CHAPTER 4

Question 4B

01. Define risk. Does greater risk imply a bad investment?

Risk is potential variability in future cash flow. The possibility than an actual return
will differ from our expected return. The wider the range of possible future events that
can occur, the greater the risk.

02. What is meant by the investor’s required rate of return? What are the two
components of the investor’s required rate of return?

The minimum rate of return necessary to attract an investor to purchase or hold a

security. It is also the discount rate that equates the present value of the cash flows
with the value of the security. We can separate the return into 2 parts of components
which are risk free rate and risk premium.

03. What is unsystematic risk? Give some examples.

The owner of a company's securities is at risk of adverse changes in the value of those
securities because of the risk associated with that organization. Examples of
unsystematic risk include a new competitor in the marketplace with the potential to
take significant market share from the company invested in, a regulatory change
(which could drive down company sales).

04. What is systematic risk? Give some examples.

Systematic risk reflects mainly macroeconomic shocks that effect aggregate behavior
of the economy and it measured by beta. This type of risk cannot be diversified as for
example unexpected changes in interest rate, tax rate changes, war, turbulent political
event and foreign competition.

05. What is the meaning of beta? Explain what a portfolio beta of 1.5 means.

Slope of characteristic line called as BETA. Beta measures the average

responsiveness of security’s return to the movement of the general market. A stock
with a beta exceeding 1 has more market risk than the typical stock. If beta is
1.5, the security returns move up and down 1.5 percent for every 1 percent
change in the market’s returns.
06. Define the security market line. What does it represent?

Security market line is a graphic representation of the CAPM, where the line shows
the appropriate rehired rate of return for a given stock’s systematic risk. The security
market line refers to the attitudes of investors regarding the minimal acceptable return
for a given level of systematic risk.

07. Assuming the market is efficient, what is the relationship between a stock’s price
and the security market line?

Stock falls above the security market line is considered as undervalued stock, which
means these stocks are expected to earn a return exceeding what should be expected
given their beta or systematic risk. Overvalued stocks are those stock falling below
the security market line.

08. What is

a) Capital asset pricing model (CAPM)

Provide an intuitive framework for understanding the risk and return relationship. It
suggests that investors determine an appropriate required rate of return depending
upon the amount of systematic risk inherent in a security.

b) Beta

Beta measures the average responsiveness of security’s returns to the movement of

the general market.

09. How do we measure beta portfolio and what is characteristic line?

Portfolio beta measure the average responsiveness of the portfolio’s returns to the
movement of the general market, such as the Composite Index. Portfolio beta
indicates the percentage change on average of the portfolio for every 1 percent change
in the general market. It is weighed average of the individual assets beta and asset has
its own beta.