Discuss the trade-off of risk – Risk Management
Identify a “risky” and a “safe” investment and provide rationale to justify your choices. Also, discuss the trade-off of risk and reward between your two investments.
Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation or by the variance term, which is simply the standard deviation squared.
A large standard deviation of the returns indicates greater riskiness associated with an investment. However, whether the standard deviation is large relative to the returns has to be examined with respect to other investment opportunities. Alternatively, probability analysis is a meaningful approach to capture greater understanding of the significance of a standard deviation figure. However, we have chosen not to incorporate such an analysis into our explanation of the valuation process.
The security market line is a graphical representation of the risk-return trade-off that exists in the market. The line indicates the minimum acceptable rate of return for investors given the level of risk. Since the security market line results from actual market transactions, the relationship not only represents the risk-return preferences of investors in the market but also represents the investors’ available opportunity set.
QUESTION: Redesign Corp is considering a new strategy that would increase its expected return from 12% to 13.9%, but would also increase its beta from 1.2 to 1.8. If the risk free rate is 5% and the return on the market is expected to be 10%, should Redesign change its strategy?
