Page 83 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes the capital asset owner would receive. Consequently, the current price of any capital asset can be
expected, symbolically, as
n E(I ) P
P = ∑ t + n ...(3)
+
+
0 t1 (1 r) t (1 r) n
=
Where E (I ) = Expected income to be received in year ‘t’
t
P = Current price of the capital asset
0
P = Price of the asset on redemption or on liquidation
n
R = the rate of return investors expect given the risk inherent in that capital asset.
Thus, ‘r’ is the rate or return, which the investors need in order to invest in a capital asset that is
used to mark down the expected future cash flows from that capital asset.

Self Assessment
Fill in the blanks:

5. ...................... and expected returns are the two major determinants of an investment decision.
6. There is invariably a ..................................... association between the rates of return and the
asset prices.

4.4 Risk-return Relationship

The most fundamental principle of finance literature is that there is a trade-off between risk and
return. The risk-return relationship needs that the return on a security should be proportionate
with its riskiness. If the capital markets are operationally efficient, then all investment assets
should provide a rate or return that is consistent with the risks linked with them. The risk and
return are directly variable, that is, an investment with higher risk should produce higher return.
The risk/return trade-off could easily be called the “ability-to-sleep-at-night test.” As some
people can deal with the equivalent of financial skydiving without batting an eye, others are
frightened to climb the financial ladder without a secure harness. Deciding what amount of risk
you can take when remaining comfortable with your investments is very significant.
In the investing world, the dictionary definition of risk is the possibility that an investment’s
actual return will be different than expected. Technically, this is calculated in statistics by standard
deviation. Risk means you have the possibility of losing some, or even all, of your original
investment.
Low levels of uncertainty (low risk) are related 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 wish for the lowest possible risk and the highest possible return. A higher standard
deviation means a higher risk and higher possible return. The figure below corresponds to the
relationship between risk and return.

Figure 4.1: Risk and Return Relationship

Return

Low risk Average risk High risk M

Slope indicates required

Return per unit of risk

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