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Chapter 8 Assignment

1. What is risk in the context of financial decision-making?

The risk of financial decisions means that the investment may be lost in whole or in part.

High-risk investments have a high potential return because if the potential return is low and the

risks are high, there is no point in investing in them.

2. Define return, and how to find the rate of return on investment?

The return is the net income on the initial investment over a period. The rate of return on

investment is determined as a percentage of the net return on the initial investment.

3. Compare the following risk preferences: (a) risk-averse, (b) risk-neutral, and (c)

risk-seeking.

Risk appetite refers to the level of risk that people are willing to take in getting an

investment. Risk preferences fall into three categories that determine an investor’s responses

towards their willingness to invest: (a) risk aversion, (b) risk-neutral, and (c) risk-seeking.

Risk Aversion

Risk-averse investors are those who prefer a less risky investment over a higher-risk

investment given the expected rate of return. They hope, the risk will increase the expected

return of the portfolio which might be problematic.

Risk Neutral

Risk-neutral investors are those who choose investment opportunities based on expected

returns. In between from two investment options, risk-neutral investors ignore the risk factor and

choose the one that offers the highest expected return.

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Risk Seeking

Risk-seeking investors are those who tend to invest with higher risk. The seeking

investors consider risk factors and ignore yield factors. Risk investors seeking all three risks

while choosing investments regardless of lower expected returns but the higher risks.

4. Explain how the range is used in scenario analysis?

Risk and uncertainty provide uncertain situations about investment performance. This

investment involves greater risks. The risk can be measured by analyzing the program. When

analyzing the program, different results can be used to understand the ineffectiveness of the

results. In this case, the results can be pessimistic (worst), optimistic (better), and average (base).

In this method, the risk is measured by the range of possible results. The range can be achieved

by subtracting gains associated with pessimistic results, while gains associated with optimistic

results are even higher.

5. What relationship exists between the size of the standard deviation and the degree

of asset risk?

There is a direct relationship between the size of the variance and the risk level of the

asset. The larger the standard deviation, the higher the risk level of the asset. In general, the

greater the variance, the greater the volatility of returns and the greater the risk of obtaining

returns.

6. What does the coefficient of variation reveal about an investment’s risk that

standard deviation does not?

The standard deviation in absolute terms measures the risk. For example, the standard

deviation of one investment is 15% and that of the second investment is 17%. They can only be
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compared if they have the same return, where the coefficient of variation is the unit feedback

from the risk measures. The formula for calculating the coefficient of variation is the standard

deviation divided by the average rate of return. The coefficient of variation measures the risk of

return on the one hand and can be compared with other portfolios.

7. What is an efficient portfolio? How can the return and standard deviation of a

portfolio be determined?

An efficient investment portfolio is the investment portfolio that can provide the best

return for a given risk. To calculate the expected return on an investment portfolio, we multiply

the expected return on each asset in the investment portfolio by the weight of the investment

portfolio and then add it up. To calculate the variance of a portfolio, we need to determine the

number of assets in the portfolio. If there are two assets in the portfolio, the formula is as

follows:

Suppose that the weights of the two devices are W1 and W2 and the standard deviation of

SD1 and SD2, then

Variance = (w12 * SD12 + W22 * SD22 + 2 WI W2 Covariance (Inv A, Inv B)1/2

8. Why is the correlation between asset returns important? How does diversification

allow risky assets to be combined so that the risk of the portfolio is less than the risk of the

individual assets in it?

Correlation is a statistical tool used to measure any two classes on the same pitch and can

be classified as follows:

• Positive correlation: The two classes usually change in the same direction
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• Negative correlation: The two classes usually change in opposite directions

Concept or relevance is very important in selecting an investment portfolio and building

an effective investment portfolio. It should be noted that it is a reduction in the risk that a given

monopolist will receive a risky portfolio return. Diversification is the process of reducing risk

through the allocation of investments across different financial instruments, industries, etc.

Type of Risk

1. Systemic risk - this type of risk is not specific to a particular company or sector and

cannot be eliminated or reduced by diversification. The main causes are inflation,

interest rates, exchange rate fluctuations, and so on.

2. Irregular risk - this risk is specific to the company or industry. These risks can be

reduced through diversification. The most common non-systematic risks are financial

and business risks. Companies need to diversify because in an emergency if one stock

is not working, the other stock can support the remaining ones.

9. How are total risk, non-diversifiable risk, and diversifiable risk related? Why is a

non-diversifiable risk the only relevant risk?

Total risk includes systemic and non-systematic risks. Systemic risks are risks that cannot

be diversified such as civil wars, political unrest, etc., these are common to all sectors. Therefore,

systemic risks cannot be diversified. Non-systematic risks are diversifiable risks. If certain

services perform poorly, an investor can diversify their asset base to reduce the exposure of risk.

According to the CAPM model, the compensable risk is a risk that cannot be diversified.

10. What risk does beta measure? How can you find the beta of a portfolio?
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Risk Measurement

Beta is a relative measure of irreversible risk. This indicates that the rate of return on

assets varies with the market return. The beta of the assets can be calculated based on the

immediate income of the asset.

Portfolio Beta

The portfolio is the sum of several individual stocks. To obtain the beta value of a

portfolio, the beta value of each stock must be rounded and then multiplied by the weight or a

specific portion of the market portfolio. We can find the beta of the portfolio by multiplying the

weight of assets with the beta of the assets and then sum all the values.

11. Explain the meaning of each variable in the Capital Asset Pricing Model (CAPM)

equation. What is the security market line (SML)?

CAPM model = RF + B * (RM - RF) or RF + B * RP

Rf = risk-free interest rate, usually the 10-year treasury rate of return

B = asset beta

RM = Market Return

RP = market risk premium

The security market line (SML) is a graphical representation of the fixed asset valuation

model. This represents the expected rate of return relative to the risk of the system.

11. Rate of return, standard deviation, and coefficient of variation: Mike is searching

for a stock to include in his current stock portfolio. He is interested in Hi-Tech, Inc.; he has been

impressed with the company’s computer products and believes that Hi-Tech is an innovative
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market player. However, Mike realizes that any time you consider a technology stock, the risk is

a major concern. The rule he follows is to include only securities with a coefficient of variation

of returns below .90. Mike has obtained the following price information for the period 2015

through 2018. Hi-Tech stock, being growth-oriented, did not pay any dividends during these 4

years.

Stock Price
Year Beginning End
2015 $14.36 $21.55
2016 21.55 64.78
2017 64.78 72.38
2018 72.38 91.80

a. Calculate the rate of return for each year, 2015 – 2018, for Hi-Tech stock.

Year Beginning Ending Dollar Return Percentage Return

2015 $ 14.36 $ 21.55 $ 7.19 50.07%
2016 $ 21.55 $ 64.78 $ 43.23 200.60%
2017 $ 64.78 $ 72.38 $ 7.60 11.73%
2018 $ 72.38 $ 91.80 $ 19.42 26.83%

b. Assume that each year’s return is equally probable, and calculate the average

return over this period.

Expected Return = (50.07 % + 200.6 % + 11.73 % + 26.83 %) / 4

Expected Return = 72.31 %

c. Calculate the standard deviation of returns over the past 4 years.

Percentage Return Probability Expected Return Deviation Deviation^2 Deviation^2 * Prob

50.07% 0.25 72.31% -22.24% 4.95% 1.24%
200.60% 0.25 72.31% 128.29% 164.59% 41.15%
11.73% 0.25 72.31% -60.58% 36.70% 9.17%
26.83% 0.25 72.31% -45.48% 20.68% 5.17%
Variance 56.73%
Standard Deviation 75.32%
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d. Based on b and c, determine the coefficient of variation of returns, for the

security.

Coefficient of variation = SD / Mean = 75.32 % / 72.31 % = 1.04

e. Given the calculation in d, what should be Mike’s decision regarding the

inclusion of Hi-Tech stock in his portfolio?

As the coefficient of variation is greater than the required level of 0.9 so, Mike

will not include this stock in their portfolio.