Risk & Return in Financial Management

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The concept of financial risk and return is an important aspect of a financial manager's core responsibilities within a business. Generally, the more financial risk a business is exposed to, the greater its chances for a more significant financial return. There are obviously exceptions to this, as there are many examples of irrational risks that do not come with correspondingly high returns.

Volatility

  • Volatility refers to the way prices for certain securities change during a certain period of time. It is a statistical measurement that measures the average difference between prices and the average price in the given time period. The greater the volatility of a security, the greater the uncertainty. Financial managers are often very concerned with the volatility of the stock of the company they work for as well as any stock they may have invested money into.

Risk

  • Risk is closely tied to volatility. A volatile stock or investment is risky because of the uncertainty. Risk, in this sense, does have a positive side because the uncertainty can translate into high returns as well as low returns.

Risk Premium

  • The risk premium refers to the concept that, all else being equal, greater risk is accompanied by greater returns. This is an important concept for financial managers hoping to borrow money. Lenders will look closely at a company to determine how risky they believe the company is and will base their decision to lend to that company on that level of risk. Additionally, if the lender does agree to lend money to a risky business, they will require a greater return in the form of higher interest rates.

Financial Leverage

  • Most companies are financed through either debt or equity. Equity financing comes from shareholders, the owners of the company. These shareholders share in the earnings of the company in an amount proportional to their investment. Debt financing comes from lending institutions, and, while the borrowing company must pay regular interest payments to its lender, it does not need to share earnings with the lender. For this reason, a company can use debt rather than additional equity to finance its operations and magnify the profits with respect to the current equity investment. At the same time, losses are also magnified through this financial leverage. This is the fundamental risk/return consideration in the makeup of a company's financing.

Interest Rate Risk

  • In addition to the outside investments made by a company, a financial manager faces other risks as well. For example, when using financial leverage, a financial manager must worry about the interest rates the company is paying because the corresponding interest payments could put a significant strain on the company's cash flow and could ultimately cause the company to default on its loans and declare bankruptcy.

References

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