RISK RETURN RELATIONSHIP
A business operates in a market environment, which is not within its control. It is exposed to several dangers from the internal with external sources or factors. It may result in the incapability of the firm to withstand its competitors; its products or services may deteriorate, or become obsolete in the market. It is the duty of the finance manager to maintain all internal and external risks at the smallest and prepare the firm to face all the challenges resulting in higher shareholder wealth maximization.
Risk and return concepts are fundamental to the catching of the valuation of assets or securities. Risk may be described as 'the chance of future loss that can before- seen' implying that the extent of loss can be estimated. This is generally done by assigning probabilities to the risk on the basis of past data and the probable trends. Risk refers to the variability of expected returns related with a given security or asset. Return on an asset includes capital gain and dividend yield. The expected rate of return on a security is the total of the products of possible rates of return and their probabilities. The rate of return to a great extent depends on the
Risk involved. The relationship of return and risk are - higher the risk, higher is the return. It is also the duty of the finance manager to take all decisions which will result in shareholder wealth maximization. The word 'return' has been explained in several ways by several people.
The two main concerns of an investor while choosing a asset are the expected return from holding the asset and the risk that the actual return may be below the expected return.
The rate of return required by a business consists of three components - return at premium of business risk (business risk refers to the variability of operating profit due to changes in sales) which is the return expected by the shareholders for facing the higher risk involved, zero risk (it refers to the expected return when the risk level - business risk or financial risk, is zero) and premium for financial risk (financial risk refers to the risk on account of pattern of capital structure - that is., debt and equity mix) which represents the return expected by the share holders for the higher financial risk they are facing.
The most general and popular approaches (behavioral) to assess risk are -
Probability distribution and Sensitivity analysis. Some of the most popular statistical measures of variability of returns include - standard deviation and coefficient of variation.
The relationship between return and risk can be described by the equation
Return = Risk free rate + Risk premium