Looking for the answer to the question below related to Financial Management ?
Required Return from an investment =____________
|A. Risk free return + Risk premium
B. Risk free Return – Risk Premium
C. Risk free return x Risk premium
D. Risk free Return / Risk Premium
The Correct Answer Is:
- A. Risk free return + Risk premium
The correct answer is A. Risk-free return + Risk premium because the required return from an investment is typically calculated as the sum of the risk-free return and the risk premium. This formula is fundamental in finance and investment analysis, and it reflects the principles of risk and return in financial decision-making.
Let’s explore in detail why Option A is the correct choice and why the other options (B. Risk-free Return – Risk Premium, C. Risk-free return × Risk premium, and D. Risk-free Return / Risk Premium) are not accurate in this context.
A. Risk-free return + Risk premium (Correct):
The formula for calculating the required return from an investment is typically expressed as the sum of two components:
- The risk-free return, which represents the return that an investor could earn with certainty and without exposure to any financial risk. It is often associated with investments in low-risk assets like government bonds.
- The risk premium, which represents the additional return demanded by investors to compensate for taking on various types of financial risk. This risk premium varies depending on the specific type of investment and the level of risk associated with it.
By adding the risk-free return to the risk premium, investors determine the minimum expected return they should receive for taking on a particular level of risk. The risk premium can be thought of as the extra compensation for bearing risk, which varies from one investment to another.
Now, let’s examine why the other options are not correct in this context:
B. Risk-free Return – Risk Premium (Not Correct):
Subtracting the risk premium from the risk-free return is not the correct formula for calculating the required return from an investment. This would result in a negative number, which does not make sense in the context of expected returns. The required return should be greater than the risk-free return to account for the risk premium.
C. Risk-free return × Risk premium (Not Correct):
Multiplying the risk-free return by the risk premium is not a standard formula for calculating the required return. This formula does not reflect the principles of risk and return as understood in finance. Instead, investors typically add the risk-free return and the risk premium to determine the required return.
D. Risk-free Return / Risk Premium (Not Correct):
Dividing the risk-free return by the risk premium does not yield a meaningful result for determining the required return. It is not a recognized formula in finance for calculating expected returns. Required return is typically determined by adding the risk-free return to the risk premium, not by dividing them.
In summary, the correct answer is A. Risk-free return + Risk premium because this formula reflects the standard approach in finance for calculating the required return from an investment. It takes into account the risk-free return (a baseline return without risk) and adds the risk premium (the additional return required for taking on financial risk).
The other options do not align with established financial principles and do not provide a meaningful calculation for determining the required return. Understanding the concept of required return is crucial for making informed investment decisions and assessing the trade-off between risk and potential reward.
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