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Risk and Return: The Basics: Answers To End-Of-Chapter Questions

This document provides solutions to end-of-chapter questions and problems related to risk and return fundamentals. It defines key terms like beta, standard deviation, variance, and correlation. It also shows examples of calculating portfolio beta, required rates of return using the CAPM model, and expected return, variance and coefficient of variation for a portfolio. The security market line equation is provided relating asset risk measured by beta to required rates of return.

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Fatikchhari USO
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61 views

Risk and Return: The Basics: Answers To End-Of-Chapter Questions

This document provides solutions to end-of-chapter questions and problems related to risk and return fundamentals. It defines key terms like beta, standard deviation, variance, and correlation. It also shows examples of calculating portfolio beta, required rates of return using the CAPM model, and expected return, variance and coefficient of variation for a portfolio. The security market line equation is provided relating asset risk measured by beta to required rates of return.

Uploaded by

Fatikchhari USO
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Chapter 6

Risk and Return: The Basics


ANSWERS TO END-OF-CHAPTER QUESTIONS

6-1 a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes
by holding only one asset. Risk is the chance that some unfavorable event will occur.
For instance, the risk of an asset is essentially the chance that the asset’s cash flows
will be unfavorable or less than expected. A probability distribution is a listing, chart
or graph of all possible outcomes, such as expected rates of return, with a probability
assigned to each outcome. When in graph form, the tighter the probability
distribution, the less uncertain the outcome.

d. The standard deviation (σ) is a statistical measure of the variability of a set of


observations. The variance (σ2) of the probability distribution is the sum of the
squared deviations about the expected value adjusted for deviation. The coefficient
of variation (CV) is equal to the standard deviation divided by the expected
return; it is a standardized risk measure which allows comparisons between
investments having different expected returns and standard deviations.

f. A risk premium is the difference between the rate of return on a risk-free asset and the
expected return on Stock i which has higher risk. The market risk premium is the
difference between the expected return on the market and the risk-free rate. [ Risk
premium depends on business risk, financial risk, liquidity risk, country risk and
exchange rate risk]

i. Correlation is the tendency of two variables to move together. A correlation


coefficient (ρ) of +1.0 means that the two variables move up and down in perfect
synchronization, while a coefficient of -1.0 means the variables always move in
opposite directions. A correlation coefficient of zero suggests that the two variables
are not related to one another; that is, they are independent.

j. Market risk is that part of a security’s total risk that cannot be eliminated by
diversification. It is measured by the beta coefficient. Diversifiable risk is also
known as company specific risk, that part of a security’s total risk associated with
random events not affecting the market. This risk can be eliminated by proper
diversification. The relevant risk of a stock is its contribution to the riskiness of a
well-diversified portfolio.
k. The beta coefficient is a measure of a stock’s market risk, or the extent to which the
returns on a given stock move with the stock market. The average stock’s beta would
move on average with the market so it would have a beta of 1.0.

l. The security market line (SML) represents in a graphical form, the relationship
between the risk of an asset as measured by its beta and the required rates of return
for individual securities. The SML equation is essentially the CAPM, r i = rRF + bi(rM -
rRF).
SOLUTIONS TO END-OF-CHAPTER PROBLEMS[ Risk and return]

[6.1] Investment Beta ( it is measurement of systematic risk]


$35,000 0.8
40,000 1.4
Total $75,000

Portfolio Beta = Summation of [Wi*Beta] = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) =


1.12.

[6-3] rRF = 5%; RPM = Risk premium = Rm -Rrf = 6%; rM = Market return = ?
[ CAPM Model: rs = return of shares = rfr + Beta ( Rm -rfr)

rM = RFR + beta of market ( Rm -rfr) = 5% + 1(6%) = 11%.

rs when b = 1.2 = ?

rs = required return = RFR + beta ( Rm - rfr) = 5% + 6%(1.2) = 12.2%. [ According to SML]

Given,
Risk-free Rate, RRF = 5%
Market Risk Premium, RPM = 6%

When, Beta of Market = 1.0

Then, Market Return on Stock, RS = RRF + Beta × RPM


= 5% + 1.0 × 6%
= 11%

And, when Beta of Market = 1.2

Then, Market Return on Stock, RS = RRF + Beta × RPM


= 5% + 1.2 × 6%
= 5% + 7.2%
= 12.2%
6.4] LIKE THE SLIDE

r = Probability of * Possible return



r = Expected return = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)
(60%)
= 11.40%.= expected return

σ2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4)


+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)
σ = 712.44; σ = sqrt(σ2) = 26.69%.
2

26.69%
CV = coefficient of variation = stdev/expected return = = 2.34. [ CV is a
11.40%
relative measure of risk. CV 2.34 implies that for every one Taka average return risk is 234%.
The lower the CV, the better.
…………………………………………………………………………………………………..
Portfolio Beta = Summation of [Wi*Beta]
$142,500 $7,500
6-8] Old portfolio beta = (b) + (1.00)
$150,000 $150,000
1.12 = 0.95b + 0.05
1.07 = 0.95b
1.13 = b.

New portfolio beta = Summation (wi*beta) = 0.95(1.13) + 0.05(1.75) = 1.16.

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