Relationship Risk And Required Rate Of Return

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The relation between the risk and return is based on the premise that the investors must be compensated for undertaking the additional risk, otherwise, they will not supply the funds. Obviously, no investor would like to invest in say 6% debenture of a private sector company, if the rate of interest on commercial bank deposit is equal to or more than 6% ( a the risk involved in commercial bank deposit is almost nil or certainly less than that of a private sector company). The difference in risk makes the 6% bonds to be considerably less attractive. However, the investor might be willing to commit the funds for these bond if the interest offered by the company is higher than 6%. The investor demands a compensation for bearing risk.

Government securities and Bonds generally, do not have any inherent risk and consequently these have the lowest return offered to the investors. This return is also called the risk free rate of return or the risk free interest rate. However, rate of return offered on the bonds issued by Government Department e.g. railways etc., is higher than this risk free rate. The rate of interest offered on the private sector bonds and debentures is still higher. Similarly , a firm has to offer a still higher rate of dividends on preference share as these are risky then debts. The rate of return expected in case of equity shares will be highest as the equity share investment is considered to be most risky.

 In general therefore, it can be aid that all debt holders have a less risky position then the preference share holders and both of these bear less risky than equity share holders. The difference in the required rate of return of these security truly reflect the differences in the risk levels. Te risk return relationship of an investor has been presented in figure
The figure shows that different types of securities have different risk. There is a pure interest rate which is also called the risk free rate of interest, applicable to government bonds. The other components of return i.e., the risk premium goes on increasing as the risk increases. Different securities i.e., bonds preferences shares and equity shares have a different risk level and therefore the risk premium components is also different. Higher the risk, more is the risk premium components and therefore higher is the require rate of the investors.    

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