RISK-RETURN TRADE-OFF

Risk and return are the key concepts in investment theory. Risk can be measured by looking
at the universe of potential outcomes.

a. Provide the name of the statistical measure that is being used in investing to
determine risk. You do not have to describe the measure.

Suppose an investment offers the following possible outcomes:

Probability Possible return

11% -24%
28% -11%
37% +3%
14% +17%
10% +26%

b. Calculate the expected return of this investment.

c. Describe how fundamental analysis incorporates the risk of a financial asset into its
value.

THE EMH AND THE CAPM

The Efficient Market Hypothesis holds that available information is already incorporated in
the current prices of securities. The Capital Asset Pricing Model builds on Modern Portfolio
Theory in terms of providing the benefits of diversification.

d. Describe the semi-strong form of market efficiency.

e. Describe how the underlying assumptions for the CAPM might conflict with everyday
professional practice. Choose one of the assumptions to answer the question.

f. Provide a sketch for the CAPM, including the Capital Market Line and the Efficient
Frontier. Label the axes and name all relevant points.

g. Explain why investors have maximised the benefits of diversification under CAPM.