Sri Sharada Institute Of Indian Management - Research

(A unit of Sri Sringeri Sharada Peetham, Sringeri)

Approved by AICTE

Plot No. 7, Phase-II, Institutional Area, Behind the Grand Hotel, Vasant Kunj,

New Delhi – 110070

Tel.: 2612409090 / 91; Fax: 26124092

E-mail: administration@srisim.org; Website: www.srisim.org

DEVELPOMENT DAY PROJECT REPORT

FINANCIAL RISK MANAGEMENT

SUBMITTED TO SUBMITTED BY:

PROF.HARPREET SINGH KARISHMA GUPTA
(20090127)
SHILPA JAISWAL
(20090156)

ACKNOWLEDGEMENT
I am deeply indebted to Prof. HARPREET SINGH. He gave me an opportunity to
express my sincere appreciation and deep sense of gratitude for their esteemed guidance
invaluable and inspiring suggestion, constructive criticism and keen sustained interest
in preparation of this report.

I also forward my sense of gratitude to my parents for their cooperation and

encouragement in completing my project

INTRODUCTION
Financial Risk Management
Financial risk management is the practice of creating economic value in a firm by using
financial instruments to manage exposure to risk, particularly credit risk and market risk.
Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks,
etc. Similar to general risk management, financial risk management requires identifying its
sources, measuring it, and plans to address them.
Financial risk management can be qualitative and quantitative. As a specialization of risk
management, financial risk management focuses on when and how to hedge using financial
instruments to manage costly exposures to risk.
In the banking sector worldwide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market risks.
When to use Financial Risk Management
Finance theory (i.e., financial economics) prescribes that a firm should take on a project when
it increases shareholder value. Finance theory also shows that firm managers cannot create
value for shareholders, also called its investors, by taking on projects that shareholders could
do for themselves at the same cost.
When applied to financial risk management, this implies that firm managers should not hedge
risks that investors can hedge for themselves at the same cost. This notion was captured by
the hedging irrelevance proposition: In a perfect market, the firm cannot create value by
hedging a risk when the price of bearing that risk within the firm is the same as the price of
bearing it outside of the firm. In practice, financial markets are not likely to be perfect
markets.
This suggests that firm managers likely have many opportunities to create value for
shareholders using financial risk management. The trick is to determine which risks are
cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is
that market risks that result in unique risks for the firm are the best candidates for financial
risk management.
The concepts of financial risk management change dramatically in the international realm.
Multinational Corporations are faced with many different obstacles in overcoming these
challenges. Research by many, including Raj Aggarwal has started to disclose much of the
decisions and impacts firms must make when operating in many countries. Research has
specifically identified three kinds of foreign exchange exposure for various future time
horizons, transactions exposure[1], accounting exposure[2], and economic exposure.
Megaprojects (sometimes also called "major programs") have been shown to be particularly
risky in terms of finance. Financial risk management is therefore particularly pertinent for
megaprojects and special methods have been developed for such risk management.

WHAT IS RISK
R I S K has been know to man ever since he first faced adversity. It is an
integral part of the evolution of man. Risk has been encountered primarily in
his physical environment, later on in his social environment. With time, risk
has evolved alongwith man. The main risk Neolithic man faced was an attack
by a wild animal. This was mitigated with the discovery of fire. Note:
Mitigated not eliminated. Risk can rarely, if ever, be completely eliminated.
This mitigation has now take the form hedging sales of currencies in the
future using forward contracts or options. It is risk, but it has changed with
man and his society.
R I S K is essentially, the probability that the outcome maybe damaging or result
in a loss. With risk, the outcomes of an event are thrown open to uncertainty.
Tossing a dice, is at a basic level a risky endeavor, that has uncertain
outcomes. If you were to be shot depending on the outcome of a dice roll
(say prime number you live, non-prime number you die), you would have a
50% chance of survival. A risky outcome with a level of uncertainty
involved.

W HAT are the standard types of risk?

1. Pure v/s Speculative

a. Pure Risk: The situation in which a gain will not occur. The best
possible outcome is that of no loss occurring.
E.g.: A pilot flying an airplane will be happy with not crashing the
airplane. He has not gained anything, but avoiding the catastrophe
is the best possible outcome.(This is an extreme example, intended
to clarify the concept).
b. Speculative Risk: A risk in which either a gain or a loss may occur.
E.g.: You commit to sell a bag of wheat 3 months into the future at
$10. Three months down if the price of wheat is $5 you make a
profit of $5; if it is $15, you incur a loss of $5 by not being able to
sell it at the market price. You speculated on the price of wheat 3
months into the future.

2. Diversifiable v/s Non-diversifiable

Essentially diversifiable risk is that which can be mitigated through a
process of pooling risks. Vice versa for non-diversifiable.
E.g.: This is best exemplified through the theory of portfolio
diversification. Buying one stock (portfolio of 1 stock) exposes you to 2
types of risk. Risk of the market (Systematic risk) and risk of the firm
specific stock (Non-systematic risk). Increasing the number of stocks in
your portfolio would be a form of pooling that mitigates non-systematic
risk of the whole portfolio. But the portfolio is implicitly exposed to the
systematic risk of the market.

R I S K averse individuals tend to be willing to pay the expected value of the

loss rather than face the risk of the loss. This can be explained by the fact
that the value of the loss, if incurred, is greater than the amount sacrificed by
the individual to cover that loss.
E.g.: If your house has a 20% chance of catching a fire and being destroyed.
The loss you would incur on this would be $20,000. This the absolute
amount you would lose given the house caught fire. The expected value of
this is (.2)*($20,000) + (.8)*(0) = $4,000 * . So the risk averse person would
be willing to pay $4,000 to avoid a loss of $20,000 with a 20% probability.
The amount a risk averse person is willing to pay depends on the degree of
risk aversion. This also depends on the amount of initial wealth that is at
risk. Due to the declining marginal utility of wealth (each additional unit of
wealth is less useful, as the level of wealth increase), a larger loss has a
greater impact than a smaller loss. The effect of a larger loss is to set back
the initial level of wealth, inverting the marginal utility of wealth. Though,
the fact that a larger loss sets you back is something very obvious, and would
not need an explanation.

RISK IN FINANCIAL TERMS

I N a financial context risk can be mitigated in two ways. One, by hedging

using the correlations of stocks (CAPM), secondly using derivatives.
Investors normally use both, though their applications are different.
In a portfolio, the demand for any financial asset rests on the correlation
between all the assets in the portfolio. In a portfolio, if two assets are
negatively correlated (a loss in one results in a simultaneous gain in the
other) then they have naturally hedged themselves against each other.
Financial models are used to evaluate returns on portfolios. The CAPM is the
most popular model.

CAPM

C A P M or the Capital Asset Pricing model is the most frequently used financial
model to enable portfolio diversification. If returns on risky assets have less
than perfect correlation, i.e., they do not naturally hedge against each other,
risk averse individuals diversify risk in their holding of assets. A well
diversified portfolio would have less fluctuation than returns on individually
held financial assets.

S O how does this work? Assume that you have a portfolio of financial assets
(in this case, equity securities). Each stock as explained in the types of risk,
has two elements of risk. These are systematic and non-systematic risks.
The non-systematic risk of individual securities can be mitigated through a

* * This is a pure risk; hence the opposite of the loss $20,000 is “no gain”.
well-diversified portfolio. Theoretically it can be completely negated by
holding a diversified portfolio that is identical to the market. This normally
does not happened since
a) This would be a very very large portfolio.
b) People would make money only based on the entire market moving
up or down. (i.e., if your portfolio is a perfect substitute for the
DJIA, then you will make money only if the entire market moves
up). Most people who do hold real portfolios would like to make
money regardless of the market movements.
Given that non-systematic risk is virtually nullified by a large portfolio
(CAPM assumes such a large portfolio), the only risk that remains is the
systematic risk. Thus, the only type of risk for which and investor would
earn a return would be the systematic risk. This systematic risk is measured
as Beta. Beta (β) calculates the volatility/exposure of a security’s return to
the entire market (CAPM) portfolio.

M A T H E M A T I C A L L Y this is how it is understood. A security ‘a’ has its β = σ /

a am

σ 2 β is the beta of the security ‘a’, σ is the covariance between the return
m. a am

on security ‘a’ and the CAPM portfolio (m since the ideal CAPM would be
identical to the market portfolio) and σ 2 is the variance of the return on this
m

CAPM (market) portfolio. The covariance σ can also be expressed as a

am

function of the correlation coefficient (ρ ) and the standard deviations of the

am

individual security and the market portfolio. σ = ρ σ σ . Thus the beta is

am am a m

β = ρ σ / σ .
a am a m

FINANCIAL ASSETS

E X P O S U R E of financial assets is a vast topic and very detailed to get into. This
is intended to provide a brief overview. A simple illustration of risk in
financial terms is as follows. You are issue a loan to another person. The
risk you are exposed to is that of the interest rates on loans rising after you
issued the loan. This means that the amount of money you lent could have
been invested to earn a higher return. The issued person is conversely
exposed to the risk of interest rates dropping after he borrows from you. In
the case of a company that issues debt this changes slightly. Companies
would prefer issuing debt when interest rates are low and vice versa for the
debtholders.

F I N A N C I A L assets are unique, as they do not necessarily convey rights to

specific tangible assets to the holder. Financial assets can entitle the holder
to a certain income or the right to buy another asset at a pre-specified price
in the future. For instance common stock is a financial asset. The holders of
common stock are the owners of the corporation; but they do not exercise
direct control over the physical assets of the corporation. Their ownership
role is restricted to that of a principle with the management and the board of
directors as their agents. Hence, often firms have employees as shareholder,
so that their interests are aligned with that of the non-employee shareholders.

A financial asset has one or more of the three following characteristics:

1. Ownership rights of a corporation or asset.
2. Single or Multiple series of payments.
3. Right to buy or sell another asset, subject to certain changes in
price, interest rates, volatility, time horizons.

T YPES of financial assets .

 Stock: In the form of a single share, this certifies an individuals

ownership of a certain percentage of the corporation. Individuals
rarely own 1 or 2 shares of a corporation. More often than not they
own, a block of shares. This can range from 100 to 100,000. These
ownership rights are valid as long as the corporation does not
become insolvent or not pay any contractual obligations. The return
on common stock comes in the form of dividends that are paid out
of the net income after all the obligations to other creditors and
debtholders are made. The board of directors/management is not
compelled to declare dividends out of the residual net income. This
money can be re-invested by the firm, if the deem that there are
better investment opportunities. To mitigate the conflict of interest
between shareholders and management/directors, companies more
often than not insist on employee compensation scheme based
partially on stock based compensation. In this case the
management/directors are more certain to make more prudent
investment decisions.

 Debt: This is basically a series of promised payment to be made by

the borrower to the lender. Often the debt obligation is called a
bond. A 3-year $100 bond with a 5% coupon rate would provide 6
semi-annual payments of $2.5 (bonds normally pay the interest in
semi-annual installments) and $100 after 3 years. Debt can have
these additional features.
 ➢ Call feature: This allows the issuer to recall the bond before
its maturity date. Early retirement of the bond would require
the payment of premium over the bonds value by the issuer.
➢ Secured debt: Debt that has another asset pledged as
collateral. In which case the debtholder can claim the asset
pledged as a collateral in case of a default by the issuer.
➢ Subordinated debt: Also known as junior debt. The basic
implication of this is that in case of default, the subordinated
debtholders have a secondary claim on the firms assets, as
opposed to senior debtholders.
Note: Junior/Subordinated debtholders are still senior to
shareholders in terms of laying claim to a firms assets.

The present value of a stream of bond payments of a 4 year annual

bond is with
I1 + I2 + I3 + I4 interest
(1+ I)1 (1+I)2 1+I)3 (1+I)4 payments of
I1-I4 is:

PV of bond =

Assessing the risk of debt is done mainly through the duration of the
bond. Duration measure the time-weighted average till payments are
received from bonds.
The duration
(D) is therefore:

(1 x I1) + (2 x I2) + (3 x I3) + (4 x I4)

1
(1+ I)1 (1+I)2 1+I)3 (1+I)4
P
D =

Duration conveys that the longer the stream of cash flow payments, the
more susceptible the bond is to a change in the interest rates. This
concept of duration is comparable to the systematic risk portion of a
security.

 Future and Forward Contracts: Futures and forwards are financial

derivatives . They are referred to as such since their value is derived from
an underlying asset. Options are another type of derivative. Derivatives
allow the investor to protect himself against the risk of a price variation
while at the same time not owning the asset.
 An Arab Sheikh, disturbed by world events can choose to enter into a
future or forward contract with a Dutch oil development company, by
promising to deliver a million barrels of crude oil at 3 months into the
future @$21/barrel. He is the writer/seller of the contract.
Futures also enables a company to possess assets, without physically
storing them. In the above example, the Dutch company owns $21 million
of oil in assets. While the exchange will take place later, the contract has
guaranteed them these assets in the future. It is a form of artificially
storing the asset for this period. The price is determined at the time of the
transaction but the actual payment is not made at that time. The futures
contract has a daily “marking to market” where the exchange posts gains
and losses on the contract to either parties’ account. Futures are traded in
standardized sizes and on organized exchanges.
Forwards on the other hand are private agreements that are not traded on
exchanges and unlike futures they are not marked to market.

 Options: An option provides the holder with a right to buy or sell an asset
at an exercise price. A put option is the right to sell and a call is the right
to buy the financial asset. The holder has the right, but not the obligation,
to buy or sell the asset at a specific expiration date (European Option) or
by a specified expiration date. If the option is not exercised by a specific
date, then it expires without value. Options are available on financial
assets such as common stock, foreign currencies and even on futures
themselves. Options are conceptually the hardest financial assets to
understand but they do provide the best insurance at a small premium (as
opposed to futures and forwards which have no premium). But options
have a greater upside potential and no downside risk.

RISK /RETURN TRADEOFF

The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some
people can handle the equivalent of financial skydiving without batting an eye, others are
terrified to climb the financial ladder without a secure harness. Deciding what amount of risk
you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the chance that an investment's
actual return will be different than expected. Technically, this is measured in statistics by
standard deviation. Risk means you have the possibility of losing some, or even all, of our
original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is
the balance between the desire for the lowest possible risk and the highest possible return.
This is demonstrated graphically in the chart below. A higher standard deviation means a
higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return
tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no
guarantees. Just as risk means higher potential returns, it also means higher potential
losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on
U.S. Government Securities because their chance of default is next to nothing. If the risk-
free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on
our money.

The common question arises: who wants to earn 6% when index funds average 12% per
year over the long run? The answer to this is that even the entire market (represented by
the index fund) carries risk. The return on index funds is not 12% every year, but rather
-5% one year, 25% the next year, and so on. An investor still faces substantially greater
risk and volatility to get an overall return that is higher than a predictable government
security. We call this additional return the risk premium, which in this case is 6% (12% -
6%).

Determining what risk level is most appropriate for you isn't an easy question to answer.
Risk tolerance differs from person to person. Your decision will depend on your goals,
income and personal situation, among other factors.
Return On Investment - ROI

What Does Return On Investment - ROI Mean?

A performance measure used to evaluate the efficiency of an investment or to compare the
efficiency of a number of different investments. To calculate ROI, the benefit (return) of an
investment is divided by the cost of the investment; the result is expressed as a percentage or
a ratio.
ROI = Gain on Investment- Cost of Investments
Cost of Investment

In the above formula "gains from investment", refers to the proceeds obtained from selling
the investment of interest. Return on investment is a very popular metric because of its
versatility and simplicity. That is, if an investment does not have a positive ROI, or if there
are other opportunities with a higher ROI, then the investment should be not be undertaken.
Keep in mind that the calculation for return on investment and, therefore the definition, can
be modified to suit the situation -it all depends on what you include as returns and costs. The
definition of the term in the broadest sense just attempts to measure the profitability of an
investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that
each product has generated by its respective marketing expenses. A financial analyst,
however, may compare the same two products using an entirely different ROI calculation,
perhaps by dividing the net income of an investment by the total value of all resources that
have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the
user's purposes, and the result can be expressed in many different ways. When using this
metric, make sure you understand what inputs are being used.

IN FINANCIAL TERM
In finance, rate of return (ROR), also known as return on investment (ROI), rate of
profit or sometimes just return, is the ratio of money gained or lost (whether realized or
unrealized) on aninvestment relative to the amount of money invested. The amount of money
gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The
money invested may be referred to as the asset, capital, principle, or the cost basis of the
investment. ROI is usually expressed as a percentage rather than a fraction.
Calculation

The initial value of an investment, Vi, does not always have a clearly defined monetary value,
but for purposes of measuring ROI, the expected value must be clearly stated along with the
rationale for this initial value. Similarly, the final value of an investment, Vf, also does not
always have a clearly defined monetary value, but for purposes of measuring ROI, the final
value must be clearly statedalong with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an average over
multiple periods.
Single-period
Arithmetic return
The arithmetic return is:

rarith is sometimes referred to as the yield. See also: effective interest rate, effective
annual rate (EAR) or annual percentage yield (APY).

Logarithmic or continuously compounded return

The logarithmic return or continuously compounded return, also known as force of
interest, is defined as:

It is the reciprocal of the e-folding time.

Multiperiod average returns

Arithmetic average rate of return
The arithmetic average rate of return over n periods is defined as:

Geometric average rate of return

The geometric average rate of return, also known as the time-weighted rate of return,
over n periods is defined as:

The geometric average rate of return calculated over n years is also known as the annualized
return.

Internal rate of return

The internal rate of return (IRR), also known as the dollar-weighted rate of return, is
defined as the value(s) of that satisfies the following equation:
 where:

 NPV = net present value of the investment

 Ct = cashflow at time t

When the rate of return r is smaller than the IRR rate , the investment is profitable,
i.e., NPV > 0. Otherwise, the investment is not profitable.

Comparisons between various rates of return

Arithmetic and logarithmic return

The value of an investment is doubled over a year if the annual ROR rarith = +100%, that is,
if rlog = ln(200% / 100%) = ln(2) = 69.3%. The value falls to zero when rarith = -100%, that is,
if rlog = -∞.

Arithmetic and logarithmic returns are not equal, but are approximately equal for small
returns. The difference between them is large only when percent changes are high. For
example, an arithmetic return of +50% is equivalent to a logarithmic return of 40.55%, while
an arithmetic return of -50% is equivalent to a logarithmic return of -69.31%.

Logarithmic returns are often used by academics in their research. The main advantage is that
the continuously compounded return is symmetric, while the arithmetic return is not: positive
and negative percent arithmetic returns are not equal. This means that an investment of $100
that yields an arithmetic return of 50% followed by an arithmetic return of -50% will result in
$75, while an investment of $100 that yields a logarithmic return of 50% followed by an
logarithmic return of -50% it will remain $100.

Comparison of arithmetic and logarithmic returns for initial

investment of $100

Initial investment, Vi $100 $100 $100 $100 $100

Final investment, Vf $0 $50 $100 $150 $200

Profit/loss, Vf − Vi −$100 −$50 $0 $50 $100

 Arithmetic
−100% −50% 0% 50% 100%
return, rarith

Logarithmic
−∞ −69.31% 0% 40.55% 69.31%
return, rlog

Arithmetic average and geometric average rates of return

Both arithmetic and geometric average rates of returns are averages of periodic percentage
returns. Neither will accurately translate to the actual dollar amounts gained or lost if percent
gains are averaged with percent losses A 10% loss on a $100 investment is a $10 loss, and a
10% gain on a $100 investment is a $10 gain. When percentage returns on investments are
calculated, they are calculated for a period of time – not based on original investment dollars,
but based on the dollars in the investment at the beginning and end of the period. So if an
investment of $100 loses 10% in the first period, the investment amount is then $90. If the
investment then gains 10% in the next period, the investment amount is $99.

A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss and gain occurs
does not affect the result. A 50% gain and a 50% loss is a 25% loss. An 80% gain plus an
80% loss is a 64% loss. To recover from a 50% loss, a 100% gain is required. The
mathematics of this are beyond the scope of this article, but since investment returns are often
published as "average returns", it is important to note that average returns do not always
translate into dollar returns.

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average at End of

5% 5% 5% 5%
Year

$105.0 $110.2 $115.7 $121.5

Capital at End of Year
0 5 6 5
 Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55

Compound Yield 5% 5.4%

Example #2 Volatile Rates of Return, including losses

Year 1 Year 2 Year 3 Year 4

Rate of Return 50% -20% 30% -40%

Geometric Average at End of

50% 9.5% 16% -1.6%
Year

$150.0 $120.0 $156.0

Capital at End of Year $93.60
0 0 0

($6.40
Dollar Profit/(Loss)
)

Compound Yield -1.6%

Example #3 Highly Volatile Rates of Return, including losses

Year
Year 2 Year 3 Year 4
1

Rate of Return -95% 0% 0% 115%

Geometric Average at End of - -

-95% -42.7%
Year 77.6% 63.2%
 Capital at End of Year $5.00 $5.00 $5.00 $10.75

($89.25
Dollar Profit/(Loss)
)

Compound Yield -22.3%

]Annual returns and annualized returns

Care must be taken not to confuse annual and annualized returns. An annual rate of return is a
single-period return, while an annualized rate of return is a multi-period, geometric average
return.

An annual rate of return is the return on an investment over a one-year period, such as
January 1 through December 31, or June 3, 2006 through June 2, 2007. Each ROI in the cash
flow example above is an annual rate of return.

An annualized rate of return is the return on an investment over a period other than one year
(such as a month, or two years) multiplied or divided to give a comparable one-year return.
For instance, a one-month ROI of 1% could be stated as an annualized rate of return of 12%.
Or a two-year ROI of 10% could be stated as an annualized rate of return of 5%. **For GIPS
compliance: you do not annualize portfolios or composites for periods of less than one year.
You start on the 13th month.

In the cash flow example below, the dollar returns for the four years add up to $265. The
annualized rate of return for the four years is: $265 ÷ ($1,000 x 4 years) = 6.625%.
Uses

• ROI is a measure of cash generated by or lost due to the investment. It measures the
cash flow or income stream from the investment to the investor, relative to the amount
invested.Cash flow to the investor can be in the form of profit, interest, dividends, or
capital gain/loss. Capital gain/loss occurs when the market value or resale value of the
investment increases or decreases. Cash flow here does not include the return of
invested capital.

Cash Flow Example on $1,000 Investment

Year 1 Year 2 Year 3 Year 4

Dollar Return $100 $55 $60 $50

 ROI 10% 5.5% 6% 5%

• ROI values typically used for personal financial decisions include Annual Rate of
Return and Annualized Rate of Return. For nominal risk investments such as savings
accounts or Certificates of Deposit, the personal investor considers the effects of
reinvesting/compounding on increasing savings balances over time. For investments
in which capital is at risk, such as stock shares, mutual fund shares and home
purchases, the personal investor considers the effects of price volatility and capital
gain/loss on returns.
• Profitability ratios typically used by financial analysts to compare a company’s
profitability over time or compare profitability between companies include Gross
Profit Margin, Operating Profit Margin, ROI ratio, Dividend yield, Net profit
margin, Return on equity, and Return on assets.
• During capital budgeting, companies compare the rates of return of different projects
to select which projects to pursue in order to generate maximum return or wealth for
the company's stockholders. Companies do so by considering the average rate of
return, payback period, net present value, profitability index, and internal rate of
return for various projects.[3]
• A return may be adjusted for taxes to give the after-tax rate of return. This is done in
geographical areas or historical times in which taxes consumed or consume a
significant portion of profits or income. The after-tax rate of return is calculated by
multiplying the rate of return by the tax rate, then subtracting that percentage from the
rate of return.
• A return of 5% taxed at 15% gives an after-tax return of 4.25%
0.05 x 0.15 = 0.0075
0.05 - 0.0075 = 0.0425 = 4.25%
• A return of 10% taxed at 25% gives an after-tax return of 7.5%
0.10 x 0.25 = 0.025
0.10 - 0.025 = 0.075 = 7.5%
Investors usually seek a higher rate of return on taxable investment returns than on non-
taxable investment returns.

• A return may be adjusted for inflation to better indicate its true value in purchasing
power. Any investment with a nominal rate of return less than the annual inflation
rate represents a loss of value, even though the nominal rate of return might well be
 greater than 0%. When ROI is adjusted for inflation, the resulting return is considered
an increase or decrease in purchasing power. If an ROI value is adjusted for inflation,
it is stated explicitly, such as “The return, adjusted for inflation, was 2%.”
• Many online poker tools include ROI in a player's tracked statistics, assisting users in
evaluating an opponent's profitability.
]Cash or potential cash returns

Time value of money

Investments generate cash flow to the investor to compensate the investor for the time value
of money.

Except for rare periods of significant deflation where the opposite may be true, a dollar in
cash is worth less today than it was yesterday, and worth more today than it will be worth
tomorrow. The main factors that are used by investors to determine the rate of return at which
they are willing to invest money include:

• estimates of future inflation ratesestimates regarding the risk of the

investment (e.g. how likely it is that investors will receive regular
interest/dividend payments and the return of their full capital)
• whether or not the investors want the money available (“liquid”) for other uses.
The time value of money is reflected in the interest rates that banks offer for deposits, and
also in the interest rates that banks charge for loans such as home mortgages. The “risk-free”
rate is the rate on U.S. Treasury Bills, because this is the highest rate available without
risking capital.

The rate of return which an investor expects from an investment is called the Discount Rate.
Each investment has a different discount rate, based on the cash flow expected in future from
the investment. The higher the risk, the higher the discount rate (rate of return) the investor
will demand from the investment.

Compounding or reinvesting
Compound interest or other reinvestment of cash returns (such as interest and dividends) does
not affect the discount rate of an investment, but it does affect the Annual Percentage Yield,
because compounding/reinvestment increases the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an
annual interest rate of 4%, compounded quarterly, the CD would earn 1% interest per quarter
on the account balance. The account balance includes interest previously credited to the
account.

Compound Interest Example

 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter

Capital at
the
$1,000 $1,010 $1,020.10 $1,030.30
beginning of
the period

Dollar
return for $10 $10.10 $10.20 $10.30
the period

Account
Balance at
$1,010.00 $1,020.10 $1,030.30 $1,040.60
end of the
period

Quarterly
1% 1% 1% 1%
ROI

The concept of 'income stream' may express this more clearly. At the beginning of the year,
the investor took $1,000 out of his pocket (or checking account) to invest in a CD at the bank.
The money was still his, but it was no longer available for buying groceries. The investment
provided a cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the
investor got $1,040.60 back from the bank. $1,000 was return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves

reinvestment of capital; the interest earned during each quarter is reinvested. At the end of the
first quarter the investor had capital of $1,010.00, which then earned $10.10 during the
second quarter. The extra dime was interest on his additional $10 investment. The Annual
Percentage Yield or Future value for compound interest is higher than for simple interest
because the interest is reinvested as capital and earns interest. The yield on the above
investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital.
Investors/Depositors lend money to the bank, and the bank is obligated to give investors back
their capital plus all earned interest. Because investors are not risking losing their capital on a
bad investment, they earn a quite low rate of return. But their capital steadily increases.
Summary: overall rate of return

Rate of Return and Return on Investment indicate cash flow from an investment to the
investor over a specified period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While

compound interest and dividend reinvestment can increase the size of the investment (thus
potentially yielding a higher dollar return to the investor), Return on Investment is a
percentage return based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the
greater the potential investment loss.

Achieving A Balance Between Risk And Return

Because risk management is costly, many health plans and providers practice risk avoidance
by transferring risk to other entities. Risk-bearing healthcare organizations can improve their
return on assets, but to do so they need complete information about patients' health status and
the availability of effective medical treatment.
To improve their return on assets, providers can use risk-management strategies such as
growth, designing incentives to encourage providers and health plans to reduce or eliminate
unnecessary variations in resource use, and improving information about the reasons for
variations in resource use and controlling those variations when possible. Providers need data
to analyze why variations in resource use occur and to evaluate the efficiency of their
resource use.
Uncertainty, or risk, pervades the healthcare industry. This uncertainty is attributable to two
factors: the randomness with which illness occurs and progresses, and inadequate information
about health status and the capacity of medical technology to change that health status.
Effective healthcare financial management requires effective risk management. Often,
however, both providers (hospitals and physicians) and health plans equate risk management
with risk avoidance because uncertainty tends to increase costs. Hospitals, for example,
maintain excess capacity because they cannot know what their census will be on any given
day and do not want to turn patients away. More uncertainty leads to maintaining more
excess capacity which in turn increases the average cost per patient day. According to this
logic, higher costs lead to smaller margins. The best strategy, therefore, is to shift the
uncertainty elsewhere.
Many recent developments in healthcare financial arrangements can be interpreted in terms of
this risk-transfer paradigm. For example, inpatient prospective payment systems shift the risk
of variations in resource use for hospital stays from the insurer to the provider. The decision
to adjust per case or per diem payments for case mix is actually a decision to shift risk related
to case mix from the provider to the payer. Similarly, capitation and subcapitation
arrangements move risk of variations in resource use per enrollee from the payer to the
capitated provider.
It is tempting to conclude that risk transfers benefit the entity transferring risk to the
detriment of the risk-bearing entity. As obvious as this conclusion may seem, however, it is
not necessarily correct.
The capital asset pricing model (CAPM) demonstrates that assuming more risk can lead to
higher rates of return. In its simplest version, the CAPM predicts that the return on an asset
(R) is related to the return on risk-free assets ([R.sub.risk-free]) and the returns currently
prevailing in the market ([R.sub.market]) as follows:
R = [R.sub.risk.free] [beta] ([R.sub.market] - [R.sub.risk-free])
In this equation, beta ([beta]) measures the financial risk of an asset on the basis of the
amount of variation in its expected return in relation to marketwide rates of return. If [beta] =
1, the asset bears average risk, and its rate of return will equal the market rate of return over
time (R = [R.sub.market]). If [beta] [less than] 1, the asset has below-average risk, and its
return is expected to be below the market rate of return. If [beta] [less than] 1, the asset has
above-average risk, and its return is expected to be above the market average.
Given the assumptions of the CAPM model, providers and insurers can increase their rates of
return by assuming risk, rather than attempting to transfer risk to other entities. Still, risk
avoidance seems to dominate behavior in the healthcare industry. A combination of factors
appears to explain why.
Many health plans and providers work to avoid large variations in utilization. The lesson of
the CAPM is that average returns increase with the variability of those returns. Despite
increasing consolidation, however, the healthcare industry still is characterized by relatively
small, independent providers that have a limited capacity to absorb variations in rates of
return. Such providers tend to be risk averse and inclined to shift risk to other entities, when
possible.
A substantial portion of the risk that health plans and providers face is due to inadequate
information rather than random fluctuations in returns. Historically, health plans have
depended upon providers to assess the resource requirements of their insured population.
Health plans that are in fee-for-service arrangements, for example, are entirely at risk for
variations in resource use. Health plans responded to this uncertainty by transferring risk onto
providers and thereby imposing financial penalties for excess resource consumption.
Health plans and providers rarely operate in a true competitive market. The CAPM is
founded in the economist's notion of a competitive marketplace, in which no buyer or seller is
so large as to affect the prevailing price or rate of return appreciably Large health plans and
health systems, however, often have sufficient market power, especially in defined
geographic areas, to shift risk onto other entities without recognizing the full economic value
of that shift. Health plans, for example, may implement per diem or per case payment
systems without factoring risk or a case-mix adjustment into the payment amount.
CONCLUSION
The relationship between financial risk and return is the gain or lose of from investments or
securities. The "risk" denotes that the investor could lose money and the "return" is the profit
the investor obtains. If the investors chooses to invest in security that is a low risk then the
return will be small. If the security is high risk factor the investor has the potential to get
higher returns. The return on an investment can be measured by a real rate which is what is
earned after inflation has been figured into the value.

Risk-bearing healthcare organizations can improve their return on

assets, but to do so they need complete information about patients' health status and the
availability of effective medical treatment.
To improve their return on assets, providers can use risk-management strategies such as
growth, designing incentives to encourage providers and health plans to reduce or eliminate
unnecessary variations in resource use, and improving information about the reasons for
variations in resource use and controlling those variations when possible. Providers need data
to analyze why variations in resource use occur and to evaluate the efficiency of their
resource use.
Uncertainty, or risk, pervades the healthcare industry. This uncertainty is attributable to two
factors: the randomness with which illness occurs and progresses, and inadequate information
about health status and the capacity of medical technology to change that health status.
So, This suggests that firm managers likely have many opportunities to
create value for shareholders using financial risk management. The trick is to determine
which risks are cheaper for the firm to manage than the shareholders. A general rule of
thumb, however, is that market risks that result in unique risks for the firm are the best
candidates for financial risk management.