the risk-return spectrum (also called risk-return tradeoff or risk-reward ) is the relationship between the amount of profit earned on an investment and the amount of risk done in that investment. The more you look for, the more risk you have to make.
Video Risk-return spectrum
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There are various possible investment classes, each with their own position on the overall profit-risk spectrum. The general developments are: short-term debt; long-term debt; property; high yielding debt; justice. There are many overlapping ranges for each investment class.
All of this can be visualized by plotting the expected return on the vertical axis against risk (represented by the standard deviation on expected returns) on the horizontal axis. This line starts at a risk-free level and increases as risk rises. The lines will tend to be straight, and will be straight at equilibrium - see the discussion below about dominance.
For certain types of investments, the line drawn from the risk-free rate on the vertical axis to the point of risk return for the investment has a slope called the Sharpe ratio.
Short-term loans to good government agencies
At the lowest end are short-term loans to governments and government-guaranteed entities (usually semi-independent government departments). The lowest of all is the risk-free rate of return. The risk free rate has zero risk (most modern governments will inflated and monetize their debt rather than default), but the return is positive because there is still a component of time preference and premium inflation with the expected minimum rate of return. which must be met or exceeded if funding will come from the provider. The risk-free rate is usually estimated by a 30-day or equivalent payback, but in reality it is more related to the monetary policy of the country's central bank than the market supply conditions for credit.
Medium and long term loans to good government agencies
The next type of investment is long-term loans to the government, such as 3-year bonds. The width of the range is greater, and follows the influence of the increased risk premium required as the debt matures grow longer. However, due to good government debt, the highest end of this range is still relatively low compared to other types of investment discussed below.
Also, if the government concerned is not in the highest jurisdiction (that is, the state or municipal government), or the smaller the government, the greater the spectrum of profit-risk becomes government securities.
Short-term loans for blue-chip companies
Following investments with the lowest risk are short-term bills from big blue-chip companies with the highest credit ratings. The farther from the perfect credit rating, the higher the spectrum of risk returns that will be a particular investment.
Medium-term and long-term loans to blue chip companies
The overlapping range for short-term debt is the long-term debt of companies that are rated as good. This is higher in reach because its maturity has increased. Overlap occurs from medium-term debt of the best rated company with near-perfect corporate short-term debt, but does not have a perfect rating.
In this arena, the debt is called investment grade by the rating agency. The lower the credit rating, the higher the yield and thus the expected result.
Rental properties
Commercial properties that investors rent out are proportional to risk or return to low investment levels. Industrial properties have higher risks and returns, followed by housing (with the possible exception of the investor's own home).
High yield debt
After a return on all classes of investment grade debt, go back to the high-yield debt of speculative rate (also known as junk bonds). This may come from lower-middle-ranking companies, and less politically stable governments.
Equity
Return on equity is profit earned by the business after interest and taxes. Even equity returns at the highest-rated firms are very risky. Small hat stocks are generally more risky than big hats; companies that primarily serve the government, or provide basic consumer goods such as food or utilities, tend to be more unstable than in other industries. Note that because stocks tend to rise when corporate bonds fall and vice versa, portfolios that contain small percentages of stocks can be less risky than those containing only debt.
Options and futures
Options and futures contracts often have an effect on the underlying stocks, bonds or commodities; This increases profit but also risks. Note that in some cases, derivatives can be used to hedge, lowering overall portfolio risk due to negative correlation with other investments.
Maps Risk-return spectrum
Why development?
The existence of risk leads to the need to spend a certain amount of costs. For example, the more risky investment, more time and effort is usually required to obtain information about it and monitor its progress. For others, the importance of losing X amounts is greater than the importance of obtaining X amounts, so riskier investments will attract higher risk premiums even if the estimates are equal to less risky risks. investation. Therefore, risk is something to be compensated for, and the greater the risk, the more compensation it needs.
If the investment has a high rate of return with low risk, eventually everyone wants to invest there. It will lower the actual rate of return achieved, until it reaches the rate of return that the market considers equal to the level of risk. Similarly, if investments have low returns with high risk, all investors now want to abandon that investment, which will then increase the actual profit until it reaches the rate of return that the market considers equal to the level of risk. Part of the total return that sets the appropriate rate is called the risk premium.
Leverage expands the spectrum
The use of leverage can expand further development. Examples include borrowing funds to invest in equities, or use of derivatives.
If leverage is used then there are two lines, not one. This is because even if one can invest at a risk-free rate, one can only borrow at an interest rate in accordance with its own credit rating. This is visualized by a new line that starts at the point of investment without the most risky risk (equity) and rises on a lower slope than the original line. If this new line is traced back to the vertical axis of zero risk, it will cross it at the loan level.
Domination
All types of investments compete against each other, even though they are in different positions on the spectrum of risk returns. Any mid-range investment can have their performance simulated by a portfolio consisting of risk-free components and the highest risk components. This principle, called property separation, is an important feature of modern portfolio theory. This line is then called the capital market line.
If at any time there is an investment that has a Sharpe ratio higher than the other then the profit is said to dominate . When there are two or more investments above the spectrum line, then the highest Sharpe ratios are the most dominant, even if the risks and returns on certain investments are lower than others. If any mid-range return falls below the spectrum line, this means that the highest risk investment has the highest Sharpe Ratio and so dominates over all others.
If at any time there is an investment that dominates then the funds will tend to be withdrawn from others and diverted to the dominating investment. This action will lower the return on that investment and increase it to others. Withdrawals and capital transfers stop when all returns are at the appropriate level for risk levels and commensurate with opportunity costs arising from competition with other types of investment on the spectrum, which means they all tend to end up with the same Sharpe. Comparison.
See also
References
- Campbell, John Y., and Luis Viceira. The term structure of a risk-return tradeoff. No. W11119. Bureau of National Economic Research, 2005.
- Lundblad, Christian. "Long-term return on tradeoffs: 1836-2003." Journal of Financial Economics 85.1 (2007): 123-150.
- Lettau, Martin, and Sydney Ludvigson. "Measuring and modeling variations in risk-return tradeoffs." Handbook of Financial Econometrics 1 (2003): 617-690.
- Ghysels, Eric, Pedro Santa-Clara, and Rossen Valkanov. "There is a trade off risk-return." Journal of Financial Economics 76.3 (2005): 509-548.
Source of the article : Wikipedia
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