Page 75 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes
Figure 2.1: Risk and Return Relationship
Return

Low risk Average High risk M
risk

Slope indicates required

Return per unit of risk

Risk free return R(f)
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is
the balance between the desire for the lowest possible risk and the highest possible return. This
is demonstrated graphically in the chart below. A higher standard deviation means a higher risk
and higher possible return. The figure below represents the relationship between risk and
return.

The slope of the Market Line indicates the return per unit of risk required by all investors.
Highly risk-averse investors would have a steeper line, and vice versa. Yields on apparently
similar stocks may differ. Differences in price, and therefore yield, reflect the market's assessment
of the issuing company's standing and of the risk elements in the particular stocks. A high yield
in relation to the market in general shows an above average risk element.
This is shown in the figure below:

Figure 2.2: Risk Return Relationship of Different Stocks
Rate of
Return Risk Market Line E(r)
Premium
Ordinary shares
Preference shares
Subordinate loan stock
Unsecured loan
Debenture with floating charge
Mortage loan
Government stock (risk-free)

O Degree of Risk

Given the composite market line prevailing at a point of time, investors would select investments
that are consistent with their risk preferences. Some will consider low-risk investments, while
others prefer high-risk investments.
A common misconception is that higher risk equals greater return. The risk/return trade-off
tells us that the higher risk gives us the possibility of higher returns. But there are no guarantees.
Just as risk means higher potential returns, it also means higher potential losses.

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