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Principle of Utmost Good Faith

Risk and Return

Unit 4 provides an explanation of the relationship between risk and return. Every investment decision carries a certain amount of risk. Therefore, the role of the financial manager is to understand how to calculate the “riskiness” of an investment so that he or she can make sound financial and business decisions. For example, you are the financial manager for a large corporation and your boss has asked you to choose between two investment proposals. Investment A is a textile plant in a remote part of a third world country. This plant has the capacity to generate $50 million dollars in yearly profits. Investment B is a textile plant located in the United States, near a small Virginia Town with a rich textile industry tradition. However, investment B’s capacity for profits is only $30 million (due to higher start-up and operating costs). You are the financial manager. Which option do you chose? While investment A has the capacity to yield significantly higher profits, there is a great deal of risk that must be taken into consideration. Investment B has a much lower profit capacity, but the risk is also much lower. This relationship between risk and return is explained in this unit. Specifically, you will learn how to compute the level of risk by calculating expected values and the standard deviation. Also, you will learn about handling risk in a portfolio with different investments and how to measure the expected performance of a stock investment when it is being affected by the overall performance of a stock market.