Introduction
The purpose of business is to obtain the maximum revenue at the lowest cost of capital in a competitive environment. The realization of this goal requires of comparing the size of the capital invested in the production and trading activities with the financial results of this activity.
However, in the implementation of any kind of economic activity there is objectively a risk of loss, the volume of which is due to the specifics of a particular business. Risk is the probability of losses, damages, shortfalls of projected revenues, profits. Losses that occur in business activities can be divided into losses in materials, labor and finance.
For the financial manager, risk is the probability of an adverse outcome. Various investment projects have different degrees of risk, the most profitable option of investing can be so risky, that, as they say, "the game is not worth the candle." Risk is an economic category, so it is an event which may or may not occur. In the case of such an event, there are three possible economic outcomes: negative (loss), null or positive (gain). Commercial risks are the danger of losses in the financial and economic activity. They mean uncertainty of the outcome of the commercial transaction.
Body
The concept of trade-off between risk and return is that the receipt of any income associated with risk, and there is a directly proportional relationship: the higher the expected return, the higher the degree of risk associated with the possible non-receipt of the return. Profitability and risk, as we know, are interrelated categories. The most common patterns that reflect the mutual relationship between the risks taken and the expected return of investor activity are as follows:
• riskier investments tend to be characterized by a high rate of return;
• when revenue increases, the probability of receiving this revenue decreases, while the minimum guaranteed income can be obtained with little risk or even without risk.
The optimum ratio of profit and risk means the achievement of the maximum for the combination of "profitability - risk" or minimum for the combination of "risk - yield". This However, the following two conditions should be carried at the same time:
1) no other combination of risk and return can not provide higher returns for a given level of risk or less;
2) no other combination of risk and return can not provide less risk for a given level of return or more.
However, in practice, the investment activity is associated with multiple risks and the use of different sources of resources. So the number of the optimum combinations of risk and return increases. In this regard, in order to achieve a balance between risk and return step by step approximation solution method must be used. Implementation of the investment activity involves not only the adoption of a known risk, but also obtaining a certain income. If we assume that minimal risk corresponds to the minimum necessary income, we can distinguish several sectors, characterized by a specific combination of yield and risk: A, B, C.
Sector A, where the investments do not provide the minimum necessary income - this sector can be considered as an area of insufficient profitability. The operation in the sector C is associated with with higher risk, reducing the possibility of obtaining the expected higher incomes, so the sector C can be defined as an area of high risk. The investments in the sector B provide investors with a certain income at the acceptable level of risk, therefore, the sector B is in the region of the optimal values of the ratio of return and risk.
Risk category in financial management is seen in a variety of ways: in the evaluation of investment projects, the formation of the investment portfolio, the choice of financial instruments, the adoption of decisions on capital structure, dividend policy justification, etc.
A great contribution to the study of the relationship between risk and return has been made by famous economist Harry Markowitz in his work "A Portrfolio Selection" (1952). In this article, there was proposed a first mathematical model of the securities optimal portfolio formation ("Harry Markowitz | Jewish Virtual Library", 2016). There also were given the methods of constructing such portfolios under certain conditions. The main merit of Markowitz is the proposed in this small article theoretical probabilistic formalization of the concept of risk and return. This immediately allowed to transfer the task of choosing the optimal investment strategy on rigorous mathematical language. Markowitz was first who drew attention to the common practice of portfolio diversification and accurately showed how investors can reduce the standard deviation of portfolio returns, selecting stocks whose prices have changed in different ways. From a mathematical point of view, the resulting optimization strategy refers to a class of quadratic optimization problems with linear constraints. To date, together with the tasks of linear programming is one of the most studied classes of optimization problems, which developed a large enough number of efficient algorithms.
The main conclusions of the theory of Markowitz:
In order to minimize the risk, investors should unite risky assets in the portfolio;
The level of risk for each separate asset should be measured non-isolatedly from other assets, and in terms of its impact on the overall level of risk of a diversified investment portfolio.
At the same time, the portfolio theory does not specify the relationship between risk and return. This relationship is taken into account in the capital asset pricing model (CAPM) developed by William Sharpe, Jan Mossin and John Lintner ("Capital Asset Pricing Model - CAPM - Economics", 2016). According to this model, the required rate of return for any kind of risky assets is a function of three variables: the risk-free yield, the average return on the market index of variability and profitability of a financial asset in relation to the profitability of the market average.
Conclusion
Understanding the relationship between risk and return (in particular, how they are related in CAPM) will help me in future business venture. Now, when we considered the relationship between the risk and return, it is possible to answer the question: which is more risky – bonds or common stocks? As it was already noticed above, the higher risk is associated with higher revenue. The investments with a minimum risk give the lowest guaranteed profit. Common stocks are the riskiest securities – they associated with the highest expected return. Corporate (risky) bonds usually have the least level of risk and their return is lower than in common stocks, because bonds provide regular payments of dividends ("Are Corporate Bonds Riskier Than Common or Preferred Stock?", 2016).
References
Are Corporate Bonds Riskier Than Common or Preferred Stock?. (2016). Smallbusiness.chron.com. Retrieved 22 June 2016, from http://smallbusiness.chron.com/corporate-bonds-riskier-common-preferred-stock-38641.html
Capital Asset Pricing Model - CAPM - Economics. (2016). Economics.fundamentalfinance.com. Retrieved 22 June 2016, from http://economics.fundamentalfinance.com/capm.php
Harry Markowitz (2016). Jewishvirtuallibrary.org. Retrieved 22 June 2016, from http://www.jewishvirtuallibrary.org/jsource/biography/markowitz.html
