1. Briefly discuss.

a. What is investment risk?

Investment risk is a risk of a individual or a company that need their money in higher
return it can be related as that brave to invest their money for they future or for they
life and they value. Sometimes, when the equity of the investment fall down the
investor will get the lower return, In the investment it was many type of investment
risk. Such as, stand-alone risk, port-folio risk and market risk. Stand-alone risk is a risk
with a single operating of a single of a company, a company division, or asset, as
opposed to a larger, well diversified portfolio. Portfolio risk reflects the overall risk for
a portfolio of investments. It is the combined risk of each individual investment within
a portfolio. The major risks a portfolio will face are market and other systemic risks.
These risks need to be managed to ensure a portfolio meets its objectives. Market risk
is economic development of or event that affect entire market, in market risk it have
equity risk, interest rate risk and currency risk. Market risk example is increasing
tendency of consumers to shop online and it will the market risk has presented
significant challenges to traditional retail business. All of them is a main type in the
market risk. Liquidity risk is investment that unable sell our investment in the fair price
and get our money out when we need. Credit Risk, credit risk is the business incur by
extending credit customer. Its also refer to the company’s own credit risk with
suppliers. Liquidity risk is important because its includes asset liquidity and
operational funding liquidity risk.

b. Illustrating diversification effect of a stock portfolio?

The risk of an individual asset can be measured by the variance on the returns. The
risk of individual assets can be reduced through diversification. Diversification reduces
the variability when the prices of individual assets are not perfectly correlated. In
other words, investors can reduce their exposure to individual assets by holding a
diversified portfolio of assets. As a result, diversification will allow for the same
portfolio return with reduced risk.
c. Capital asset pricing model.

The capital asset pricing model (CAPM) helps to calculate investment risk and what is
return on investment and investor should expect. In other side (CAPM) also describes
as the relationship between systematic risk and expected return for assets,
particularly stock. This also used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of those asset and cost capital.
Its required return equal the risk free return plus a risk premium that reflect the stock’s
risk after diversification.

d. The security market line (SML)

The security market line, also known as the “characteristic line”, is the graphical
representation of the capital asset pricing model. It is a hypothetical construct based
on a world of perfect information. In the absence of perfect information, we can more
or less assume historical data will give us an accurate expectation of what kind of
returns and risk to expect with a particular investment of capital. The security market
line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the
return of the whole market at a particular time, and shows all risky marketable
securities.

e. What is the market risk premium?

Market risk premium is different between the expected return on a market portfolio
and the risk free. It provide a quantitative measure of the extra return demanded by
market participant for the increased risk. Market risk premium describes the
relationship between returns from an equity market portfolio and treasury
bond yields. The risk premium reflects the required returns, historical returns, and
 expected returns. The historical market risk premium will be the same for all investors
since the value is based on what actually happened.

f. Expected vs required return

As we can know this two have a difference it is, the required rate of return helps you
decide if an investment is worth the cost, and an expected rate of return helps you
figure out how much you can reasonably expect to make from that investment.

2. Calculated the stock expected return, standard deviation and coefficient of variation.
r^ = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)
= 11.40%.

σ2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4)+ (25% -

11.40%)2(0.2) + (60% - 11.40%)2(0.1)
σ2 = 712.44; σ = 26.69%.

CV = 26.69 / 11.40 = 2.34.

3. Required rate of return

rR= 0.07 + (0.13-0.07)(1.5)= 0.16
rS= 0.07 + (0.13-0.07)(0.75)= 0.115
difference is 0.16-0.115= 0.45 or 4.5%

4. required rate of return

a)
ri = rRF + (rM - rRF) x bi

ri = 9% + (14% - 9%) x 1.3 = 15.5%

b)
rRF (1) increases to 10%

ri = 10% + (14% - 10%) x 1.3 = 15.2%

 (2) decreases to 8%

ri = 8% + (14% - 8%) * 1.3 = 15.8%

The slope of the SML remains constant. The rm remain constant ri increased by
decresing rRF and ri decreased by increasing rRF.

c)

rM (1) increases to 16%

ri = 9% + (16% - 9%) * 1.3 = 18.1%

(2) falls to 13%.

ri = 9% + (13% - 9%) * 1.3 = 14.2%

The slope of the SML doesn't remain.

5. Find the coefficient of variation of each stock.

a) stock x: 35% / 10% = 3.5
Stock Y: 25% / 12.5%= 2
b) Riskier stock for diversified investor
The word ‘diversified’ here implies that the investor has a portfolio. In a diversified portfolio,
the relevant measure of risk of a stock is the stock’s beta. In this case, stock Y’s beta higher
(1.2 > 0.9) and is, thus the riskier stock.

c) Calculate each stock’s required rate of return.

Required return of stock x:

6% + (5%)(0.9)
6% + 4.5%
=10.5%
Required return of stock Y:
6% + (5%) (1.2)
6% +6%
=12%

d) On the basis of the thoo stocks’ expected and required returns, which stock will be
more attractive to a diversified investor?

Stock Y would be the more attractive stock to a diversified investor. Not only is the expected
return of stock Y higher than stock x ,Individually it’s expected return is also higher than the
required return.

e) Calculate the required rate of refiim of a portfolio that has $7500 invested in stock X and
$2500 invested in stock Y.
7500+2500= 10000
X= ¾ x 0.9=0.675
y= ¼ x 1.2= 0.3
portfolio beta= 0.675+0.3= 0.975
6%+(5%)(0.975)
6% + 4.875%
=10.875%

f) if the market risk premium increased to 6oZ»,which of the m•o stocks would have
larger increase in its required return?

Stock Y:
6% + (6%)(1.2)
6% + 7.2%
=13.2%

Stock X:
6% + (6%) (0.9)
6% + 5.4%
=11.4%
Stock Y (higher beta)