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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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2.3 Definition and Meaning of Return

The definition of risk provided by Haslem, 2003 whereby risk was defined from a financial perspective point of view leads us to the notion of return. Return, basically is the reward to risk, even though very little has been written about return unlike risk. Never the less, from the normal day to day usage, the word return has so many meanings and definitions provided it is used within the proper context.

According to the Webster's New English Dictionary and Thesaurus (2002), return is defined as: «to come or go back; to repay; to recur. to give or send back; to repay; to yield; to answer; to elect, something returned; a recurrence; recompense; yield, revenue; a form for computing (income) tax.»(p502).

Risk and return are mostly referred to as the different sides of the same coin because in finance and looking at Haslem's definition of risk, return can be considered as the exact opposite of risk. Most economists refer to return as the investors' expected outcome for the risk they are taking and this return is made up of the periodic interest payment (yield) and the change in assets' values over a given period of time (capital gains/losses).

Return is just as risk because it is a double sided coin since return does not imply gaining all the time but sometimes losing. A gain or lost arises from either appreciating or depreciating an asset. As a result of these, investors always try to implement all forms of investment appraisal methods so as to try to be sure that the return at the said stage will only be referred to as the expected return. Note that all projects have a life cycle and it is at the end of the life of any project that the actual return is known which can turn out to be either a lost or a gain or just break-even. This merely lays the foundation for us to know that return must not always be looked at to imply profits since that will just be misleading because sometimes, expected return might show some possibility of profit while the actual return might not thereby taking us back to the idea of danger plus opportunity.

2.4 The Relationship between Risk and Return

Because risk and return are very important aspects in finance, it calls for concern to study the relationship that exists between them. This notwithstanding, it has been brought to our notice that there has been a debate on whether the relationship existing between risk and return is positive, negative or curvilinear (Fiegenbaum et al, 1996). Bear this in mind that as far as issues in finance are concerned, they will always be looked at from at least two different points of view because of the difference between the classical school of thought and the behavioural school of thought.

Statistics has proven that most investors are risk averse. This idea serves as a backbone for looking into the positive relationship existing between risk and return. This is judging from the point that most low risks are mostly associated with low return and vice versa (Fisher and Hall, 1969) thereby leaving investors with the problem of choosing the option that best maximises their abilities (Schoemaker, 1982).

Never the less, this positive relationship of risk and return has been supported by many classical financial theories including CAPM, MPT and EMH and this can be supported by the upward sloping curves of the Security and Capital Market Lines in Figures 1 and 2. Haslem loc also supported the fact that there is a positive relationship between risk and return, where he stated that «the Capital Asset Pricing Model (CAPM) posits that return and risk are positively related, higher return carries higher risk» and this was as well strongly supported by Vaitilingam et al 2006. Using the portfolio theory as a guide for investment decisions, it was suggested that the greater the risk the greater the expected return. This is because, according to Lumby 1988, the basis of the relationship between risk and return has always been justified on grounds that investors are generally risk-averse.

According to Bowman (1980 and 1982), and after carrying out exclusive research and sampling from different industries, Bowman resulted in suggesting the existence of considerable variance with the classical finance theories in relation to risk and return in what became known as the Bowman paradox or the risk and return paradox. It has been evident from his findings that most of the time, when there happen to be a negative relationship between risk and return, that implies investors must have swapped from being risk-averse to risk-seekers and this can be experienced in any institution whether the institutions are performing well or not. This therefore implies there really do exist a negative relationship between risk and return.

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