• Unit 4: Risk and Return

    Unit 4 provides an explanation of the relationship between risk and return. Every investment decision carries a certain amount of risk. Therefore, the role of the financial manager is to understand how to calculate the "riskiness" of an investment so that he or she can make sound financial and business decisions. For example, you are the financial manager for a large corporation and your boss has asked you to choose between two investment proposals. Investment A is a textile plant in a remote part of a third world country. This plant has the capacity to generate $50 million dollars in yearly profits. Investment B is a textile plant located in the United States, near a small Virginia Town with a rich textile industry tradition. However, investment B's capacity for profits is only $30 million (due to higher start-up and operating costs). You are the financial manager. Which option do you chose? While investment A has the capacity to yield significantly higher profits, there is a great deal of risk that must be taken into consideration. Investment B has a much lower profit capacity, but the risk is also much lower. This relationship between risk and return is explained in this unit. Specifically, you will learn how to compute the level of risk by calculating expected values and the standard deviation. Also, you will learn about handling risk in a portfolio with different investments and how to measure the expected performance of a stock investment when it is being affected by the overall performance of a stock market.

    Completing this unit should take you approximately 3 hours.

    • Upon successful completion of this unit, you will be able to:

      • compute expected values when risk issues need to be considered in finance;
      • explain why the standard deviation is used in finance as a measure of risk;
      • explain how the financial manager makes financial investment decisions when confronted with issues of risk and uncertainty while considering different risk preferences; and
      • analyze an investment portfolio and apply market betas to the analysis.

    • 4.1: Probabilities, Expected Value, Standard Deviation, and Risk-Return Tradeoff

      • Basic Introduction to Risk and Reward Page

        Watch this video, which gives an example of the relationship between risk and reward.

      • Uncertainty, Expected Value, and Fair Games URL

        Read this section about the basis for the analysis of individual decision making in uncertain situations.

      • Understanding Return Page

        This section introduces risk and return; understanding return; portfolio concerns such as diversification and weighting and expectations for expected returns; implications across portfolios; diversification and understanding security lines. Risk considerations include the types of risk and measuring risk. Why are these topics of risk and return important to consider?

    • 4.2: Uncertainty in Capital Budgeting

      • Risks Involved in Capital Budgeting Page

        Read this section and pay attention to the risks associated with capital budgeting. Why is risk in capital budgeting important to understand and be able to apply? The process of capital budgeting must take into account the different risks faced by corporations and their managers.

    • 4.3: Risk and Reward in a Portfolio

      • Risk Page

        Read this chapter to learn more about risk and return. When and how is risk and return used in a business setting?

    • 4.4: Risk Diversification in a Portfolio

      • Portfolio Considerations Page

        Read this section about portfolio diversification and weighting, implications for expected returns, and implications for variance.

      • Diversification Page

        This section discusses diversification and the impact of diversification on risk and return. Unsystematic risk addresses the impact of diversification on risk and return. Systematic risk evaluates the impact of diversification on risk and return. Corporations use these concepts to manage their investment portfolios and achieve the best returns possible given existing market conditions.

    • 4.5: Risk of Stock Investments and Market Betas

      • Announcements, News, and Returns Page

        This section discusses capital structure, optimal capital structure, debt and equity, and cost of capital considerations. Why are these concepts important when managing a business?

      • Implications Across Portfolios Page

        Read this section to learn more about risk and return, implications across portfolios, and the beta coefficient for portfolios. Why are these topics important to businesses?

      • Understanding the Security Market Line Page

        Read this section about expected risk, risk premium, defining the security market line, and the impact of the SML on the cost of capital.