What is the Relationship Between Risk and the Required Rate of Return?
Expected return is by no means a guaranteed rate of return. Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on. Calculate the market risk of a portfolio of investments. Explain the relationship between an investor's required rate of return on an investment and the riskiness of. Expected rate of return and the risk you are taking have a positive correlation. That's why it is said, if you want higher returns, you will have to take higher risk.
These conditions include expected future government deficits or surpluseschanges in Federal Reserve monetary policy that is, the rate of growth of the money supplyand cyclical business conditions. The liquidity or maturity premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity.
The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer-term securities.
Relationship Between Risk and Return Financial Management
As we shall see in Chapter, the value of a bond tends to vary more as interest rates change, the longer the term to maturity. Thus, if interest rates rise, the holder of a long-term bond will find that the value of the investment has declined substantially more than that of the holder of a short-term bond. In addition, the short-term bondholder has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate.
The long-term bondholder must wait much longer before this opportunity is available. Accordingly, it is argued that whatever the shape of the yield curve, a liquidity or maturity premium is reflected in it. The liquidity premium is larger for long-term bonds than for short-term bonds. Finally, according to the market segmentation theory, the securities markets are segmented by maturity.
If strong borrower demand exists for long-term funds and these funds are in short supply, the yield curve will be upward sloping. Conversely, if strong borrower demand exists for short-term funds and these funds are in short supply, the yield curve will be downward sloping. Several factors limit the choice of maturities by lenders. One such factor is the legal regulations that limit the types of investments commercial banks, savings and loan associations, insurance companies, and other financial institutions are permitted to make.
Another limitation faced by lenders is the desire or need to match the maturity structure of their liabilities with assets of equivalent maturity.
The Risk / Rate-Of-Return Relationship - eXtension
For example, insurance companies and pension funds, because of the long-term nature of their contractual obligations to clients, are interested primarily in making long-term investments.
Commercial banks and money market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the form of deposits that can be withdrawn on demand. At any point in time, the term structure of interest rates is the result of the interaction of the factors just described. All three theories are useful in explaining the shape of the yield curve. The Default Risk Premium U.
In contrast, corporate bonds are subject to varying degrees of default risk. Investors require higher rates of return on securities subject to default risk. Over time, the spread between the required returns on bonds having various levels of default risk varies, reflecting the economic prospects and the resulting probability of default.
For example, during the relative prosperity ofthe yield on Baa-rated corporate bonds was approximately. By lateas the U. In mid, the spread narrowed to 0.
The spread expanded to 0. Seniority Risk Premium Corporations issue many different types of securities. A partial listing of these securities, from the least senior that is, from the security having the lowest priority claim on cash flows and assets to the most senior, includes the following: Generally, the less senior the claims of the security holder, the greater the required rate of return demanded by investors in that security.
For example, the holders of bonds issued by ExxonMobil are assured that they will receive interest and principal payments on these bonds except in the highly unlikely event that the company faces bankruptcy. In contrast, ExxonMobil common stockholders have no such assurance regarding dividend payments.
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Also, in the case of bankruptcy, all senior claim holders must be paid before common stockholders receive any proceeds from the liquidation of the firm. For example, there is very little marketability risk for the shares of stock of most companies that are traded on the New York or American Stock Exchange or listed on the NASDAQ system for over the counter stocks.
For these securities, there is an active market. Trades can be executed almost instantaneously with low transaction costs at the current market price. In contrast, if you own shares in a rural Nebraska bank, you might find it difficult to locate a buyer for those shares unless you owned a controlling interest in the bank.
When a buyer is found,that buyer may not be willing to pay the price that you could get for similar shares of a largerbank listed on the New York Stock Exchange.
The marketability risk premium can be significantfor securities that are not regularly traded, such as the shares of many small- and medium-size firm. Business and Financial Risk11 Within individual security classes, one observes significant differences in required rates of return between firms.
May also be called a investor. But if the company is successful, you could see higher dividends and a rising shareShare A piece of ownership in a company. But it does let you get a share of profits if the company pays dividends. Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested. DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments.
The idea is that some investments will do well at times when others are not. May include stocks, bonds and mutual funds.
The Risk / Rate-Of-Return Relationship
The equity premium Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free. The government is unlikely to default on its debtDebt Money that you have borrowed.
You must repay the loan, with interest, by a set date. At the other extreme, common shares are very risky because they have no guarantees and shareholders are paid last if the company is in trouble or goes bankrupt.
Investors must be paid a premium, in the form of a higher average return, to compensate them for the higher risk of owning shares. The additional return for holding shares rather than safe government debt is known as the equityEquity Two meanings: The part of investment you have paid for in cash. Investments in the stock market. This Interactive investing chart shows that the average annual return on treasury bills since was 4.