Risk and Return: Types of Risk, Risk–Return Trade-off, Basics of Diversification Questions

Question 1

Define return.

Accepted Answer

Return is the **gain/benefit** from an investment over a period (income + capital gain).

Question 2

Define risk in finance.

Accepted Answer

Risk is the **uncertainty/variability** of returns (actual return may differ from expected return).

Question 3

What is diversification?

Accepted Answer

Diversification means investing in different assets to reduce **overall risk** (concept).

Question 4

Systematic risk is also known as market risk. (True/False)

Accepted Answer

True. **Systematic risk** affects the whole market/economy (concept).

Question 5

State one example of systematic risk (concept).

Accepted Answer

Change in **interest rates** or inflation affecting the overall market (concept).

Question 6

State one example of unsystematic risk (concept).

Accepted Answer

A company-specific event like **strike**, fraud, or product failure (concept).

Question 7

Differentiate systematic and unsystematic risk using a table (any three points).

Accepted Answer

Systematic vs unsystematic risk:

| Basis | **Systematic risk** | **Unsystematic risk** |
|---|---|---|
| Nature | market-wide | company/industry-specific |
| Examples (concept) | inflation, interest rates | strikes, management issues |
| Diversification | not fully eliminable | can be reduced |

Thus, diversification mainly reduces unsystematic risk.

Question 8

Explain risk–return trade-off (brief) with a table and conclusion.

Accepted Answer

Risk–return trade-off: higher expected return generally comes with higher **risk**.

| Investment (concept) | Risk | Expected return |
|---|---|---|
| Fixed deposit | low | low–moderate |
| Shares | high | higher (uncertain) |

Conclusion: investors demand **risk premium** for taking additional risk.

Question 9

List any three benefits of diversification.

Accepted Answer

Benefits of diversification (any three):

- reduces **unsystematic risk** by spreading company-specific shocks
- makes portfolio returns more stable (concept)
- improves risk-adjusted return potential (concept)
- helps match risk tolerance by mixing assets

Any three points are sufficient.

Question 10

Explain types of return (income return, capital gain and total return) using a table.

Accepted Answer

Types of return:

| Type | Meaning | Example |
|---|---|---|
| **Income return** | interest/dividend received | dividend on shares |
| **Capital gain** | price increase | share price rises |
| **Total return** | income + capital gain | dividend + price rise |

Thus, total return combines both components.

Question 11

What is risk premium? Explain briefly with an example (concept).

Accepted Answer

**Risk premium** is the extra return investors expect for taking additional **risk** over a low-risk investment (concept).

Example (concept):
- If a safe deposit offers 6% and a risky share investment is expected to give 12%, then risk premium ≈ 12% − 6% = 6%.

Thus, higher risk requires extra expected return.

Question 12

Explain why diversification does not eliminate systematic risk (concept) using a small table.

Accepted Answer

Diversification vs risk types (concept):

| Risk type | What it is | Effect of diversification |
|---|---|---|
| **Systematic** | market-wide (interest rate, recession) | cannot be fully eliminated |
| **Unsystematic** | company-specific (strike, fraud) | largely reduced |

Hence, diversification reduces company-specific shocks but market-wide risk remains.

Question 13

Write an exam-style note on systematic risk: meaning, sources and why it cannot be eliminated (include a table and conclusion).

Accepted Answer

### Meaning
**Systematic risk** is market-wide risk that affects most securities due to economy-level factors.

| Source (concept) | How it impacts |
|---|---|
| **Interest rate** changes | affects borrowing cost and valuations |
| Inflation | reduces purchasing power; affects cash flows |
| Recession | lowers demand and profits across sectors |

### Conclusion
Systematic risk cannot be fully eliminated by diversification because it impacts the entire market, not just one company (concept).

Question 14

Write an exam-style note on unsystematic risk: meaning, examples and how diversification reduces it (include a flowchart and conclusion).

Accepted Answer

### Meaning
**Unsystematic risk** is company/industry-specific risk.

### Examples (concept)
- strike, fraud, management failure
- product failure, loss of major customer

### Diversification effect (flow)
Many different securities → different company-specific risks → losses in one may be offset by gains in another → **overall portfolio risk reduces**

### Conclusion
Diversification reduces unsystematic risk because it spreads company-specific shocks across multiple investments.

Question 15

Explain portfolio and why investors create portfolios (exam-style) with a table and conclusion.

Accepted Answer

### Meaning
A **portfolio** is a collection of investments held together.

| Reason | Explanation |
|---|---|
| **Diversification** | reduces unsystematic risk |
| Goal matching | aligns return with risk tolerance (concept) |
| Liquidity | mix assets to meet cash needs (concept) |
| Stability | smoother overall performance (concept) |

### Conclusion
Portfolios help investors balance **risk and return** more effectively than a single investment.

Basis	Systematic risk	Unsystematic risk
Nature	market-wide	company/industry-specific
Examples (concept)	inflation, interest rates	strikes, management issues
Diversification	not fully eliminable	can be reduced

Risk and Return: Types of Risk, Risk–Return Trade-off, Basics of Diversification

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