Financial Risk Manager Part 1
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The concept of risk and reward is a fundamental principle that governs investment decisions. This principle suggests a certain relationship between the level of risk an investor is willing to take and the potential reward they might receive. Which of the following statements accurately describes this relationship between investment risk and potential reward?
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TTanishq
A
As the investment risk increases, the reward decreases.
B
As the investment risk decreases, the reward increases.
C
As the investment risk increases, the potential for reward increases.
D
The relation between investment risk and reward depends on the financial product.
Explanation:
Explanation
The correct answer is C because it accurately describes the fundamental risk-reward tradeoff principle in finance.
Key Concepts:
- Risk-Reward Tradeoff: This is a core principle stating that higher potential returns are generally associated with higher levels of risk.
- Direct Relationship: As investment risk increases, the potential for reward also increases - this is a direct, not inverse, relationship.
- Compensation for Risk: Investors demand higher potential returns to compensate for taking on additional risk.
Why Other Options Are Incorrect:
A is incorrect because risk and potential reward are directly related, not inversely. Higher risk investments offer the potential for higher returns to compensate investors for taking on that additional uncertainty.
B is incorrect because it contradicts the basic principle. Lower-risk investments (like government bonds) typically offer lower potential returns than higher-risk investments (like startup companies).
D is incorrect because while specific risk levels vary by financial product, the general principle that higher risk correlates with higher potential reward applies across virtually all investment types.
Important Nuances:
- Higher risk doesn't guarantee higher returns - it only provides the potential for higher returns
- The actual outcome may still result in losses despite higher risk
- Risk represents the uncertainty that actual returns will deviate from expected returns
- Greater risk means a wider range of possible outcomes, including both larger gains and larger losses
This principle is foundational to modern portfolio theory and investment decision-making.
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