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

Topics: Investment, Capital asset pricing model, Finance Pages: 4 (1262 words) Published: May 13, 2013
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) This concept in finance is the idea that all investment carries a risk, the higher the risk, the greater the return, however the adverse is also relevant, when the risk of an investment is lower the return is expected to also be lower. However, with all investment there is never a guarantee of return. Return is the total gain or loss experienced on an investment over a given period of time. It is measured by the asset’s cash distributions plus change in value, divided by its beginning-of-period value. (Gitman, et al., 2011, p. 208) Returns on investment are the motivation to all investors, however as all investment carries a risk, the investor must have a required and expected return on the investment. Expected return, is the return that an asset is expected to produce over some future period of time, while required return, is that which an investor requires an asset to produce if he/she is to be a future investor in that asset. It is here that we see the relationship between risk and return. With the expected and required return on an asset, an investor can calculate the return of an asset and its risk. (Kidwell, et al., 2007, p. 307) To better understand this relationship we must analyse risk premium. Risk premium refers to an...
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