Relationship between profitability, risk and liquidity

comparisons

These three concepts are characteristics of financial assets that have an established and logical relationship between them.

There is usually a positive relationship between risk and return. Since if the possibility of suffering losses is greater, the debtor will have to offer greater benefits to creditors. Otherwise, it will be very difficult to obtain financing.

That is why the debt of underdeveloped countries, for example, offers higher returns than that of developed countries. On the contrary, a debtor who offers more security will not need to promise as many benefits to finance himself. It will be easier for you to find investors with a conservative profile who will be willing to sacrifice future benefits in exchange for securing their investments.

Profitability, risk and liquidity

When there is less liquidity in a financial asset, the expected profitability is higher, since it will be more difficult to sell that asset when we want to get rid of it. Let's briefly expose and clarify these concepts first:

Cost effectiveness

Profitability refers to the profit obtained by an asset in relation to its acquisition cost, (ability of the asset to produce interest or other returns to the acquirer or investor)

Profitability = Profit / Acquisition Cost

Example: we buy a bond for a value of 1,000 and upon maturity we agree to receive 1,030, we would obtain a profit of 30, so the profitability obtained would have been 30/1000 = 0.03, that is, 3%.

Risk

The risk of an asset depends on the probability that, upon maturity, the issuer will comply with the agreed profitability and financial amortization clauses. That is, following our previous example, it would refer to the probability that at the end of the bond contract, from which we have bought it, it actually pays us the 1,030. The greater the probability of non-payment or breach of the conditions, the risk will be greater.

It is common to measure risk through mathematical variance. In addition, in financial markets, rating agencies usually put "notes" on the ability of companies to default or default.

The risk depends on the solvency of the issuer and the guarantees that it incorporates to the title.

Liquidity

The liquidity of an asset is measured by the ease and certainty of converting it into money in the short term without suffering losses. Therefore, money is the most liquid asset that exists as opposed to the least liquid that are real assets. An example of a real asset could be a house.

Savings and term deposits in credit institutions are very liquid financial assets.

Relationship between profitability, risk and liquidity

Once these concepts have been explained, we expose the relationship between them:

  • Higher risk and higher profitability: Anyone who is going to invest in an asset will assess its probability of default or of not receiving the conditions agreed upon at the beginning. The more likely it is that the issuer will not be able to meet the conditions, the higher the return will be required by the investor in terms of payment for assuming a risk.
  • Lower liquidity and higher profitability: The more difficult it is for an investor to convert the asset he owns into money, the higher the return that he demands from the asset. This is justified by the fact that the investor is sacrificing his purchasing power today. By not being able to dispose of your invested money at the time you want, it would be understood as a payment for the sacrifice of purchasing power made.
  • Greater liquidity and lower risk: The easier it is for an investor to convert an asset into money, the less risk it is exposed. Let's imagine that an investor wants to convert an asset into money that does not allow it to be done in the short term. In order to sell it, you will have to sell at a price, usually below the actual price. In some cases, the asset can be converted into money before it expires, but with a commission that will reduce its profitability.

The above is summarized in the following triangle. This triangle reflects very well the relationship between profitability, risk and liquidity:

From the triangle above, the teaching follows that we cannot have it all. In other words, there is no type of investment without risk, with high profitability and high liquidity.

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