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