How Can Risk Influence Risk Premium? How Are Risk and Return Related?

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How can risk influence risk premium? How are risk and return related? Risk and return are the fundamental basis upon which investors make their decision whether or not they should invest in a particular investment. How they are related and the influence between the two, is the decision making process that all investors must weigh up. This essay will show how risk can influence risk premium, outlining their relationship and how risk and return are related. Within any investment there is a certain amount of risk, which must be taken into account by an investor when deciding to invest. Risk is defined as the chance of financial loss or, more formally the variability of returns associated with a given asset. (Gitman, et al., 2011, p. 208)…show more content…
The key goal for any financial manager is to manage risk, by finding the appropriate balance between the levels of risk so that both risk premium and return can be maximised with as little risk as possible. By understanding risk and return any financial manager can implement formulas such as the one shown above to better understand the investments potential and harness the best outcome for the individual or firm. To further understand the theoretical influence risk has on risk premium, we will use the example below to illustrate their connection. The example will take into account the use of the CAPM formula to calculate the required rate of return on a Qantas share. Example The Australian Government bond rate is 3.1% (Tresury, 2012) while the average return on the All Ords Index is 10.6% (ASX, 2012) and Qantas has a Beta of 1.41. (Reuters, 2012) What should be the required rate of return on Qantas Airways Ltd shares? Rj = Rf + [Bj (Rm-Rf)] Rj= the required rate of return Rf= 3.1 Bj= 1.41 Rm= 10.6 Solution Rj = 3.1 + [1.41 (10.6-3.1)] Rj= 3.1 + [10.575] Rj= 13.675 From the solution we see that according to CAPM, Qantas shares should be priced to give a 13.675% return on the original investment. However if the risk free rate and therefore, the government bond rate were to change to 8% the required rate of return on an investment in Qantas shares would

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