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QUESTION 18

  1. Diversification refers to the _____.

A.

reduction of the stand-alone risk of an individual investment,measured by the standard deviation of its returns, by combining itwith other investments in a portfolio

B.

reduction of the systematic risk of an individual investment,measured by the standard deviation of its returns, by combining itwith other investments in a portfolio

C.

reduction of the systematic risk of an individual investment,measured by its beta coefficient, by combining it with otherinvestments in a portfolio

D.

reduction of the stand-alone risk of an individual investment,measured by its beta coefficient, by combining it with otherinvestments in a portfolio

E.

reduction of the unsystematic risk of an individual investment,measured by its coefficient of variation, by combining it withother investments in a portfolio

QUESTION 19

  1. Which of the following statements is true about capitalbudgeting analysis?

A.

Higher discount rates are used for computing the net presentvalues (NPVs) of riskier cash flows.

B.

The payback period method should be used for capital budgetingdecisions if the project has multiple cash outflows.

C.

The payback period method should be used for capital budgetingdecisions if there is a conflict in the project rankings as per theNPV method and the IRR method.

D.

The net present value (NPV) method should be used to evaluateindependent projects, and the internal rate of return (IRR) methodfor mutually exclusive projects.

E.

A project with only cash outflows and no cash inflows would havetwo internal rates of return (IRRs).

5 points

QUESTION 20

  1. Other things held constant, if the investors become less riskaverse, the new security market line (SML) would _____.

A.

not be affected

B.

shift down

C.

shift up

D.

have a steeper slope

E.

have a less steep slope

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Trinidad Tremblay
Trinidad TremblayLv2
28 Sep 2019

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RISK AND RATES OF RETURN

(I need help explaining the following and/or demonstrating it for my upcoming exam if anyone could help me comprehend the concepts I would greatly appreciate it!!)

Explain the positive relationship between risk and return..

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Relate the CAPM formula to the Security Market Line (SML) and explain what the SML shows..

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Explain how changes in investor risk aversion (MRP) affects the SML..

Hi guys could someone help me and explain in detail the two fundamental principles of investments – the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investor’s portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties –his risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock “A “may have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in “A” and 40% in another stock “B” having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

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