, expected return, and profits? Can you show how expected return is calculated?

Answer 1

A. No, Business risk is different from financial risk and interest rate risk.

Business Risk is related to risk arising from day to day operations of business whereas Finance risk and interest risk is related to risk arising from financial activities.

Business risk is concerned with all the expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses.

Financial risk is concerned with a company's ability to generate sufficient cash flow to be able to make interest payments on financing or meet other debt-related obligations.

Business Risk is general phenomena whereas Financial risk is specific to financial leverage.

Interest Rate Risk is risk arising due to fluctuations in the rate of interest in market, It is nothing but a probability of an unexpected change in market interest rate that may affect negatively.

B. Real return means return by taking into consideration inflation (if any), that is to say that when we talk about real return we must reduce the inflation from it, it is based on time value of money concept which states that " a rupee today is worth more than tomorrow"

Real return is what a person actually earns and not what he thinks he has earned.

The reason these calculations exist is that inflation reduces the purchasing power of each dollar of savings you hold. If you keep your money in a safe, it's nominal value remains the same, but the real value of each dollar is diminished by the inflation rate.

On the other hand, expected return is based on historical data, which may or may not provide reliable forecasting of future returns. Hence, the outcome is not guaranteed. Expected return is simply a measure of probabilities intended to show the likelihood that a given investment will, on average, generate a positive return, and what the likely return will be.

Expected Return = SUM (Return_i * Probability_i), where i indicates each known return and its respective probability in the series.

Example: Assume an investment manager has created a portfolio with Stock A and Stock B. Stock A has an expected return of 30% and a weight of 30% in the portfolio. Stock B has an expected return of 25% and a weight of 70%. What is the expected return of the portfolio?

E(R) = (0.30)(0.30) + (0.70)(0.25)
= 9%+ 17.5% = 26.5%

so the expected return in this scenario will be 26.5%