Chapter 3:RISK AND RETURN
Definition of investment
A current commitment for a period of time in order to derive future payments that will compensate for:
⭐ the time that the funds are committed
⭐ the expected rate of inflation
⭐ uncertainty of future flow of funds
Types of income
❤Active income-wages, pensions, bonus
❤ Passive income - real estates, income from tax investments
❤ Portfolio income-shares, bonds. saving accounts, dividend, capital gains
Risk
✅ Uncertainty that an investment will earn its expected rate of return
✅ As a chance of monetary loss
✅ Probability is the likelihood of an outcome
Systematic Risk
🚩 Occurs outside of the company and beyond the financial manager beyond control
Unsystematic risk
🚩 Occurs inside the company within financial manager control
🚩 Risk cannot be reduced or eliminated but can be reduced to some extend with proper mix of securities in portfolio investment.
Sources of risk
❗ Business risk-caused due to the mismanagement of the company assets
❗ Financial risk-Caused by the improper financing mix used by the company to finance its investment
❗ Liquidity risk-Not being able to convert the asset into cash at short notice without losng value
❗ Exchange rate risk-Affect the investors return when converting an investment back into the "home" currency
❗ Country risk-Political risk is uncertainty of returns caused by the possibility of major change in the political or economic environment in country
Return
🔥 The reward of investing
🔥 It consist of a periodic cash payment(interest, dividend) or current income
Classification of return
: ❤ Rate of return-can earn from investing in the various types of assets
❤ Expected return-Investing in a particular investment over a period
❤ Realized return-Actual return. It can be more or less from expected return
❤ Required return minimum rate of return required by investors to compensate to taking a level of risk
Measure of return
⚠ Expected return = (Ending value – Beginning value) + income/ Beginning value
⚠ Rate of return= (real rate of return + Expected inflation) + Risk premium
⚠ HPR= Ending value of investment/Beginning value of investment