Question

Discussion Question 1 - Risk and Return in Finance: Why Is It So Important and How Is It Management?

Report on the reasons why risk and return are important concepts in finance. Also, identify at least two challenges that corporations face when dealing with risk and return. Finally, how corporations overcome these challenges to risk and return. Make sure to mention at least 3 sources within 300 words, please.

Answer 1

Risk Return relationship

Risk is one of the most essential components when trying to understand the Financial management.

Risk - This is the degree of willingness of an investor in parking their money in investments to varying degree : more conservative side of the spectrum, or on the risky side of the spectrum.

Risk is measured by some statistical methods such as :

1. Variance analysis.

2. Variation with average market return using coveriance / correlation vs market returns as a base.

3. Deviations , and ups and downs in the investment historically - the standard deviation.

4. Beta bottoms up calculation - Adding country risk , specific risk, leverage risk and industry risk as components, starting from a risk free investment as a base.

Reward :

1. The relationship of return/ reward with respect to risk is an inverse relationship. This is because the higher risk an investor is willing to take, the higher should be the reward for him to get compensated for the higher risk assumed.

2. CAPM model factors this in as : Required return = Risk free return + Beta * market risk premium

hence the more risky the investment is vs the market - the higher will be the required rate of return.

3. This is a fundamental concept that needs to be a part of evaluation a series of cash flows, since discounting rate for a risky investor will be higher than that of a conservative investor, and hence the cash flows generated needs to be higher (to compensate for the higher risk assumed)