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RISK AND RETURN_2022

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RISK AND RETURN_2022 Risk is an important concept in financial analysis, especially in terms of how it affects security prices and rates of return. Investment risk is associated with the probability ... of low or negative future returns. The riskiness of an asset can be considered in two ways: (1) on a stand-alone basis, where the asset’s cash flows are analysed all by themselves or (2) in a portfolio context, where the cash flows from a number of assets are combined and then the consolidated cash flows are analysed. Assessing the return and risk characteristics of a single security Risk is often defined as the chance of a loss. However, in a strict financial context, this is not right. Risk is synonymous with the term uncertainty; it is the uncertainty surrounding the return an investment will earn. The more variable the returns to an asset, the more uncertain they are and the more risky they are. The total rate of return on an investment is measured as the total gain or loss experienced on behalf of its owner over a given period of time. Return is the change in the asset’s value plus any cash distributions received while it is owned. The return is calculated using the following formula: Rate of return = Pt - Pt-1 + CtPt-1 Pt : The end of the period value Pt-1 : The beginning of period value Scenario analysis, while not a method for measuring risk, can be used to get a feel for risk. When different scenarios, such as pessimistic (worst case), most likely (expected), and optimistic (best), are evaluated, the greater the difference in the outcomes, the greater is the risk. If changing sales, for example, has little impact on net income, the firm is less risky than one where a small change in sales greatly affects the bottom line. The range is found by subtracting the return associated with the pessimistic outcome from the return associated with the optimistic. It is not unusual to use spreadsheets to create different scenarios as an aid to evaluating the riskiness of an investment. [Show More]

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