Introduction to: Risk & return. Risky and risk free investments.

s. Indirect investments & direct investments Marketable & non- marketable securities. Capital & money market securities.

Often defined as the standard deviation of the return on total investment or degree of uncertainty of return on an asset or the possibility that the actual return on an investment will be different from its expected return. As defined by SBP For the purpose of these guidelines financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on banks ability to meet its business objectives.

Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance / legal / regulatory and reputation risks.
(BSD Circular 07 of 2003)

A fundamental premise of investing is the risk-reward trade-off. The greater the amount of risk an investor is willing to take on, the greater the potential return. It is the tendency for potential risk to vary directly with potential return, so that the more risk involved, the greater the potential return, and vice versa. The reason for this is that investors need to be compensated for taking on additional risk. For example, a GoP Ijara Sukuk Bond is considered to be one of the safest investments and therefore provides low potential

returns. Stocks are riskier; they offer no guarantee and thus can yield higher returns. After all, the government is unlikely to go out of business, whereas many companies fail every day. In the end, investors should expect to be rewarded for taking on additional risk. Three different levels of potential risk: 1. The maximum return offered by an investment may not be materialized. 2. The investor get only a very low or no return at all. 3. The investor may even lose some or all of his capital.

The concept of risk free investment where the capital and the return is guaranteed means that returns are low as the product provider is actually charging a fee for the guarantee. In this respect the wealth manager needs to look at other product providers for similar products. On the other hand, under a high risk product, the product provider has a special investment vehicle which they believe will produce a very high returnprovided it works. Since the product provider strongly believes that the vehicle will produce very high returns and since they need capital to make it work, they are willing to give the investing client a higher return. Investing clients usually are willing to participate in such investments if they think that the risks are lower then the return.

Another risk that investors may face with respect to the trade-off concept is the consistency in performance which means that while the instrument performs well on average, the performance is inconsistent; sometimes it performs well and sometimes otherwise. This means that if the investing client plans to sell the instrument, he faces a high level of uncertainty with respect to the price that he will get. This is called VOLATILITY. The higher the volatility, the higher is the uncertainty. Nowadays, the introduction of an expanding range of more complex financial instruments like fixed income instruments each with its own individual risk characteristics is challenging the traditional asset allocation and risk management strategies from trade off perspective.

Investors must always consider the trade off concept when planning wealth for accumulation, distribution, protection and also preservation. While allocating assets, the different strategies and types of allocation should be undertaken on a modular basis. By managing risk and returns, the investor can identify the fundamental and structural differences between the various asset classes in order to create more wealth or to preserve the existing wealth. Because of the risk-return trade-off, investors must recognize their personal risk tolerance when choosing investments. Taking on additional risk is the price of achieving potentially higher returns; therefore, if an investor wants to make money, he or she cannot cut out all risk. The goal instead is to find an appropriate balance that generates some profit but allows the investor to sleep at night.

The trade-off in Islam has another dimension: it is between this world and the hereafter. In Islam, one must always give performance to the hereafter unlike the risk-return where one has a choice whether to take a higher risk in exchange for a higher expected return. The concept is explained in the Quranic verse: therefore those who sell the life of this world for the hereafter should

fight in the way of Allah. Whose fights in the way of Allah, be he slain or be he victorious, on him We shall bestow a vast reward
(Quran 4:47). The verse explains that the returns (vast reward) definitely obliterates the risks (be slain). In another verse, the Quran says: Such are those who by the life of the world at the price of the

Hereafter. Their punishment will not be lightened, neither will they behave support (Quran 2:86)

The theoretical rate of return for an investment that has zero risk. The risk-free rate represents the expected return from an absolutely risk-free investment over a specified period. It is an investment where the return is known with certainty. The certainty generally comes from a supreme amount of confidence in the issuer of the investment; for example, Treasury securities are considered riskless investments because the Government is considered the best possible issuer. Critics contend that there is no such thing as a riskless investment because, in theory, even the Government could default. However, riskless investments have such a low level of risk that it may be ignored.

Direct Investments Defined The purchase of a controlling interest in a company or at least enough interest to have enough influence to direct the course of the company.

It means an Investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investors purpose being to have an effective voice in the management of the enterprise." In practice, this translates to an equity holding of 10% or more in the foreign firm.
(International Monetary Fund)

In-direct Investments Defined A type of investment in real estate without an actual investment in a physical (tangible) property. Typically this type of investing includes purchasing real estate related stocks or other real estate related funds.

Securities that can be converted into cash quickly at a reasonable price; marketable securities are liquid because they exhibit high trading volumes and tend to have shortterm maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices. A marketable security is a near-cash asset and is recorded at acquisition cost (purchase price plus incidentals, commissions, and taxes) or market value (whichever is lower) in the account books under current assets. Examples of marketable securities are commercial paper, banker's acceptances, Treasury bills, and other money market instruments.

A security that may not be easily bought or sold. Generally, a nonnegotiable security may be redeemed by the issuer, but this is often subject to some limitations. Low-risk instruments such as savings bonds and certificates of deposit are examples of nonnegotiable securities. They are also called nonnegotiable or nontradeable securities. These type of security does not trade on a normal market or exchange instead they are traded over the counter (OTC) or in a private transaction. Finding a party with which to transact business is often difficult. In some cases, these securities can't be resold due to regulations surrounding the security.

A financial market that works as a conduit for demand and supply of debt and equity capital. It channels the money provided by savers and depository institutions (banks, insurance companies, etc.) to borrowers and investees through a variety of financial instruments (bonds, notes, shares) called securities. A capital market is not a compact unit, but a highly decentralized system made up of three major parts: (1) stock market, (2) bond market, and (3) money market. It also works as an exchange for trading existing claims on capital in the form of shares.

A financial market for trading short-term, low-risk securities such as commercial paper, bonds, certificates of deposit etc. The market is made up of dealers in these securities who are linked by electronic communications. Network of banks, discount houses, institutional investors and money dealers who borrow and lend among themselves for the short term. Money market also trade in highly liquid financial instruments such certificates of deposit, commercial papers and government securities such as treasury bills, sukuk bonds. Money markets are largely unregulated and informal where most transactions are conducted over phone, fax, or online.

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