Risk & Return

Anyone used to hear the saying: “No risk no reward.” Indeed, risk and return are always linked together. In finance, an investments with high risk always implies high reward. So what is the relationship between risk and reward.

According to the text book Fundamental of Financial Management by Brigham, the formula for quoted interest rate is as follow:

            Quoted Interest Rate = r = r* + IP + DRP + LP + MRP

Where:

            r*: the real risk-free of interest.

            IP: inflation premium which is the premium to take risk of inflation.

DRP: default risk, the premium for taking risk of default which occurs when debtors or companies invested could not pay money back to investors.

LP: liquidty premium, the premium for taking the risk of liquidity which is the ability of converting securities to money.

MRP: maturity risk premium which is the premium paying for risk of maturity.

After all, this is the basic formula for investors to estimate normal interest rate or normal return for investments. They will base on economic and financial conditions to estimate r*, IP, DRP, LP, and MRP in order to have an expected normal return.

Reference:

Eugene F. Brigham. Fundamental of Financial Management. 2009. South Western Centrage Learning. Page 168-169.