Management Accounting Interview Questions, Cheque Truncation System Interview Questions, Principles Of Service Marketing Management, Business Management For Financial Advisers, Challenge of Resume Preparation for Freshers, Have a Short and Attention Grabbing Resume. Content Guidelines 2. Investment-grade corporate bonds 4. There will be situations that result in differences in the ordering of risk and required returns. One such factor is the legal regulations that limit the types of investments commercial banks, savings and loan associations, insurance companies, and other financial institutions are permitted to make. Understanding the relationship between risk and return will help you choose the right investments. Over time, the spread between the required returns on bonds having various levels of default risk varies, reflecting the economic prospects and the resulting probability of default. Over the decade from 1991 to 2000, the operating profit margin ratio for Southwest Airlines was consistently higher and much less variable from year to year than for US Airways.As a stronger, and more efficient firm, Southwest Airlines can be expected to have a lower perceived level of business risk and a resulting lower required return on its common stock (all other things held constant). Risk and Return Relationship in Financial Management. Furthermore, interest rates within each maturity segment are determined to a certain extent by the supply and demand interactions of the segment’s borrowers and lenders. Each of these risk elements is examined here. Similarly, common stock investors expect to receive dividends and price appreciation from their stock. Increased potential returns on investment usually go hand-in-hand with increased risk. The Annual Rate of return would be . Broadly speaking, the Risk-Return Tradeoff from the lowest to the highest for conventional asset classes and instruments can be as follows. The term structure of interest rates is the pattern of interest rate yields (required returns) for securities that differ only in the length of time to maturity. For example, there is very little marketability risk for the shares of stock of most companies that are traded on the New York or American Stock Exchange or listed on the NASDAQ system for over the counter stocks. People invest because they hope to get a return from their investment. These risks are subdivided into business risk and financial risk. Several factors limit the choice of maturities by lenders. Select one: a. an increase in return, for a given increase in risk b. no changes in return, for a given increase in risk c. an increase in return, for a given decrease in risk d. decrease in return, for a given increase in risk The relationship between risk and required rate of return can be expressed as follows: Required rate of return = Risk-free rate of return + Risk premium The greater the variability, the riskier is the security; the lesser the variability, less risky is the security. Various changes occur in a society like economic, political and social systems that have influence on the performance of companies and thereby on their expected returns. Commercial banks and money market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the form of deposits that can be withdrawn on demand. 1. The liquidity (or maturity) premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. For example, in April 2004, the yield on 3-month U.S. government Treasury bills was 0.97 percent. The relationship between risk and required rate of return can be expressed as follows: A risk premium is a potential “reward” that an investor expects to receive when making a risky investment. Within individual security classes, one observes significant differences in required rates of return between firms. In the case of debt securities, no default risk means that promised interest and principal payments are guaranteed to be made. According to the expectations theory, long-term interest rates are a function of expected future (that is, forward) short-term interest rates. Accordingly, common stockholders require a higher rate of return on their investment in ExxonMobil stock than do the company’s bondholders. For example, the holders of bonds issued by ExxonMobil are assured that they will receive interest and principal payments on these bonds except in the highly unlikely event that the company faces bankruptcy. Risk is associated with the possibility that realized returns will be less than the returns that were expected. High-yield corporate bonds 5. Two approaches are followed in measurement of risk: Mean-variance approach is used to measure the total risk, i.e. Report a Violation, Relationship between Leverage and Business Risk, Techniques to Face Risk Factor in Capital Budgeting Decisions | Financial Management, Calculating the Effective Rate of Interest. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Historically, the real rate of return has been estimated to average in the range of 2 to 4 percent. No mutual fund can guarantee its returns, and no mutual fund is risk-free. According to the expectations theory, current and expected future interest rates are dependent on expectations about future rates of inflation. So cash flows are nothing but the earnings generated by the project that we refer to as returns. Seniority Risk Premium Corporations issue many different types of securities. Risk is associated with the possibility that realized returns … Accordingly, it is argued that whatever the shape of the yield curve, a liquidity (or maturity) premium is reflected in it. g. CAPM is a model based upon the proposition that any stock’s required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the risk re- maining after diversification. This includes both decisions by individuals (and financial institutions) to invest in financial assets, such as common stocks, bonds, and other securities, and decisions by a firm’s managers to invest in physical assets, such as new plants and equipment. The treasury bill rate at the time was 5.8%, and the treasury bond rate was 6.4%. In other words, it is the degree of deviation from expected return. It is the uncertainty associated with the returns from an investment that introduces a risk into a project. The standard deviation of A's returns is 4% and the standard deviation of B's returns is 6%. Actual return can be calculated using the beginning and ending asset values for the period and any investment income earned during the period. Their return is 13 to 14%. It is concerned with the impli-ca-tions for security prices of the portfolio decisions made by investors. The investor sees the risk/reward of … If, for example, inflation is expected to average 4 percent over some future period, the risk-free rate of return on U.S. Treasury bills (assuming a real rate of return of 3 percent) should be approximately equal to 3 percent + 4 percent = 7 percent by Equation . The liquidity premium is larger for long-term bonds than for short-term bonds. Under this approach the variance and standard deviation measure the extent of variability of possible returns from the expected return and is calculated as: Correlation or regression method is used to measure the systematic risk. Investment Risk and Return Assessment Hire an expert writer from Case Study Solutions Online and get the best quality and satisfying Assignment Help on Risk and Return Assessment. If, for example, all investors select stocks to maximize expected portfolio return for individually acceptable levels of investment risk, What are avoidable questions in an Interview? These conditions include expected future government deficits (or surpluses), changes in Federal Reserve monetary policy (that is, the rate of growth of the money supply), and cyclical business conditions. Sample: x = 0.63%, s = 4.25%, N = 672 months Std dev ( x ) = 4.25 / 672 = 0.164% 95% confidence interval The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer-term securities. So, when realizations correspond to expectations exactly, there would be no risk. Over the period from 1926 to 2003, investors in small-company common stocks earned average returns of 17.5 percent compared with 12.4 percent for investors in large-company stocks.12 However, these higher returns on smallcompany stocks have come with substantially more variability in annual returns. Returns on long-term corporate bonds have averaged about 6 percent, or less than one-half the returns on largecompany stocks, but the risk (standard deviation) of the returns on these bonds have also been much lower. 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