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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.
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Solved in 2 steps
- which one is correct please confirm? Q18: "An increase in the volatility of the underlying asset, all other things held constant, will ______ the option premium." increase decrease increase or decrease Not enough information is given.Let rf be the risk free rate of interest. E[r e ] be the expected return of some risky asset. Suppose that this risky asset pays out in states when the aggregate endowment is particularly low. There are three possibilities: ( a) E[r e ] > rf (b) E[r e ] = rf (c) E[r e ] < rf Which case applies to E[r e ] and why?Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, which of the following factors must be considered by an individual investor? A Investor's wealth. B Expected return on one asset relative to alternative assets. C Risk of one asset relative to alternative assets. D All of the above must be considered. Which of the following is correct about the expected return on a particular asset? Question 6 options: A If the asset's beta is 1.0, then the expected return on that asset is equal to the risk-free rate of return. B If the asset's beta is zero, then the expected return on that asset is greater than the risk-free rate of return. C If the asset's beta is zero, then the expected return on that asset is equal to the risk-free rate of return. D If the asset's beta is greater than 1.0, then the…
- (b) Evaluate the following investment advice: “Futures allow us to lock in the price we pay(receive when shorting) for the commodity/index. As a result, futures are perfectly safe investment choice for retirees.”Question 2: Assume that the risk-free rate, RF, is currently 8%, the market return, RM, is 12%, and asset A has a beta, of 1.10. (could be done on word document or excel). Assume that as a result of recent economic events, inflationary expectations have declined by 3%, lowering RF and RM to 5% and 9%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required return for asset A. Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 2%, to be14%. Ignoring the shift in part c, draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A. From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets?QUESTION 2 Exhibit 6.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Asset (A) Asset (B) E(RA) = 25% E(RB) = 15% (σA) = 18% (σB) = 11% WA = 0.75 WB = 0.25 COVA,B = −0.0009 Refer to Exhibit 6.2. What is the expected return of a portfolio of two risky assets if the expected return E(Ri), standard deviation ( σ i ), covariance (COVi,j), and asset weight (Wi) are as shown above? a. 18.64% b. 22.5% c. 11% d. 13.65% e. 20.0%
- Question 2 a) Plot the Security Market Line (SML).b) Superimpose the CAPM’s required return on the SML.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 doesit show? Identify undervalued/overvalued investments from the graph(Figure in attachment!!!) Problem 4: For each of the following statements, judge if it is true or false, andprovide a detailed explanation behind your answers.a) Roll’s critique is that the market is never truly in equilibrium and henceone can never truly test whether the CAPM holds.b) The figure below shows the risk and expected return of 4 given assets.Consider an investor with “Mean-Variance” preferences, and the statement:“If the investor is indifferent between assets A and D, then she prefers Cto B; but if she is indifferent between B and C, she prefers A to D.”.c) Suppose you make a “scatter plot”, each point representing a pair ofcontemporaneous returns from a time series of returns on the marketportfolio and a single asset. If the CAPM holds, you would expect all points to line up perfectly on a straight line, the slope of which is theasset’s beta.PS: (Problem 4 figure in attachment!!!)Which of the following is TRUE? a. The convenience yield measures the average return earned by holding futures contracts. b. The convenience yield is always positive for an investment asset. c. The convenience yield is always negative for a consumption asset. d. The convenience yield is always positive or zero.
- Assume that the following two assets are priced according to the zero-beta security market line: asset 1 has expected return of 6% and beta 0.5; asset 2 has expected return 14% and beta 2. (i) A third asset is mispriced by the market: it has beta 1.5 and expected return of 8%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such portfolio? [33%] (ii) A fourth asset is mispriced by the market: it has beta 1.2 and expected return of 18%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such portfolio? [33%] (iii) What should be the expected return for an asset with beta 0.8?Suppose you observe the following situation:Security Beta Expected ReturnDiamond Co 1.3 0.2Spade Co 0.8 0.14 (a) According to the above information, could we figure out the market return and risk-free rate? Explain your answer. (b) Discuss the possibility of including zero beta or negative beta assets in your portfolio. Explain the pros and cons of including these types of assets.Compute the expected rate of return on investment i given the followinginformation: Rf = 8%; E(RM) = 14%; βi = 1.0.b. Recalculate the required rate of return assuming βi is 1.8.25. a. Compute the expected rate of return on investment i given the followinginformation: the market risk premium is 5%; Rf = 6%; βi = 1.2.b. Compute E(RM)