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Homework answers / question archive / Part I (Based on the video): Fully watch the video and answer the following questions
Part I (Based on the video): Fully watch the video and answer the following questions. Question 1: According to the video, how do we define risk? Question 2: According to the video, how would the risk of a portfolio consisting of stocks from a variety of economic sectors compare to one consisting of stocks from just one sector? What is the technical finance term for this concept? Question 3: According to the video, what is the difference between std. dev. and beta in terms of measuring risk? Question 4: According to the video, what are some caveats associated with CAPM? Question 5: According to the video, what is the difference between systematic and unsystematic risk? How is each type of risk impacted by holding a well-diversified portfolio? Part II Question 1: You invest in a portfolio of 5 stocks with an equal investment in each one. The betas of the 5 stocks are as follows: .8, -1.3, .95, 1.2 and 1.4. The risk-free return is 3% and the market return is 7%. 1. Compute the beta of the portfolio. 2. Compute the required return of the portfolio. Question 2: You are given the following probability distribution for a stock: Probability Outcome .5 -6% .5 18% 1. A) Compute the expected return. 2. B) Compute the standard deviation. 3. C) Compute the coefficient of variation. Part III Question 1: What is the rationale for the positive correlation between risk and expected return? Question 2: Why is it possible to eliminate unsystematic risk in a well-diversified portfolio? Likewise, why is it not possible to eliminate systematic risk?
Part 1
Question 1
Risk is the fact that the return expected on a particular investment would be different or less than our expectations (falling short on our expectations).
Question 2
The risk of a portfolio consisting of stocks from various economic sectors compared to one consisting of stocks from just one sector has lesser volatility regarding returns. This is usually referred to in technical terms as diversifying risk.
Question 3
Standard deviation measures the total risk (diversifiable and non-diversifiable risk); however, Beta is the measure of only non-diversifiable risk, which means that Beta measures the risk that interests investors when calculating risk.
Question 4
Some caveats associated with CAPM include the fact that Beta measures when it comes to a particular asset might vary and change according to the way it is calculated. Moreover, the assumption that the particular asset is priced correctly is the core and basis for the risk, return relationship when utilizing CAPM. This basic assumption often requires that the asset market is efficient, which is hard to prove right based on the history over the recent years.
Question 5
Systematic or market-level risk is that associated with the whole market and cannot be diversified away. On the other hand, the unsystematic or firm-specific risk is associated with a particular company and can be reduced or diversified.
Part 2
Question 1
Required Return on Portfolio = 3% + (7% - 3%) * 0.61 = 0.0544
Required Return on Portfolio = 0.0544 * 100 = 5.44%
Question 2
Expected Return = 0.06 * 100 = 6%
Standard Deviation = √ 0.0144
Standard Deviation = 0.12
Standard Deviation = 0.12 * 100 = 12%
Part 3
Question 1
The rationale for the positive correlation between risk and expected return is that investors are usually risk-averse; therefore, the higher the risk, the higher the expected return for a particular asset to appeal to potential investors.
Question 2
Unsystematic or firm-specific risk is that associated with a particular company. Thus, an adverse event or loss in one firm in a well-diversified portfolio can be compensated by an improvement or a profit in another. On the other hand, the systematic or market-level risk is associated with the whole market, including changes in interest rates, inflation, and various economic factors.
