Corporate Finance Research Paper: Risk, Return, and Investment

This research paper explores the core concepts of risk and return in corporate finance. It begins by defining risk, return, and risk preferences, then delves into procedures for assessing and measuring the risk of a single asset, including probability distribution, sensitivity analysis, coefficient of variati...Read More

Running Head: CORPORATE FINANCE
Research Paper
Gabrielle Jobity
Salem International University
Dr. Mitchell Miller,
Corporate Finance
Risk and Return
07/28/2018

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Table of Contents
a) Explain
the meaning and the fundamentals of risk, return, and risk preferences:.................................2
b) Describe procedures for assessing and measuring the risk of a single asset. .......................2
c) Discuss the measurement of return and standard deviation for a portfolio and the concept of
correlation..................................................................................................................................3
d) Explain the risk and return characteristics of a portfolio in terms of correlation and
diversification and the impact of international assets on a portfolio. .......................................3
e) Review the two types of risk and the derivation and role of beta in measuring the relevant risk
of both a security and a portfolio...............................................................................................4
f) Explain the capital asset pricing model (CAPM), its relationship to the security market line
(SML), and the major forces causing shifts in the SML............................................................5
References:.................................................................................................................................6

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Explain the meaning and fundamentals of risk, return, and risk preferences.
In the world of investment risk is referred as the chance that an investment actual return
would be different from that anticipated. An individual making an investment anticipates
obtaining certain return from the investment in the future (Baker & Haslem, 2015). Risk
represents the uncertainty that is related with the returns from the investment that introduces risk
into the project.
Return on the other hand refers to the actual income from the project along with the
increase in the worth of capital. There are mainly two constituents of return the basic element or
the periodic cash flow from the investment either as the interest or dividend and modification in
the asset price of the asset which is generally known as the capital gains or loss.
Risk preference is defined as the attitude of people towards risks forming as the key
factor in studying the investor’s behaviour of decision making. According to Mishra, (2015)
assumptions investors are rational and believe that while making investment decisions the
investors tend to have invariant risk preferences.
Describe procedures for assessing and measuring the risk of a single asset.
The numerous process of measuring risk of single asset is given below;
a. Probability distribution: This process of risk measurement provides an insight into the
risk by expecting that the range of probable consequences and allocating the same to
different possibilities.
b. Sensitivity Analysis: This method measures the risk of single asset by employing
numerous ranges of probable yields (İmrohoroğlu & Tüzel, (2014). It judges the
numerous variances in probable outcomes.

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c. Coefficient of variations: This process is particularly used to compare the risk of assets
in terms of coefficient of variation. It considers the anticipated worth of single asset
based on the relative risks of the specified assets or vice versa.
d. Standard Deviation: This is most common process of assessing and measuring the risk
of the asset from the mean or the anticipated value or return. This process particularly
measures the distribution around the anticipated return. Standard deviation signifies that
greater the standard deviation of returns, higher is the distribution of returns, meaning
that the asset has greater level of risk.
Discuss the measurement of return and standard deviation for a portfolio and the concept
of correlation.
Measurement of return refers to the evaluation of efficiency of investment or comparing
the efficiency of number of different investment (Villadsen et al., 2017). As the anticipated
return represents the average of the profitability of probable return rates, it cannot be considered
as the guaranteed rate of return. Nevertheless, it is used to forecast the value of portfolio and
offer a guide through which actual returns can be measured.
The standard deviation of portfolio or return refers to the alternative statistical measures
that are used to measure the risk investment. These strategies measure the degree up to which
returns are anticipated to vary across average over time.
Correlation refers to the statistical measure which indicates the degree to which two or
more variables fluctuate together. A correlation coefficient refers to the statistical measure up to
which modification in the value of one variable forecasts changes in value of another.

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Understand the risk and return characteristics of a portfolio in terms of correlation and
diversification and the impact of international assets on a portfolio.
A portfolio represents the collection of all investment that is held by a person or
institution, together with the stocks, bonds and options. Majority of the portfolio are diversified
so that a protection can be offered against risk of single securities or the class of securities. The
portfolio analysis comprises of assessing the portfolio as the whole instead of trusting solely on
the security analysis forming the assessment of detailed forms of securities (Fama, 2017). The
risk and return portfolio of the security largely relies on the security itself. The risk and return
portfolio is not only dependent on the components securities but also on the combination of
allocation and on the extent of association.
Review the two types of risk and the derivation and role of beta in measuring the relevant
risk of both a security and a portfolio.
There are numerous types of risks however two specific types of risk is stated below;
a. Credit or Default risk
b. Interest rate risk
Derivatives on the other hand refer to the financial instruments whose value is derived
from other underlying assets. There are four types of derivatives are futures contracts, forwards
contracts, options contracts and swaps contracts.
a. Forward Contracts: Forward contracts occur between two counter parties which signify
that exchange is not the intermediary to these transactions.

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b. Future Contracts: Future contracts are identical to forward contracts (Baker & Haslem,
(2015). The future contracts are listed on the stock exchange meaning that the exchange
is an intermediary.
c. Option Contracts: Options is evidently different from the two types. In first two types
both the parties are bound by the contracts to discharge specific duty on a particular date.
d. Swaps: Swaps offers the participants to exchange their streams of cash flows.
Beta plays an important role in measuring the risk that originates from the exposure to the
over-all marketplace activities opposite to distinctive factors. The beta of the portfolio helps in
determining the weighted average cost of the individual asset betas (Klingebiel & Rammer,
2014). Beta plays in important role for investors measuring the risk of security and portfolio as
they can construct their portfolios with whatever the value of beta they want.
Explain the capital asset pricing model (CAPM), its relationship to the security market line
(SML), and the major forces causing shifts in the SML.
The CAPM can be defined as the model that helps in describing the relationship between
the anticipated return and risk of investing in the security. The security market line is regarded as
the visual representation of the CAPM (Chandra, 2017). It represents the relationship between
the anticipated return of the security and the risk that is measured by the beta coefficient. The
security market line helps in displaying the anticipated return for any given beta or reflects the
risk that is associated with any given anticipated return.
The main factors that are responsible for leading to shift in SML are given below;
a. Investment by individuals can result in change in position of SML.

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b. If a company’s risks changes because of the changes in one source of risk namely the
business risks, it would move along with the SML.
c. Changes in the inflationary anticipations lead to parallel shift in the SML.

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References:
Baker, H. K., & Haslem, J. A. (2015). The impact of investor socioeconomic characteristics on
risk and return preferences.
Chandra, P. (2017). Investment analysis and portfolio management. McGraw-Hill Education.
Fama, E. F. (2017). The Fama Portfolio: Selected Papers of Eugene F. Fama. University of
Chicago Press.
İmrohoroğlu, A., & Tüzel, Ş. (2014). Firm-level productivity, risk, and return. Management
Science, 60(8), 2073-2090.
Klingebiel, R., & Rammer, C. (2014). Resource allocation strategy for innovation portfolio
management. Strategic Management Journal, 35(2), 246-268.
Mishra, C. S. (2015). Risk and Return. In Getting Funded (pp. 193-218). Palgrave Macmillan,
New York.
Villadsen, B., Vilbert, M. J., Harris, D., & Kolbe, L. (2017). Risk and Return for Regulated
Industries. Academic Press.