Question

The relationship between risk and return is an important concept as it has numerous implications for both corporate managers and investors. Corporate managers assess the risk and return of new projects or investments. Investors assess the risk and return of financial assets before making investment decisions.

Discussion Questions:

1. Explain the risk and return trade-off.

2. Describe the differences between systematic risk and unsystematic risk.

3. Provide examples of systematic risk and unsystematic risk.

   1. How both risks are measured?

   2. Which risk is more relevant? Why?

Answer 1

Question 1:

The term "Risk and Return Trade Off" refers to higher risk is associated with greater probability of getting higher return and lower risk is associated with a higher probability of getting lower returns. This trade off, which an investor faces between risk and return while considering investment decisions is called the risk return trade off.

For example, a person faces a risk return trade off while making his decision to invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank. However, if he invests in equities, he faces the risk of losing a major part of his capital along with a chance to get a much higher return than compared to a saving deposit in a bank.

Question 2:

Systematic risk means the risk is associated with the market or the segment as a whole. Unsystematic risk means the risk is associated with specific security or industry or company. Systematic cannot be avoided as it effects every one in the market. But the unsystematic risk can be avoided by diversifying the portfolio.

Question 3:

Examples for Systematic risk:

a. Change of government policies

b. Raise in Interest rates

c. Natural disasters such as earthquake, floods, etc.

d. Economic recession, ...etc.

Examples of Unsystematic risk:

a. Increased labor turnover rate due to dispute of payment related issues among employer and employee

b. Increase in research and development cost of the company

c. Increase in operational expenses,...etc.

Question 3(a):

Systematic risk can be measured using beta. Stock Beta is the measure of the risk of an individual stock in comparison to the market as a whole. Beta is the sensitivity of a stock’s returns to some market index returns (e.g., S&P 500). Basically, it measures the volatility of a stock against a broader or more general market. It is a commonly used indicator by financial and investment analysts. The Capital Asset Pricing Model (CAPM) also uses the Beta by defining the relationship of the expected rate of return as a function of the risk free interest rate, the investment’s Beta, and the expected market risk premium. Beta is also calculated using correlation or regression analysis.

Unsystematic risk is measured through the mitigation of the systematic risk factor through diversification of your investment portfolio. The systematic risk of an investment is represented by the company's beta coefficient.

Question 3(b):

Unsystematic risk is more relevant because we cannot avoid the systematic risk so we can't do anything to reduce the risk. But unsystematic risk, yes we can take some steps to reduce the unsystematic risk. This is the main reason why unsystematic risk is more relevant.