Risk Curve - Explained
What is the Risk Curve?
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Table of ContentsWhat is the Risk Curve?How is the Risk Curve Used?The Risk Curve in MPT and the Efficient FrontierAcademic Research on the Risk Curve
What is the Risk Curve?
The Risk Curve is a graphical presentation of the risks and returns of two variables. The risk curve plots two variables on a graph to reflect their financial risks and returns, this graph creates visuals on how returns are made on the assets and the risks entailed. The nature of the risks are also indicated in the graph. The risk curve is made of multiple data representing multiple assets in order to aid the visualization of the relative risks and returns of these assets. The risk curve is an important metric in mean-variance analysis and the Capital Asset Pricing Model.
How is the Risk Curve Used?
In the risk curve, two variables is often plotted on a graph where their relative risks are pitched on the vertical axis (x-axis) and the financial returns outlined on the horizontal axis (y-axis). The assets that can be displayed on a risk curve are not just similar assets but also dissimilar assets. Assets that are risk-free but have little returns are often lined on the lower part of the left side of the chart, such assets include the Treasury bill. Assets that have huge returns and high rate of losses are also position at the top right corner of the chart, assets like these include the leveraged ETF.
The Risk Curve in MPT and the Efficient Frontier
There are certain economic theories that use the risk curve, these include the Modern Portfolio Theory and the Efficient Frontier theory. Through the risk curve, the categories in portfolios and their relative risks and returns are identified. The risk curve also display multiple data on different assets that will help in discovering the historical performances of the assets which will foster the creation of risk curve models. The historical variance in risks and returns of the outlined assets and what the expected average return and relative risk of each asset should be are presented on the risk curve.
Academic Research on the Risk Curve