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Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
The continuously compounded annual return on a stock is
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- Yields Year TLS DI PFE WMT 20x5 12.00% 4.50% 5.80% 11.30% 20x6 13.30% 5.30% 5.70% 9.00% 20x7 10.20% 3.10% 5.90% 13.90% 20x8 9.30% 2.70% 4.50% 14.80% 20x9 8.60% 1.90% 6.30% 15.00% Correlations: CPP = Perfect positive correlation, CP = Perfect correlation, SC = No correlation, CN =Negative correlation, CPN = Perfect negative correlation TLS – DI= 0.996145099 = (CPP) DI – PFE= 0.005359947 = (SC) TLS – PFE= 0.08450695 = (CP) DI – WMT= -0.975050934 = (CPN) TLS – WMT= -0.986408221 = (CPN) PFE – WMT= -0.144303856 = (CN) b. Which three of the four stocks would you combine to build a diversified portfolio and why? It starts from the premise that there is an investment distribution in equal parts (33.3%) among the selected shares. c. Calculate the return, risk and coefficient of variation for the portfolio of three stocks selected in the previous exercise. It starts from the premise that there is an…coefficient variation=.55 positive coeficient of correlation =.20 expected value=$1200 What does standard deviation equal?T-Bills Philips Pay-up Rubber-Made Market Index Mean 7.00% 16.90% 2.07% 19.60% 15.00% Variance 0.00% 5.50% 2.40% 3.60% 3.10% Standard deviation 0.00% 23.40% 15.60% 18.90% 17.70% coefficient of variation 0 0.32 1.18 0.18 0.21 Covariance with MP 0 0.04 -0.03 0.02 0.03 Beta 0 1.32 -0.88 0.74 1 CAPM return 7.00% 17.54% -0.02% 12.89% 15.00% Correleation with market index 0.9953 -0.9953 0.6894 1 Mean 7.00% 16.90% 2.07% 19.60% 15.00% Valuation Overvalued (CAPM Above Benchmark) Undervalued (CAPM Below Benchmark) Undervalued ( CAPM Below Benchmark) Fairly priced (Benchmark) Nature of stock Aggressive (Beta is above 1) Defensive (Beta is below 1) Defensive (Beta is above 1) Defensive (Beta is 1) C) Indicate which investments will plot on, above and below the SML? d) If an investment’s expected return (mean return) does not plot on the SML, what does it show? Identify undervalued/overvalued investments from the graph
- Use the following information: Stock A B Good state 10% 14% Bad state 2% -2% Assume there is 60% probability that the good state occurs and 40% chance the bad state occurs. What is the standard deviation of stock A? (Please use 5 decimal places, this should be written in percentage, so an answer of 23.143% should be written as .23143)Table 9.2 Average Returns for T-bills T-Bills 1950 to 1959 Average 2.0 % 1960 to 1969 Average 4.0 1970 to 1979 Average 6.3 1980 to 1989 Average 8.9 1990 to 1999 Average 4.9 2000 to 2009 Average 2.8 Table 9.4 Annual Standard Deviation for T-Bills T-Bills 1950 to 1959 0.8 % 1960 to 1969 1.3 1970 to 1979 1.8 1980 to 1989 2.6 1990 to 1999 1.2 2000 to 2009 1.9 Use the tables above to calculate the coefficient of variation of the risk-return relationship in T-bills during each decade since 1950. (Round your answers to 2 decimal places.)14. John Lewis of Hungerford plc may have returns next year as follows: Return probability 10% 30% 20% 20% -10% 30% -20% 20% What is the standard deviation of returns for John Lewis? A. 24.65% B. 15.86% C. 14.83% D. 22.25%
- 10.7 Calculating Returns and Variability Using the following returns, calculate the arithmetic average returns, the variances, and the standard deviations for X and Y: Returns Year X Y 1 12% 14% 2 24 29 3 -27 -33 4 14 17 5 19 37A regression line has an intercept value of 174.71 and slope value of 25.22. What is the predicted value (the y-value) in the 100th period (the x-value is 100)? Round to two decimal places.Calculate WACC given the following: rs = 6 percent%, rd = 10%, rps = 4%, wd = 40%, ws = 50%, wps= 10%
- An asset has an average return of 10.73 percent and a standard deviation of 20.70 percent. What range of returns should you expect to see with a 95 percent probability? Multiple Choice −9.97% to 31.43% −51.37% to 72.83% −30.67% to 52.13% −20.32% to 41.78% −9.97% to 11.49%A4 2d The stocks on ABC Company and XYZ Company have the following returns over the last five years. Year ABC returns XYZ returns 1 –0.2 0.2 2 –0.1 0.1 3 0.5 –0.1 4 0.3 0.05 5 0.1 0.08 d. Calculate the variance and standard deviation on the returns on XYZ.Market Data Return Standard Deviation Beta Market Data 0.120 0.200 1.000 Risk-Free Rate 0.025 0.000 0.000 Company Data A B C Alpha 0.015 0.020 -0.005 Beta 1.200 0.800 1.250 Residual standard deviation, σ(e) 0.105 0.195 0.067 Standard Deviation of Excess Return 0.245 0.235 0.210 Required: Using the data above, please solve for the Sharpe Ratio, Treynor's Measure, and Information Ratio. (Use cells A3 to D10 from the given information to complete this question. Negative answers should be input and displayed as a negative values. All other answers should be input and displayed as positive values.) Risk-Adjusted Performance Measures A B C Market Sharpe Ratio Treynor's Measure Information Ratio