RISK RETURN ANALYSIS 1 Essay Example

LITERATURE REVIEW ON RISK-RETURN ANALYSIS

A risk-returns trade off represents a classical rationale on investor’s willingness to an additional risk with expectations of additional returns. There is a positive relationship between risk and return. The greater the expected return, the greater the risk. Inflation affects investments in the market. The difference between real and nominal rate of interest is the adjustment for inflation (lee, 2002).

Risk can be classified to either market risk or firm specific risk. Market risk is caused by changes in economic conditions and factors such as war. This can be attributed to foreign competition, changes in tax regimes and swings in business cycles firm factors such as striking workforce and death of senior employees will affect interest rates in the market. Beta is the most common measure of risk in a market. Beta measures sensitivity of shares to unexpected changes in the market. Beta measures market volatility in relation to risk. When beta=1, there is average market risk which implies that there is same market volatility. When beta>1, the firm is more volatile than the market while when beta<1 the firm under study is less volatile than the market. Beta is the slope of the characteristic line which relates company return with market return (Elton, 2010).

According to Fisher effect, 1+i= (1+R) (1+r)

i=R +r+ Err

Risk is the difference between actual and expected returns. Risk is the measure of variation between present and future cash flows. Risk can be measured using the standard measure returns. Default risk measures the possibility of borrower not paying the debt in the future. Risk premium represents additional return expected for assuming risk (Lee, 2002).

The required rate of return for treasury security is equivalent with the risk-free rate of return. This is because of absence (free) default risk for treasury securities. Corporate securities incorporate risk premium in the determination of required rate of return. The three most common measures of risk include variance, beta and standard deviation. Standard deviation I the scientific approach of measuring risk. Increase in standard deviation reflects increase in uncertainty and thus great risk (Elton, 2010).

Literature Review on risk (beta) and return analysis (existing current literature)

Share preference in the market depends on levels of risk tolerance of the investor. Risk management involves risk diversification, risk transfer, risk avoidance among other measures in the market. Risk diversification involves combination of several securities into a single portfolio. This means that incidences of risk reduction will result from offsetting losses from one portfolio with profits from another portfolio. For positively correlated securities, investment in two securities will result in no risk. Risk minimization will occur for securities with perfect negative correlation (lee, 2002).

Different factors affect/determine portfolio risk. The factors include individual asset risk factor in the portfolio, amount of funds invested in individual assets and the relationship existing between assets in the combined portfolio in relation to risk (Jones, 2010).

Literature Review on risk (beta) and return analysis (existing current literature) 1

Capital asset pricing model pose imitations in the use of beta to measure risks in the market. Risk return relationship sometimes varies from one company to another which means there are not constant. The variation makes it difficult to measure the beta of a security. A change in sensitivity of a security as a result of one variable is unrealistic measure (Cornwall, 2013).

It does not matter how much we can invest to diversify investments but the dawning reality is it is difficult to eliminate all risk in a stock exchange market. Systematic risk cannot be diversified in any manner. The common examples of systematic risks include wars, recessions and interest rates change which result from unexpected changes. Unsystematic risks are specific risks as they can be related to an individual stock in the market. General market movements do not affect returns of a specific stock. Unsystematic risk can be eliminated through diversification. The limitation is that it cannot eliminate problem of systematic risk.

Beta measures market volatility. Market volatility scares away potential investors. We have three different types of investors; risk averse, risk neutral and risk lover. Risk-averse stock investors in the New York stock exchange fear price fluctuations of the stocks. Price fluctuations will make investors lose a part of value of stock shares. Right decisions from investor will make tem make good value from their speculative investments in the New York Stock exchange market. Beta measures the degree of price fluctuations in the stock exchange market. Beta is useful in measuring the relative stock market riskiness (Jones, 2010).

Regression analysis uses bet n the risk measure of stocks in a given stock market. When beta is one, it measures the security price moves in the same direction with the market. High tech stocks have a beta of more than one while utility stocks have beta less than one(Cornwall,2013).

References

CORNWALL, J. R., VANG, D. O., & HARTMAN, J. M. (2013). Entrepreneurial financial management: an applied approach. Armonk, N.Y., M.E. Sharpe.

ELTON, E. J. (2010). Modern portfolio theory and investment analysis. Hoboken, NJ, J. Wiley & Sons.

JONES, C. P. (2010). Investments: analysis and management. Hoboken, NJ, John Wiley & Sons, Inc.

LEE, C. F. (2002). Advances in investment analysis and portfolio management. Volume 9 Volume 9. Amsterdam, JAI. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&A N=199088.