In this episode, we dive into the interconnected concepts of risk, return, and the cost of capital, essential knowledge for anyone navigating finance and investment. We start by defining risk in finance as the uncertainty in an asset's future cash flows, exploring why investors, typically risk-averse, require a risk premium as compensation for taking on higher risk.

We discuss different measures of return, including realised and multi-period returns, and examine the link between risk and return. Using concepts like expected return and volatility, we highlight how these metrics help describe the probability distribution of returns, showing that riskier assets often provide higher potential returns.

Moving into portfolio management, we explain how combining multiple assets can reduce risk through diversification, especially when assets have low or negative correlation. We also break down systematic and idiosyncratic risk and clarify why only systematic risk, measured by beta (β), warrants compensation in the form of a risk premium.

To conclude, we introduce the Capital Asset Pricing Model (CAPM), a popular method for estimating an asset’s cost of capital, and explain how companies should use a project’s beta-adjusted discount rate when making investment decisions. Tune in to gain a deeper understanding of how these concepts shape sound investment strategies and decision-making!