Investment Risks Principles - Essay Example

The above risk profile of the different investments reflects a combination of the different risks and expected returns on all four investments. The principle is that higher the risk, higher the return shall be provided to the investors. Based on this principle, the above graph indicates that as the risk increases so do the expected return. Risk here is defined as the variability in the expected cash flows to be transferred to the shareholders therefore higher this variability is; more volatile will be the return therefore in order to compensate the investors for increased risks investors must therefore get higher returns. It is also important to note that the relative degree of risk against the return does not need to be in linear relation i.e. it is not necessary that the risk and return increase in same proportion however, if risk increases, it is necessary that the return must increase too in order to compensate the investors for taking increased risk. (Ante, 2009). The above graph therefore indicates that the investment four has the highest risk and highest return whereas investment 1 has the lowest risk and lowest return. This graph also indicate that the investors may be preferring different combinations of the investments i.e. the investment that is providing lowest returns may be made in the government treasury securities whereas investment providing highest returns may made in the stocks of a corporate as the stocks provide highest returns and also carry greatest risk among all instruments of investment. Second It is important to understand that the expected return is always calculated by multiplying the return with the probability and the resulting figure is called the expected return on any investment. Therefore the investment that provides highest expected return shall be chosen over other investment. The investor should choose an investment that pays a guaranteed return of 7% because given the overall probability of different returns, the investors will get the expected return of 5% with a probability of 0.5 whereas the investment providing 7% result has the probability of 1 that means the expected return will be 7% which is highest as compared to other investment. The higher the probability greater are the chances that the return will be guaranteed therefore an investment with a lower probability will yield lower expected returns whereas an investment with higher probability of getting the same return will yield higher expected returns. Therefore in this case, since the probability of getting 7% return is 1 (100%) therefore investor shall choose this investment. Third Foreign Corporate Stocks are most risky investments because they carry additional risk elements such as political risk, foreign exchange risk as well as the risk that stocks are most risky investments because shareholders, in case of liquidation of the firm are paid in last. Foreign exchange risk is the most significant element of the risk in foreign corporate stocks because dividends or capital gains have to be translated from foreign currency to local currency. Any adverse movement therefore can result into more volatility hence higher risks. U.S. Corporate Stocks are more risky because shareholders are paid in the last in case of liquidation. Under the law, shareholders are the last category of stakeholders who are paid out of the sale proceeds after satisfying the claims of all stakeholders. It is important to note that the investors may not get anything at all if all the proceeds, in case of liquidation, are appropriated among the existing claim holders. Corporate bonds are the third class of assets which are most risky because corporate bonds carry the risks which are individual to companies. Thus the relative risk of bonds changes according to the individual credit ratings of the firm. However, bond holders are assured to get a fixed some in the form of coupon interest during the life time of the bond as well as whole principal amount is also paid at the time of maturity of the bonds. Lastly, treasury bonds are least risky because they are issued by the Government and as such government does not default on their commitments therefore treasury bonds are least risky. However, rate of return offered on treasury bonds are low as compared to other investments because the risk is low i.e. it is assumed that the government will not default on its commitments and as such the investment in the treasury bonds is risk free investment. Treasury bonds are issued by the government of United States and are backed up government security against the risk of default against these securities. (Burghardt & Terry, 1993) Fourth For a retiree, an investment into treasury stocks will be ideal because it offers no risk and guaranteed returns with little or no volatility. It is assumed that the people of higher age groups prefer to have a continuous and certain income streams to be flowing to them because they are retired with no other source of income. Thus an ideal investment for such person would be an investment which offers lowest risk and consistent guaranteed returns. For a young grad, an investment into corporate stocks will be ideal because stocks provide highest returns however, risk is higher too. This is so because young MBA may have other sources of income to support himself too therefore in order to gain more quickly it is critical that an investment into the stocks shall be made because returns are highest when one invests into the stocks. Lastly, our professional who is looking for good investment income can either invest into corporate bonds or make a portfolio carrying treasury and corporate bonds as well as corporate stocks. This strategy is more relevant for a person of his age because it will not only allow building of portfolio to reduce or minimize the risk but will also offer an opportunity to get relatively handsome returns at a risk which is just matching the overall risk appetite of the investor. For this purpose, construction of a portfolio comprising of both bonds and corporate stocks therefore will serve as an ideal investment. Bibliography 1. Ante, S. E. (2009, September 29). The Return of Risk-Taking. Retrieved November 06, 2009, from Business Week: http://www.businessweek.com/magazine/content/09_40/b4149026642234.htm 2. Burghardt, G. D., & Terry, B. (1993). The Treasury Bond Basis: An In Depth Analysis for Hedgers, Speculators and Arbitrageurs (2nd Edition ed.). New York: McGraw-Hill. Read More