Risk and Return

Guess it, why developed countries enjoy privilege in interest rate and developing countries are charged with very higher interest rate as compared to those of developed nations. Obviously, the answer is the risk factor involved in the transaction. The debt to developed nations are unlikely to default whereas to those of developing countries are most likely to default leaving less probability of recovery. It is same when an individual lends to other individual or invests in any available project. Financial institutions follow the same policy.

Investors or fund providers always look at the certainty of recovery of their fund and the benefit expected for their investing/lending. Cash flow reflects the availability of money at particular time in past, present and future. Therefore, finance is coherently linked with the cash flow statement. Investors and financiers takes their decision based on the future cash position of the firm. However, for every projection uncertainty exists. Before taking account of uncertainty  investors/lenders need to account for associated risk.

Standard deviation is statistical tool, which measures the risk of a project/investment. Higher value of standard deviation reflects higher risk associated with the project and lower value represents lower risk. There is tradeoff between risk and return. Risk is directly linked to return. Higher the risk, higher the return and lower the risk, lower the return.

No investment/financing can avoid market risk. Market risk exists in various forms. It is also known as systematic risk. In general risk free rate together with market premium represents systematic risk. It cannot be avoided in any investment and financing. Unsystematic risk also exists in investing and financing project. They are risk specific to the project represents operational inefficiencies. This risk can be avoided by investing in diversified projects. Investing in number of projects help diversify away the unsystematic risk.

In return for accepting systematic risk, an investor can expect different category of return. This can be illustrated in a risk return pay-off matrix. For example, a risk-averse investor will expect to earn a return, which is higher that return on risk free investment. Risk-averse investors are prepared to accept risk, in exchange for higher returns. The return on the risk free investment is supposed to be equal to the return form government bond.  A risk-seeker will be satisfied to earn lower premium for the equal weight of risk as that of the risk-averse investor. CV (coefficient of variation = standard deviation/mean)  is a unitless measure of risk, it permits comparison between reward types and risk for different projects. CV demonstrates better predictor of choice behavior.