Risk and Return

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Overview

The Risk - Return Relationship

Another fundamental relationship in the study of finance is the relationship between expected return and the expected level of associated risk. The nature of the relationship is that as the level of expected risk increases, the level of expected return also increases. The opposite is true as well. Lower levels of expected risk are associated with lower expected returns. This RISK-RETURN RELATIONSHIP is characterized as being a direct relationship or a positive relationship.

Business firms operate and invest in risky environments. Since these risks impact the level of returns from business investments, they directly affect the economic value of both individual investment projects and the firm as a whole. Because of this, the potential risks associated with project investments must be taken into account when making investment decisions.

The "expectational" nature of the relationship.

It should be noted that the risk-return relationship is stated in expectational terms. That is, it focuses on expected risk and expected returns. When an investment decision is made, the decisions reflect expectations about future performance. After the investment has been made, actual returns and actual risks may be different from what was originally anticipated. The important point, however, is that when investment decisions are made, greater levels of expected risk should be compensated for by greater expected returns on the investment.

A general definition of risk.

In its most general definition, risk is nothing more than the possibility of something unexpected happening. These unexpected occurrences could either have a positive or a negative effect on our personal financial well-being or the financial well-being of our company. In its broadest sense, then, risk is essentially the unknown or uncertainty. Finance related risks can then be thought of as the impact of the unknown on an...
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