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Risk And Return Essay

1306 words - 6 pages

Risk and return will be very central terms in our analysis and it is essential that the reader clearly understands the meaning of each term and how assets with different payout structures can be compared. General utility theory suggests that the average investor is risk averse. Given the same expected return of two assets with different risks, he would prefer the one with less risk. (This assumption may not be perfectly true for all individuals in all situations, but for the investor community as a whole it is probably true). For an asset with uncertain cash flows and payoffs, which are normally distributed, the mean of the distribution will be the expected return while the standard ...view middle of the document...

This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investmentA fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return
What Does Return Mean?The gain or loss of a security in a particular period. The return consists of the income and the capital gains relative on an investment. It is usually quoted as a percentageThe general rule is that the more risk you take, the greater the potential for higher return - and loss.

What Does Risk-Return Tradeoff Mean?The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.  Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night

Risk Analysis for Traders Portfolio managers traditionally are the primary users of risk models. Increasingly though, traders are using risk models to manage their positions, formulate trading strategies, and create optimized trading lists. This trend is fueled by the growth of portfolio trading, increased sophistication by both buy- and sell-side traders, and automation. High frequency (daily or weekly), stock-specific (time- series) risk models are especially useful for trading applications where parameter estimates must be cur- rent, horizons are typically short, and idiosyncratic risk is often undiversified. This section describes some interesting new uses of risk analysis in the context of trading, focusing primarily on portfolio traders. Many of our examples, however, apply equally well to single-stock traders.In large mutual fund companies, orders originate from several different portfolio managers andare aggregated by the trading desk at the open. The collective actions of several managers might...

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