Finance

The word finance comes from an old French word 'fine'. It means to pay, settle, or finish.

According to Encyclopedia of Britannica, "Finance is an act of providing means of payment".

According to the Oxford Dictionary, the word 'finance' means management of money.

In the words of Prather and Wert, "financing consists of raising, providing, managing of all
the money, capital, funds of any kind to be used in connection with business".

Thus, finance is the art and science of handling money. It is the management of flows of
money through an organization. In short, finance means funds required for operation of a
business.

Financial Management
Financial management refers to raising of funds and their effective utilization in order to
achieve the overall objectives of the firm. It is concerned with planning and controlling of a
firm's financial resources. In the words of P.G. Hastings, "Financial management is the art of
raising and spending money". According to Archer and Ambrosio "Financial management is
the application of the planning and control functions to the finance function".

Thus, financial management is a blend of management and finance. In short, the process

of managing the funds of an organization is known as financial management.

Scope Of Financial Management

The scope of financial management encompasses a wide range of activities and
responsibilities within an organization. Some key aspects are:

1. Financial Planning: This involves developing strategies and plans to achieve the financial
goals of the organization, including budgeting, forecasting, and setting financial targets.

2. Investment Decisions: Financial management involves evaluating investment

opportunities, making decisions regarding capital expenditures, and managing the
organization's assets to maximize returns.

3. Financing Decisions: Financial managers are responsible for determining the optimal mix
of debt and equity financing, as well as accessing capital markets to raise funds for the
organization's operations and growth.
4. Cash Management: This involves managing the organization's cash flows, optimizing
liquidity, and ensuring that the organization has adequate funds to meet its obligations.

5. Risk Management: Financial management encompasses the identification, assessment,

and mitigation of financial risks, including market risk, credit risk, and operational risk.

6. Financial Reporting and Analysis: Financial managers are responsible for preparing
financial statements, conducting financial analysis, and communicating the organization's
financial performance to stakeholders.

7. Capital Structure Management: Financial management involves managing the

organization's capital structure, including the issuance of stocks and bonds, and optimizing
the cost of capital.

8. Dividend Policy: Financial managers are involved in determining the organization's

dividend policy and managing the distribution of profits to shareholders.

9. Corporate Governance: Financial management encompasses ensuring sound corporate

governance practices, including transparency, accountability, and ethical financial
decision-making.

10. International Financial Management: In a globalized world, financial management also

involves dealing with international financial activities, including currency risk management
and international investment decisions.

Importance Of Financial Management

Financial management is of vital importance for individuals, businesses, and organizations
for several reasons:

1. Business planning: Financial management is crucial for creating and executing business
plans, including budgeting, forecasting, and setting financial targets.

2. Decision-making: Financial management provides the necessary information and

analysis to support strategic and operational decision-making, such as investment choices
and cost control measures.

3. Resource allocation: Effective financial management helps in allocating resources

efficiently and optimizing the use of funds for various business activities.

4. Risk management: Financial management involves identifying, assessing, and mitigating

financial risks to protect the business from potential threats and uncertainties.
5. Performance measurement: It provides tools and metrics to evaluate the financial
performance of the organization, such as profitability, liquidity, and efficiency.

6. Compliance: Financial management ensures adherence to legal and regulatory

requirements, including financial reporting standards and tax laws.

7. Stakeholder communication: It facilitates transparent communication with stakeholders,

such as investors, creditors, and employees, by providing accurate and timely financial
information.

8. Capital management: It involves managing the capital structure and funding requirements
of the business to support its operations and growth.

9. Cash flow management: Effective financial management ensures adequate cash flow to
meet operational needs, debt obligations, and investment opportunities.

10. Strategic growth: Financial management supports the planning and implementation of
strategies for business growth, expansion, and diversification.

Goals or Objectives of Finance or Financial Management

There are various parties interested in an organization. Shareholders, management, workers,
consumers and society at large are the parties interested in an organization. It is required to
safeguard the interest of all these parties. Hence, the goals of finance are also varied.

The objectives or goals of finance may be broadly classified into two-Financial and Non-
financial objectives.

Financial Objectives
Financial objectives include profit Maximisation, wealth Maximisation and value
Maximisation. These may be briefly explained as below:

(A) Maximisation of Profit

Maximisation of profit is generally regarded as the main objective of business enterprises. In
the opinion of Milton Friedman, the main objective of a business is to earn maximum profit.
According to him, "the business of business is business".
The main objective of finance is to safeguard the economic interest of the persons who are
directly or indirectly connected with the company, i.e., shareholders, creditors, employees
and others. These parties especially shareholders and creditors have contributed funds with
which the company is carrying on its operations. Hence, all these interested parties must get
maximum profit for their contributions. But this is possible only when the company earns
maximum profits. According to this view, the aim of finance is to earn the maximum rate of
profits on capital employed.

Advantages of Profit Maximisation: Profit Maximisation is one of the basic objectives of all
organization’s because of the following reasons.

(a) Profit is an indicator of growth of an organization.

(b) Profit is essential for an organization’s survival.

(c) An organization needs to maximize its profits in order to achieve the other organizational
objectives.

(d) Maximum profit means maximum return to shareholders.

(e) Maximum profit enables to set aside sufficient funds for future expansion.

(f) Profit attracts investors to invest their savings in securities.

Criticisms of Profit Maximisation: The main objections against profit Maximisation as the
goal of financial management are as follows:

(a) It does not take into consideration the long term objectives such as wealth Maximisation.

(b) It leads to exploiting workers and consumers.

(c) It attracts cut-throat competition.

(d) It does not take into consideration the welfare of the society.

(e) It attracts government intervention.

(f) It ignores uncertainty and risk.

(B) Maximisation of Wealth
According to Solomon Ezra, the ultimate goal of the financial management is Maximisation
of owners' wealth. According to him, Maximisation of profit is half and unreal motive. He
further said that proper goal of financial management is Maximisation of wealth of equity
shareholders. The concept of 'share holder wealth Maximisation' was introduced by David
Durand and Lutz in 1952. Maximisation of wealth means Maximisation of market price per
share in the long run. Every financial decision should be based on cost-benefit analysis. If
benefit is more than the cost, the decision will help to increase the wealth and vice versa.

Wealth Maximisation is an appropriate decision criterion for financial management

decisions because it removes the limitations of profit Maximisation criterion. The wealth
Maximisation approach aims at maximizing the wealth of the shareholders by increasing
earning per share.

Advantages of Wealth Maximisation: The benefits of wealth Maximisation are:

(a) It considers time value of money.

(b) It takes care of the interests of financial institutions, owners, employees and the public
at large.

(c) It fulfils the goals of different departments of an organization.

(d) It considers risk and uncertainty.

(e) It focuses on the long term growth and development of an organization.

(f) It ensures that the resources of an organization have been used effectively to accomplish
the objectives of the organization.

Criticisms of Wealth Maximisation : The limitations of wealth Maximisation approach are

as follows:

(a) The concept of increasing the wealth of the shareholders differs from company to

company.

(b) It leads to confusion and misinterpretation of financial policy, i.e., whether to increase
the wealth of shareholders or other interested groups such as debenture holders, preference
shareholders etc.
(c) It is not socially desirable.

(d) It is also profit Maximisation. It is the indirect name of profit Maximisation.

(e) It is useful only in large organization’s. Small organizations have limited financial
resources. So they prefer to maximize their profit first.

(C) Value Maximisation

Another objective of financial management is to increase the value of the organization. The
objective is to maximize the long term market value of the organization. The total value of an
organization comprises of all the financial assets, such as equity, debt, preference shares
and warrants. When the value of shares of an organization increases in the market, its total
value will increase.

The prime goal of an organization is to maximize the market value of its equity shares. The
value of equity shares acts as a benchmark to measure the performance of the organization.

Value Maximisation is similar to wealth Maximisation. Wealth Maximisation focuses on

increasing the value of shares. This in turn means increasing the wealth of shareholders.
However, value Maximisation is a broader concept than wealth Maximisation. Wealth
Maximisation focuses on increasing the value of equity shares. But value Maximisation
seeks to maximize not only the value of equity shares but also the value of all financial
assets. If an organization is able to maximize its value, then it can generate sufficient profits
to pay dividend to the shareholders and finance all its activities, operations, and projects.

Non-financial Objectives
Financial management has some non-financial goals also. These may be briefly explained
as below:

1. Enhance employee satisfaction and welfare: Employees are the backbone of any
business. Hence, an important goal of financial management is to enhance employee
satisfaction and welfare. This is achieved by giving good wages and salaries, healthy and safe
working conditions, good pension schemes etc.

2. Enhance management satisfaction: Managers are the people who actually meet all the
objectives of the company. The shareholders simply sit outside but the managers carry out
the business activities in order to create value for the shareholders. Hence, the financial
management should take care of the managers and their needs.

3. Promote well-being of society: A company is a part of the society. It is rooted deep into
the society. Hence, the financial management cannot ignore the society. For example, the
mission statement of pharmaceutical company Pfizer states. "We will become the world's
most valued company to patients, customers, colleagues, investors, business partners and
the communities where we work and live".

4. Provide quality services to customers: Some companies sate that their objective is to
render quality services to the customers. By rendering quality services, it is possible to
delight the customers. This would help to sustain the existing customers and create new
customers.

Financial Decisions
Financial decisions refer to decisions concerning financial matters of a business firm. There
are many kinds of financial management decisions that the firm makes in pursuit of
maximising shareholder's wealth, viz., kind of assets to be acquired, pattern of
capitalisation, distribution of firm's income etc. We can classify these decisions into four
major groups

1. Investment Decision: Investment decision relates to selection of assets in which funds

are to be invested by the firm. Investment opportunities are numerous. But the financial
resources are limited. Therefore, they have to be used very carefully. Financial resources
should be invested only in the most profitable projects or assets. Funds are to be invested in
two types of assets-fixed (long term) assets and current (short term) assets. Thus, there are
two types of investment decisions. One is long term investment decision. The other is short
term investment decision. Long term investment decision is known as capital budgeting
decision. Short term investment decision is called working capital management. In short,
the decision regarding how much to be invested in assets and in what type of assets is known
as investment decision.

2. Financing decision: Financing decision is concerned with the selection of the sources of
finance. Usually the company procures its capital through different sources. It has to select
the best sources of finance to meet its investment decision. This decision involves
determining the proportion of equity and debt in the capital structure of an organization. The
company has to select such sources of funds that will make optimum capital structure. In
short, the decision regarding the selection of sources of finance is known as financing
decision.

3. Dividend decision: Dividend decision is concerned with the amount of profits to be

distributed and retained in the firm. The management has to decide how much to distribute
to shareholders by way of dividend and how much to retain in the business. Dividend
decision is a crucial decision. This is so because it affects the market value of the company.
Therefore, the dividend decision should be taken in such a way as to maximize the value of
the firm.

4. Liquidity Decision: Liquidity decision is concerned with the management of current

assets. If the firm invests less funds in current assets, it loses its liquidity. Then the firm
cannot meet the short term obligations promptly and properly. This is more risky. But
profitability will Improve. On the other hand, if the firm invests more funds in current assets,
liquidity will improve. This results in the idle current assets. They earn nothing. This will
reduce the capital available for investment. Hence profitability will fall. Thus excess liquidity
eats profitability. With the fall in profitability the market price of the share will fall. Liquidity
and profitability are the two sides of a coin. It is essential for every firm to maintain both in a
balanced manner. In other words, there must be a proper trade-off between profitability and
liquidity. Hence, greater care should be taken while taking this financial decision.
FUNCTIONS OF A FINANCIAL MANAGER
The changed business environment in the recent past has widened the role of a financial
manager. The increasing pace of industrialisation, rise of larger-scale units, innovations in
information processing techniques, intense competition etc. have increased the need for
financial planning and control. The size and extent of business activities are dependent upon
the availability of finances. Financial reporting may be used as a technique of control.

In the present business context, a financial manager is expected to perform the following
functions.

1. Financial Forecasting and Planning: A financial manager has to estimate the financial
needs of a business. The amount will be needed for purchasing fixed assets and meeting
working capital needs. He has to plan the funds needed in the future. How these funds will
be acquired and applied is an important function of a finance manager.

2. Acquisition of Funds: After making financial planning, the next step will be to acquire
funds. There are a number of sources available for supplying funds. These sources may be
shares, debentures, financial institutions, commercial banks, etc. The selection of an
appropriate source is a delicate task. The choice of a wrong source for funds may create
difficulties at a later stage. The pros and cons of various sources should be analyzed before
making a final decision.

3. Investment of Funds: The funds should be used in the best possible way. The cost of
acquiring them and the returns should be compared. The channels which generate higher
returns should be preferred. The technique of capital budgeting may be helpful in selecting
a project. The objective of maximising profits will be achieved only when funds are efficiently
used and they do not remain idle at any time. A financial manager has to keep in mind the
principles of safety, liquidity and soundness while investing funds.

4. Helping in Valuation Decisions: A number of mergers and consolidations take place in

the present competitive industrial world. A finance manager is supposed to assist
management in making valuation etc. For this purpose, he should understand various
methods of valuing shares and other assets so that correct values are arrived at.

5. Maintain Proper Liquidity: Every concern is required to maintain some liquidity for
meeting day- to-day needs. Cash is the best source for maintaining liquidity. It is required to
purchase raw materials, pay workers, meet other expenses, etc. A finance manager is
required to determine the need for liquid assets and then arrange liquid assets in such a way
that there is no scarcity of funds.
TIME VALUE OF MONEY
The value of money changes with time. This is due to the presence of a 'return' factor or
'interest' factor. Thus, money earns money. That is, there is a return or income on money.
Hence, the value of money changes with time.

Concept of Time Value of Money

The concept of time value is based on the fact that money has a time value. This means that
the value of money depends upon time. That is, the value of money changes over a period of
time. It further means that the money received today is more valuable than the money
receivable in future. This happens because the money received today can be invested and it
can earn some interest. But the money receivable in future cannot be invested. Hence,
people prefer to receive the money that is receivable at the earliest. This preference for
current money as against future money is known as the time value of money.

Time value of money is defined as, "the value derived from the use of money over time

as a result of investment and reinvestment". It means that the worth of a rupee received
today is different from the worth of a rupee to be received in future. In short, time value of
money refers to change in value of money with change in time.

Reasons for Time Value of Money (Reasons for Time Preference of Money)
Money has a time value because of the following reasons:

(a) Uncertainty and risk: Money now is certain. But money receivable tomorrow is
uncertain. The party who has to make payment (i.e., debtor) may become insolvent or may
not survive at a later date. Thus, future is always uncertain and risky.

(b) Preference for present consumption: An individual generally prefers current

consumption. The promise of a bowl of rice next week counts for little to the starving man.
Even a child wants an ice cream today rather than tomorrow.

(c) Opportunity for investment: Money received today can be invested. This will earn
interest. At the same time, money receivable in future cannot be invested now.

(d) More purchasing power: In an inflationary economy, the money received today has more
purchasing power than money to be received in future.

From the above it is clear that money received today is more valuable than the money to be
received tomorrow.
It may be noted that the time value of money depends on the rate of interest. If the rate of
interest is higher, the time value of money would be higher and vice versa.

Need and Importance of the Concept of TVM

As already stated, the value of money differs with passage of time. Hence, present money
cannot be compared with future money. Therefore, time value of money should be
considered in making financial decisions. Time value of money deals with finding the value
of money at different time points. Unless it is ascertained, no financial decision is complete.
In fact, any decision made without considering the time value of money is biased and wrong.
Hence, the concept of time value of money is important. The need and importance of time
value of money may be understood from the following points:

1. It measures worth of an investment: Before investing, the organization should assess

the worth of investing. The worth of the investment can be measured with the help of the
concept of TVM. Only after assessing the worth of investment, the decision whether to invest
or not can be taken.

2. It helps to evaluate financing decisions: In making financing decisions, a company must

consider the time value of money. This involves calculation of the effective rate of interest of
each source of finance.

3. It helps to assess the credit policies: The credit policy refers to the terms and conditions
set by an organization for credit sales. A company has to formulate a suitable credit policy.
The time value of money is useful for formulating suitable credit policy.

4. It helps to determine magnitude of risk and uncertainty: Investment involves risk. This
is because the returns from investment are uncertain. However, the concept of time value of
money can assess the magnitude of risk and uncertainty involved in investment.

Techniques or Concepts of Time Value of Money

The value of money can be assessed either on a given future date or at the present date. If
value is calculated as on a future date, it is called future value of money. If it is calculated at
present date, it is called present value of money. The process of calculating future value of
present money is called compounding. The process of calculating present value of future
money is called discounting.
Compounding Value Concept (Compounding Technique)

The compounding technique is used to find out the future value (FV) of present money. It is
the same as the concept of compound interest. In the case of compound interest, the
interest earned in a preceding year is reinvested at the prevailing rate of interest for the

remaining period. Thus, the accumulated amount (principal + interest) at the end of a period
becomes the principal amount for calculating the interest for the next period. In short, in the
compound value concept, the interest earned on the initial principal amount becomes a part
of principal at the end of a compounding period.

Annual Compounding :

In order to calculate the future value of a single amount, the following formula is used:

A=P(1+r)^{n}

where, A= Amount at the end of the period (i.e., FV)

P = Principal at the beginning of the period (i.e., present amount)

r = Rate of interest

n = Number of years for which compounding is done.

Example 1

Calculate the compound value when 10,000 is invested for 3 years at 8% interest p.a.

Solution

A=P(1+r)^{n}

A (or compounded value) = 10,000(1 + 8%) ^ 3

= 10,000(1+.08 x 1+.08 x 1+.08)

= 10,000(1.08 x 1.08 x 1.08)

= 10,000 x 1.259712

= ₹12,597

Calculation of compounded value by using the above formula is time consuming if the
number of years increase, say, 10, 20, or more. In such cases to save time and effort,
compound value table (Table III) can be used. The table gives the compound value for 1 after
'n' years for a wide range of combination of 'r' and 'n'. For instance, the above example gives
the compound value of 1 at 8% p.a at the end of 3 years as 1.260 (see the Table III). When we
get the compound value of 1 for a combination of 'r' and 'n' (i.e., compound factor) we can
calculate the compounded value (or FV) of any amount. When the given amount (present
amount) is multiplied with the compounding factor (obtained from the Table) for the given
rate of interest and given number of years, i.e. :,(1+e)^{n}, we get the compounded value (FV)
In the above example, the compound value or FV of ₹ 10,000 will be 10,000 x 1.260=₹12,600.

Multiple compounding periods (non-annual compounding) :

In the above example it is presumed that the time period 'n' is a year and that the
compounding is made on annual basis However, interest may be compounded monthly,
quarterly and half yearly. In such a case, the formula used for annual compounding requires
necessary adjustment. If compounding is half yearly, interest is paid twice a year but at half
the annual rate. Hence annual rate of interest is to be divided by 2 and number of years is to
be multiplied by 2. Similarly, in case of quarterly compounding, interest rate is 1/4th of the
annual rate and there are 4 quarter years. Hence, annual interest rate is to be divided by 4
and number of years is to be multiplied by 4. The formula to calculate the compounded value
is:

A=P(1+r/m)^{m x n}

where, m= number of times for which compounding is to be done in a year.

Even if the compounding is on half yearly, quarterly or monthly interest basis, we can
calculate the compounded value by using the table value. If 12% interest p.a for 4 years on
quarterly basis is to be calculated, then annuity table-3% (dividing 12% by 4) and for 16 years
(multiplying 4 by 4)-provides the compounding interest on quarterly basis. Similar procedure
may be adopted for half yearly and monthly interest.

Example 2

Calculate the compound value when ₹ 10,000 is invested for 3 years and interest 8% p.a
compounded on quarterly basis.

A=P(1+r/m)^{m x n}

=10.000(1+0.08/4)^{4 x 3}
=10,000(1+0.02)^{12}=10,000(1.02)^{12}

=10,000 x 1.26824

= ₹12,682

With the help of table value, we can calculate the compounded amount very easily. The
compounding factor at 2%(8/4) for 12 years (3 x 4) is 1.268. Hence the compounded amount
(FV) will be ₹12,680 (i.e.,10,000 x 1.268)

The more frequently the interest is compounded, the faster a FV grows. Further, the more
frequently the interest is compounded, it begins in turn to earn further interest and hence
higher is the effective annual compound rate of interest. For instance, the principal amount,
rate of interest and number of years are same in both example 1 and example 2, but the only
difference is that in example 2, the compounding is done only a quarterly basis. Hence, the
future value will be higher in example 2 (in example 2, FV is 12,680, while in example 1, it is
12,600). It happens so because the interest amount for any 3 months will be compounded
in the next 3 months and so on (even though the rate of interest remains the same).

Risk
Risk refers to the uncertainty or potential for loss that may arise from an investment or
business decision. It is the possibility that the actual return on an investment may differ from
the expected return. In other words, risk represents the chance that an investment may not
perform as anticipated, resulting in financial loss or underperformance. Managing risk in
financial management involves identifying, analyzing, and mitigating potential risks to
minimize the impact on a company's financial health and overall performance. This is
typically done through various risk management strategies, such as diversification, hedging,
and insurance, to protect against adverse events and market fluctuations.

Types of risks
The risk is broadly classified into two types:
(i) Systematic Risk
(ii) Unsystematic Risk

(i) Systematic Risk:

Systematic Risk refers to that portion of variation in return caused by factors that affect the
price of all securities. The effect in systematic return causes the prices of all individual
securities to move in the same direction. The movement is generally due to the response to
economic, social and political changes. The systematic risk cannot be avoided. It relates to
economic trends which affect the whole market. The systematic risk cannot be eliminated
by the diversification of portfolio, because every share, bond is influenced by the general
market trend. Systematic Risk arises due to the following factors:
(a) Market Risk: Variation in prices sparked off due to real social, political and economic
events is referred to as market risk. Market risk arises out of changes in demand and supply
pressures in the market following the changing flow of news or expectations. Apart from this,
the subjective factors like psychology and sentiments of investors also cause some market
fluctuations and uncontrollable risk.
(b) Interest rate risk: Generally price of securities tend to move inversely with changes in
the rate of interest. The market activity and investor perceptions are influenced by the
changes in the interest rates which in turn depend on nature of instruments, stocks, bonds,
loans etc., maturity of the periods and creditworthiness of the issuer of the securities.
Basically the monetary and credit policy which is not controllable by the investor affects the
riskiness of the investments due to their effects on returns expectations and the total
principal amount due to be refunded.
(c) Purchasing Power Risk: Uncertainty of purchasing power is referred to as risk due to
inflation. Inflation arouses optimism since the entire prices group and that lead to higher
incomes. But the effect of this hike in incomes increases cost of production due to wage rise,
rise in prices of raw materials etc. and the consequent lower margin of profit leading to low
or no dividend. This is called cost pull inflation. Demand pull inflation is caused by the gap
between increased demand and inadequate supplies. People have more money in their
hands and they demand more consumable as well as durable goods. Purchasing power risk
is the uncertainty of the purchasing power of the amounts to be received in future due to
both inflation and deflation. There is possibility of prices of desired goods and services going
up due to inflation, during the holding period of the investment, as a consequence of which
the investor loses the real purchasing power. The element of purchasing power risk is
inherent in all investments and is uncontrollable.

(ii) Unsystematic Risk:

Unsystematic risk refers to that portion of risk which is caused due to factors unique or
related to a firm or industry. This risk is a company specific risk and can be controlled if
proper measures are taken. As it is unique to a particular firm or industry it is caused by
factors like labour unrest, management policies, shortage of power, recession in a particular
industry, consumer preferences etc. This type of risk can be further divided into following
types:
(a) Business Risk: Business risk can be internal as well as external. Internal Risk is caused
due to improper product mix, non-availability of raw materials, incompetence to face
competition, absence of strategic management etc. Internal risk is associated with the
efficiency with which a firm conducts its operations within the broader environment thrust
upon it. External business risk arises due to change inn operating conditions caused by
conditions thrust upon the firm which are beyond its controls, changes in business laws,
international market conditions etc.
(b) Financial Risk: Financial Risk is associated with the capital structure of the company. A
company with no debt financing has no financial risk. The extent of financial risk depends on
the leverage of the firm's capital structure. Proper financial planning and other financial
adjustments can be used to correct this risk and as such it is controllable.
(c) Credit or Default Risk: The credit risk deals with the probability of meeting a default. It is
primarily the probability that a buyer will default. The chances that the borrower will not pay
can stem from a variety of factors. The borrower's credit rating might have fallen suddenly
and he became default prone and in its extreme form it may lead to insolvency. In such
cases, the investor may get no return or negative returns. Proper management of credit risk
reduces the chances of non-payment of loan by the borrowers and involves exploration by
the company of ways and means of encouraging prompt payment. The concept of a portfolio
suits here.
(d) Other Risks: In addition to the above major risks there are many more risks particularly
associated with investment in foreign securities. These risks are monetary value risk,
political environment risk and inability of foreign government to meet its indebtedness. The
investor who buys foreign government bonds or securities of foreign corporations often in an
attempt to gain a slightly higher yield than obtained on domestic securities runs these risks.
The investor should weigh carefully the possibility of additional risk associated with foreign
investments against his expected return when investing in foreign securities rather than
domestic securities.

(iii) Individual and Group Risks: If a risk affects the economy or its participants on a macro
basis, it is a group risk. These risks affect most of segments of the society. These risks may
be unemployment, war. floods, earthquake etc. Individual Risks are confined to individual
identities or small groups. The risks such as fire, theft, robbery etc. are individual risks. Some
of the individual risks are insurable.

(iv) Financial and Non-Financial Risks: Financial Risks are those when a person stands to
loss or is adversely affected by some event or there is some type of loss or some occurrence
may expose assets or property to financial loss. When there is no possibility of financial loss,
these are non-financial risks.
(v) Pure and Speculative Risks: Pure risks are those situations where possibility of loss may
or may not be there. If such a risk is insured and loss arises then insurance company will
compensate that loss. For Policy, an insurance policy for a car is purchased, there is no
accident during the period of insurance policy , there will be no compensation, if damage
occurs to car due to accident then the insurer will indemnify the loss. There is no situation
of profit under such risks.
Speculative risks are those risks where there is possibility of profit or loss. These risks are
undertaken with the intention of earning a profit but possibility of loss also remains. An
investment in stock and shares may bring profit or loss. Pure risks have a possibility of
avoiding loss only whereas speculative risks have the possibility of gain also.

(vi) Static and Dynamic Risks: Dynamic risks are those which are the outcome of changes
in economy or the environment. These risks mainly refer to the macro economic variables
like inflation, income and output levels, technological changes, etc. Dynamic risks emanate
from the economic environment so these may not be anticipated or quantified.
Static risks are more or less predictable and are not affected by economic environment.
These risks are similar to pure risks and are suitable for insurance.

(vii) Quantifiable and Non-quantifiable risks: The risks which can be measured like
financial risks are quantifiable risks. Those risks which may result in situations like tensions,
loss of peace etc. are non- quantifiable.

Return
Return refers to the financial gain or loss experienced on an investment over a certain period
of time. It is a measure of the profitability or performance of an investment and is typically
expressed as a percentage. Return can be calculated in various ways, such as through the
use of metrics like return on investment (ROI), internal rate of return (IRR), or annualized
return. Understanding the return on investments is crucial for investors and financial
managers in evaluating the effectiveness of their investment decisions and assessing the
potential for future gains.

Risk-return tradeoff
The risk-return tradeoff is a fundamental concept in financial management that reflects the
relationship between the level of risk an investor undertakes and the potential return on their
investment. In general, higher levels of risk are associated with the potential for higher
returns, while lower levels of risk are typically linked to lower potential returns. This tradeoff
is central to investment decision-making, as investors must carefully consider their risk
tolerance and investment objectives in order to construct a portfolio that balances the
desired level of return with an acceptable level of risk. Understanding and managing the risk-
return tradeoff is crucial for investors seeking to optimize their portfolio's performance while
managing their exposure to risk. By assessing various investment options and their
associated risk-return profiles, investors can make informed decisions that align with their
financial goals and risk preferences.

Here are some key points regarding the risk-return tradeoff:

1. Return: Return refers to the financial gain or loss generated from an investment over a
specific period of time, usually expressed as a percentage. Different investments offer
different potential returns, and investors seek higher returns to increase their wealth.

2. Risk: Risk represents the uncertainty or variability associated with the potential return of
an investment. Investments with higher levels of risk typically have a higher chance of
experiencing greater fluctuations in return, including the possibility of loss.

3. Tradeoff: The risk-return tradeoff implies that investors must weigh the potential for higher
returns against the increased risk of potential loss when making investment decisions. In
general, investments that offer the potential for higher returns also tend to carry higher levels
of risk.

4. Risk tolerance: Investors have different risk tolerances based on their financial goals, time
horizon, and personal preferences. Some investors are willing to accept higher levels of risk
in pursuit of potentially higher returns, while others prioritize the preservation of capital and
seek lower-risk investments.

5. Diversification: Diversification is a strategy used to manage risk by spreading investments

across different asset classes, industries, and geographic regions. By diversifying their
portfolios, investors can potentially reduce overall risk without sacrificing returns.

6. Efficient frontier: The concept of the efficient frontier illustrates the optimal combination
of risk and return for a given set of investment options. It demonstrates the tradeoff between
risk and return and helps investors identify the most favorable risk-return profile for their
investment objectives.

Overall, the risk-return tradeoff is a central principle in financial management, as it guides

investors in making informed decisions about the allocation of their capital to achieve a
balance between potential returns and the associated level of risk.