Risk and Return
A question that most practitioners in finance either tend to ignore or forget to consider concerns the risk of the future, uncertain cash flows. You will want to get a higher return from cash flows that are riskier. For example, stock returns are more uncertain than bond returns and, therefore, given the same cash flows from the two, we should expect a higher return from stocks. In the first place, however, what is “return” and what is “risk?” How do we define these concepts mathematically, and how do we tie them together? More formally, how do we find a relationship between these two concepts? It turns out that by asking these questions, we discover numerous gems in the field of finance, such as the concept of diversification and the Capital Pricing Model (CAPM). These findings, among others, led several great researchers to win Nobel prizes in the field of financial economics.
