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Chapter 5 Tutorial Questions

The document discusses risk and return concepts in finance including risk preference, correlation, systematic and unsystematic risk, diversification, the capital asset pricing model, and beta. Example questions are provided about risk levels of different investments and assets.

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Eritabeta Tony
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35 views

Chapter 5 Tutorial Questions

The document discusses risk and return concepts in finance including risk preference, correlation, systematic and unsystematic risk, diversification, the capital asset pricing model, and beta. Example questions are provided about risk levels of different investments and assets.

Uploaded by

Eritabeta Tony
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 5: Understanding Risk and Return

End of Chapter Questions:


5.8 How is the definition of risk in finance different from the way people ordinarily think of
risk? Why is the distinction important?

5.10 You have been offered the choice of two games. The first game gives you the chance of
doubling your money or losing it all. The second game gives you the chance of winning
50% of your bet or losing 50% of it. Which game would be preferred by:
(a) a risk-averse person?
(b) a risk-neutral person?
(c) a risk-seeking person?

5.14 What is ‘correlation’? Demonstrate your understanding by examining the situation of


perfect positive correlation of 2 assets and by explaining what will happen with perfect
negative correlation.

5.17 What is ‘systematic risk’? What is ‘unsystematic risk’? Give some examples of sources
of both types of risk to demonstrate your understanding.

5.18 Which type of risk does diversification reduce? Explain why only one type of risk can be
reduced by diversification.

5.20 The CAPM uses the expected return on the market portfolio to calculate the expected
return on a risky asset. What is the market portfolio? Describe one of the indices that is
used to approximate the market portfolio.

5.21 (a) Explain how the following asset’s returns would respond to a 1% increase in the
market return
i) β=1

ii) β=2

iii) β = –1

(b) Explain how much systematic risk the following assets have compared to the
market
i) β=1

ii) β=2

iii) β = -1
Financial Problems:
5.10 The standard deviation and expected returns for two portfolios are as follows.

Which portfolio would you prefer to hold? Why? Why can two portfolios with the same
standard deviation have different expected returns?

5.16 You have calculated the following annual historical returns data for three companies:

(a) Calculate the standard deviation for each of the shares.

(b) Which share has the highest level of risk? Which has the lowest?

5.18 You have forecast the returns and associated probabilities for the following three
companies:

(a) Calculate the expected return on each share.

(b) Calculate the variance for each share.

(c) Calculate the standard deviation for each share

5.19 You have forecast an equity risk premium of 7%. The risk free rate is 5%. Calculate the
expected return on the following three shares:
(a) What is the expected return for each company?

(b) Which company has the highest level of risk? How can you tell?

(c) Which company would you like to be holding when the market takes a downturn?
Why?

5.20 Complete the risk preference survey in the Finance World box on page 000. Use this
knowledge of your risk preferences to identify your preferred investment from those
identified in problem 5.19.

5.21 You expect a return on the market of 15% and the risk-free rate to be 3%. The beta for
Zed Ltd is 0.89 and it is priced to return 14%. Is Zed Ltd fairly priced? Would you buy or
sell Zed Ltd?

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