Module: | MODULE B: RISK MANAGEMENT
Q258: Consider the following statements regarding the fundamental linkages between Risk and Return in banking:
1. The fundamental principle of finance dictates that undertaking higher risk must always result in guaranteed higher actual returns for the bank.
2. Banks demand a risk premium over the standard risk-free rate to logically compensate for undertaking activities with higher earnings volatility.
3. Holding absolute cash in a bank's secure vault generates zero nominal market risk and simultaneously yields zero return.
Which of the statements given above is/are correct?
2. Banks demand a risk premium over the standard risk-free rate to logically compensate for undertaking activities with higher earnings volatility.
3. Holding absolute cash in a bank's secure vault generates zero nominal market risk and simultaneously yields zero return.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: The core principle of finance states that higher assumed risk is associated with a higher *expected* return, not a *guaranteed* higher actual return.
If the higher return were guaranteed, the asset would inherently be risk-free.
Statement 2 is correct: To compensate for the uncertainty and volatility of earnings, banks strictly price their products by demanding a "risk premium" over the prevailing risk-free benchmark rate (like government bonds). Statement 3 is correct: Cash held in a vault is not exposed to market price fluctuations (zero nominal market risk), but it also generates absolutely no yield (zero return). This perfectly illustrates the foundational risk-return trade-off: avoiding all risk results in avoiding all returns.
If the higher return were guaranteed, the asset would inherently be risk-free.
Statement 2 is correct: To compensate for the uncertainty and volatility of earnings, banks strictly price their products by demanding a "risk premium" over the prevailing risk-free benchmark rate (like government bonds). Statement 3 is correct: Cash held in a vault is not exposed to market price fluctuations (zero nominal market risk), but it also generates absolutely no yield (zero return). This perfectly illustrates the foundational risk-return trade-off: avoiding all risk results in avoiding all returns.