The Relationship Between Risk And Expected Returns

1089 Words May 9th, 2016 5 Pages
The Relationship Between Risk and Expected Returns
According to investment glossaries, a risk is a future probability of loss inherent in any investment (Investopedia Financial Dictionary, 2016). To this day, the positive correlation between risk and return continues to be the cornerstone of financial theory. The basic capital asset pricing model (CAPM) formula is built on this relationship. CAPM provides the required return based on the level of systematic risk of an investment. The risk associated with an investment is taken to lie along a scale. On the low-risk end of the scale, there are low yielding government bonds and securities. At the middle of the spectrum are medium performing investments – such as high yielding loan notes, and rental property. At the far end of the scale – high-risk – are futures, options, and equity investments. However, the positive relationship between risk and return does not guarantee that taking a greater risk will result in higher returns. Rather, a higher risk may lead to the loss of a greater amount of capital. This paper seeks to examine the risk and return relationship and how investors can determine the optimal trade-off.
The risk-return principle. It is a principle that the potential returns on investment rise with the increase in risk. According to this principle, low levels of uncertainty – like in the case of government bonds – have low potential returns. For instance, a US five-year Treasury bond yields a return of 1.125…
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