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Risk and Rates of Return Problem Solving

The document discusses risk and rates of return. It defines risk as the probability of an unfavorable outcome, and distinguishes between diversifiable risk and market risk. Rates of return refer to expected, required, and actual returns on an investment. The capital asset pricing model relates required return to risk-free rate, market risk premium, and beta. Beta measures the volatility of a security compared to the market. Problems apply these concepts to calculate portfolio betas, required returns, and evaluate investment opportunities.

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3K views7 pages

Risk and Rates of Return Problem Solving

The document discusses risk and rates of return. It defines risk as the probability of an unfavorable outcome, and distinguishes between diversifiable risk and market risk. Rates of return refer to expected, required, and actual returns on an investment. The capital asset pricing model relates required return to risk-free rate, market risk premium, and beta. Beta measures the volatility of a security compared to the market. Problems apply these concepts to calculate portfolio betas, required returns, and evaluate investment opportunities.

Uploaded by

BlueBlade
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 PDF, TXT or read online on Scribd
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Risk and Rates of Return:

 Risk is the probability of having an unfavorable outcome.

 Diversifiable Risk – Risk that can be eliminated through


diversification. It is also known as Unsystematic risk

 Market Risk – Risk that can never be eliminated even if the


investment is fully diversified. It is also known as Systematic
Risk.

 Rates of Return is the percentage of return over the amount of


investment.

 Expected Rate of Return – the percentage or rate of return that


is expected to be realized on an investment after taking into
account the probability of possible outcomes.

 Required Rate of Return – the minimum rate of return


acceptable by the investor on the portfolio investment.

 Actual Rate of Return – the percentage or rate that is actually


earned by the investor on the portfolio investment.

 Market equilibrium: the event when the required rate of return is


equal to the expected rate of return on an investment.

Capital Asset Pricing Model:

 Required rate of return = Rfr + (Mrp) β

= Rfr + ( Mr – Rfr) β

Where:
 Rfr is the Risk-free rate which usually the Treasury bill
rate.
 Mrp is the Market Risk Premium
 Mr is the Market Rate of return on an average stock
market.
 β is the Beta Coefficient which measures the riskiness of
the stock.
 Beta Coefficient (β):

 Aggressive Beta – beta > 1


 Average Beta – beta = 1
 Defensive Beta – beta < 1

Security Market Line(SML): A line graph showing the relationship of risk


(beta) and the rates of return of securities.

 Characteristics of change in the SML:

Required Return Due to Risk Due to Inflation


Components Aversion

1. Rfr No Change Increase

2. Mrp Increase No Change

3. Mr Increase Increase
PROBLEM A: You are appointed as the financial manager of a P4,000,000
investment fund named Ucandoit Corporation. The fund consists of four
stocks with the following investment and betas:
Stock Investment Beta
A P 400,000 1.50
B P 600,000 (0.50)
C P1,000,000 1.25
D P2,000,000 0.75
The market’s required rate of return is 14% and the risk-free rate is 6%.

1. What is the portfolio beta?


2. What is the Market Risk Premium?
3. What is the required rate of return of the portfolio?
4. What is the required rate of return if the beta is equal to 1?

1. Beta Portfolio = A - 1.5 x 400T/4M

= B - (0.5) x 600T/4M

= C - 1.25 x 1000T/4M

= D - 0.75 x 2M /4M

Bp = 0.7625

2. Market Risk Premium

MRP = MR – RFr
= 14% - 6%
= 8%

3. Required Rate of Return = RFr + (MRP) Beta Portfolio

= 6% + (8%) 0.7625

=12.1%

4. Req. Rate of Ret. = RFr + (MRP) Beta

= 6% + (8%) 1

= 14%
PROBLEM B:Mr. Pasado plans to invest in the SurePass fund, which has a
total capital of P500M invested in 5 stocks:
Company Amount Stock’s Beta

Aral Inc. P 160 M 0.5


Bagsakan Inc. 120 M 1.2
Copyahan Corp 80 M 1.8
Dasalnalang 80 M 1.0
Industries
Ewan Company 60 M 1.6

The prevailing risk-free rate is 6% and you believe the following probability
distribution for future market returns is realistic.

Probability Market
Return
0.1 -28%
0.2 0
0.4 12%
0.2 30%
0.1 50%
5. What is the market rate of return on an average stock? 13%
6. What is the beta portfolio of the SurePass Fund? 1.088
7. What is the required rate of return for SurePass Fund? 13.62%
8. Suppose Mr. Pasado receives a proposal from a company seeking new
capital. The amount needed to take a position in the stock is P50 M, it has
expected return of 15%, and its estimated beta is 1.5. Should Mr. Pasado
invest or not invest? State the difference. NOT-by 1.5%
9. What expected rate of return should Mr. Pasado be indifferent to
purchasing the stock? 16.5%
5.(.1x-0.28)+(.4x0.12)+(.2x0.30) +(.1 x.50) = 13%
6. Beta Portfolio
Investment x Beta
Aral 160m/500m x 0.5 = 0.16
Bagsakan 120m/500m x 1.2 = 0.288
Kopyahan 80m/500m x 1.8 = 0.288
Dasal nalang 80m/500m x 1.0 = 0.16
Ewan 60m/500m x 1.6 = 0.192
Beta Portfolio 1.088
7. Req. Rate of Ret. = RFr + (Mr - Rfr) Bp

= 6% + (13% – 6%) 1.088

= 13.62%

8. If Exp. Ret. > Req. Ret. = Invest


Thus, Not Invest since Req. Ret. is greater by 1.5%

9. Expected Return vs. Required Return Minimum

15% VS. RR = 6% + (13 – 6) 1.5

= 16.5%

PROBLEM C:Your boss, Jamylca, is interested in acquiring No Fail Inc. (NFI)


shares of stock. He asks you to provide certain information with regard to
NFI’s riskiness. You have gathered the probability distribution for NFI and is
presented below:
Performance Probability of Rate of return
Of NFI this occurring if this demand
occurs
Weak 10% -50%
Below Average 20% -5%
Average 40% 16%
Above Average 20% 25%
Strong 10% 60%

10. What is the expected rate of return for NFI?


11. What is the variance for NFI?
12. What is the coefficient of variation for NFI?

10. Expected Rate of Return:


Probability x Rate of Return

Weak 10% x -50% = (5%)

Below Average 20% x -5% = (1%)

Average 40% x 16% = 6.4%

Above Average 20% x 25% = 5%

Strong 10% x 60% = 6%

R = 11.4%
11. Variance = ∑[P(R- R)2]

= P(R- R)2

Weak 10%(-50 – 11.4%)2 = 0.0376996

Below Average 20%(-5% – 11.4%)2 = 0.0053792

Average 40%(16% – 11.4%)2 = 0.0008464

Above Average 20%(25% – 11.4%)2 = 0.0036992

Strong 10%(60% – 11.4%)2 = 0.0236196

Variance ∑= 7.12%

Standard Deviation 26.69%


12. CV= Expected Return
= 11.4%
= 2.34

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