Define the concept of Risk and Return. What factors cause variations in Return and Risk?

Risk and return are most important concepts in finance. In fact, they are the foundation of the modem finance theory.

Risk exists because of the inability of the decision-maker to make perfect forecast. Forecast cannot be made with perfection or certainty since the future events on which they depend are uncertain.

An investment is not risky if, we can specify a unique sequence of cash flows for it.

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But the whole trouble arises as cash flows cannot be forecasted accurately, and alternative sequences of cash flows can occur depending on the future events.

Larger the deviation from the expectations, more risky is the situation. In statistical terminology it is said to be as dispersion in a subjective probability distribution.

There exists three states of possibilities certainty, uncertainty and risk. Where risk lie between certainty and uncertainty.

Also read | Indian Insurance Company Act India [Section 2(7A)].

The return on the other hand is equal to the weighted average of the returns of individual assets or securities with weights being equal to the proportion of investment value in each asset.

This concepts refers something that received is back after investing money on diverse fixed and current assets or securities. Return has namely, the following dimensions:

  • Book vs. Market return.
  • Single period vs. Multi-period Return.
  • Ex-ante (expected) vs. Ex-post (realized) Return.
  • Security vs. Portfolio Return

Also read | Accounting Standards Meaning, and it’s needed.

Factors Cause Variations in Return and Risk:

The risk arising from the firm-specific factors is diversifiable. It is unsystematic risk. The risk arising from the market-related factors cannot be diversified.

This represents systematic risk. In CAPM, market risk primarily arises from the sensitivity of assets returns to the market returns and this is reflected by the assets beta. Just one factor the market returns affects the firm’s return.

Hence, CAPM is one factor model. The betas of the firm would differ depending on their individual sensitivity to market.

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On the other hand, APT assumes that market risk can be caused by economic factors such as changes in gross domestic product inflation and the structure of interest rates and those factors could affects firm differently, for example, different firms may feel the impact of inflation differently.

Therefore, under APT, multiple factors may be responsible for the expected return on the share of a firm.

Therefore, under APT the sensitivity of the asset’s return to each factor is estimated. For each firm, there will be as many betas as the number of factors.


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