1
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.
2
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
3
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
4
• 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?
5
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
6
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%
7
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.
