Risk and Return Concepts in Financial Management

This article discusses the key concepts of risk and return in financial management, including the direct relationship between them and the importance of maintaining a proper balance of risk. The article also covers diversification and the risk-return trade-off. Two examples are provided to illustrate the calculation of expected return, variance, and standard deviation. References are included.

Question 1
Understanding of risk and return concepts is the most important aspect of financial
management. There is a direct relationship between a risk and the return function of an
investment. The main objective of risk-return analysis is the maximisation of return by
maintaining a proper balance of risk. The term return implies the amount generated by an
investment in a particular period of time. There can be various factors that allows an
investment to generate return such as capital appraisal, dividend or interest on such
investment, positive hedging against the inflation (Hull, 2012). The term risk is defined as the
likelihood of deviation of actual return from the expected return on the negative side. The
degree of investment risk depends on various factors such as features of assets, type of
investment instruments etc. In fact the risk and return terms are the key determinants of prices
of the shares. The investment that carries low risk has the potential to offer only low return
(defensive assets) and the investment that has the potential to offer high return generally
involves higher degree of risk (growth assets). In order to minimise the risk on the
investment, a rational investor would diversify its investments by applying different portions
of total investments to different areas. This strategy works because of the fact that each
security holds different risk. Even if the risk of one particular security increases, the other
investments could be saved from such risk. As per the risk return trade off, the money
invested can only generate higher profits when there is a possibility of it being lost (Jordan,
Miller & Dolvin, 2012).
Question 2
A B
Return 10% 15%
SD 5% 20%

r= 0.25
Rf 0.05
Wa 0.25
Wb 0.25
Wrf 0.5
Expected
Return= RaWa + RbWb + RfWf
(0.10*0.50 + 0.15*0.25 + 0.05*0.50)
11.25%
Variance
SDa2 Wa2 + SDb2 Wb2 + SDf2 Wf2 + 2 WaWbWf Sda Sdb Sdf
rab
Sd=
(0.052*0.252) +(0.202*0.252) +( 0*0.50)+
( 2*.25*.25*.50*.05*.20*0*.25)
Variance 0.27%
SD 5.15%
Note: Since SD of risk free asset is zero

Question 3
Return 17%
Standard Deviation 27%
Treasury Bill Rate 7%
W1 70%
W2 30%
Expected Return = W1R1 + W2R2
(0.17*0.70 ) + (.07*0.30)
Expected Return = 14%
Risk
Variance= SD12 W12 + SD22 W22 + 2 W1W2 Sd1Sd2r12
Variance= 3.57%
Standard Deviation 18.90%
Note: Standard Deviation of a risk
free asset is zero.

References:
Hull, J. (2012). Risk management and financial institutions,+ Web Site (Vol. 733). John
Wiley & Sons.
Jordan, B. D., Miller, T. W., & Dolvin, S. D. (2012). Fundamentals of investments: valuation
and management. McGraw-Hill Irwin..