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Risk-Return Analysis

In: Corporate Finance for Long-Term Value

Author

Listed:
  • Dirk Schoenmaker

    (Erasmus University Rotterdam)

  • Willem Schramade

    (Nyenrode Business University)

Abstract

Risk-return analysis is central to financial decision-making. The basic idea is that risk-averse investors ask compensation for higher risk, in the form of a risk premium on risky assets. The key insight of portfolio theory is that a company’s risk, at least as measured by the distribution of its historical stock returns, can be split into systematic or market-wide risk and idiosyncratic risk. As idiosyncratic risk can be diversified away in a portfolio, investors are only rewarded with a risk premium for the market risk component. This is the beta of the Capital Asset Pricing Model. But historical risk-return analysis has limitations in accurately assessing current and future financial risk. We therefore explore forward-looking measures of financial risk and return. Moreover, we expand the single-factor market model to a multifactor model by adding social and environmental factors. Yet, another step is to assess social and environmental risk in their own right, as well as their impact on integrated risk. This, in turn, allows us to estimate the cost of integrated capital, which should give corporate managers the tools to make that assessment in their investment decisions. Company examples show that integrated risk-return analysis leads to different, and more sustainable, decisions.

Suggested Citation

  • Dirk Schoenmaker & Willem Schramade, 2023. "Risk-Return Analysis," Springer Texts in Business and Economics, in: Corporate Finance for Long-Term Value, chapter 12, pages 325-366, Springer.
    • Handle: RePEc:spr:sptchp:978-3-031-35009-2_12
    DOI: 10.1007/978-3-031-35009-2_12
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