Question

QUESTION

A. Fair, Inc. is considering an investment in one of two common stocks. Given the information
that follows, which investment is better, based on risk (as measured by the standard deviation)
and return?
Stock A Stock B
Probability Return Probability Return
.30 12% .20 15%
.40 16% .30 6%
.30 18% .30 13%
.20 21%

B. ‘Understanding the relationship between risk and return and how it’s affected by time is
probably one of the most important aspects of investment’ – Discuss.
i. Different types of risk
ii. Diversification reduces risk
iii. Common measures of risk

Answer 1

Answer(B):

Risk- It is the uncertainty about future event, it is the fear that final outcome/return will differ from the expected outcome/return.

Return- It is gain or profit from an investment. It is change in the actual received value and the invested amount.

Risk and return- It is said, "More risk, more gain, No risk, no gain" so where there is risk, there is gain. If an investor wants to receive higher returns, he has to take more risk.

i. Different types of risk- There are different types of risk:

Systematic or market risk- It is the overall risk that affect overall stock market, it is not company or industry specific. It arises due to economic slowdown, recession, inflation, financial crisis etc.

Unsystematic risk- This is company or industry specific risk, it affects a particular company or companies under a particular industry. It arises due to loss in the company, shut down, strike, raw material prices, labor, demand and supply or the goods etc.

Credit or default risk- This risk happens when borrower defaults in repaying the loan or meet the obligations. When borrower takes loan from banks and default in repaying or companies issue bonds and default in repaying the money to bondholders.

Interest rate risk- This arise due to fluctuation in interest rates in the country. Interest rates depend upon the inflation.

Foreign exchange risk- This arises due to fluctuation in currency price with respect to other currency.

Reinvestment risk- This risk arises when your investment is not getting the higher interest rate or return when reinvested again.

ii. Diversification reduces risk- Yes this is true. Diversification is an art of reducing or mitigating risk. It is said, "Do not put all your eggs in one basket". Ine should not invest all his savings into one source of investment or one company/industry stock rather he should diversify his savings into different stocks, investment alternatives, asset class etc. Diversification reduces unsystematic risk and increases the return. One can make optimal portfolio with the help of diversification strategy.

iii. Common measures of risk- These are as following:

Standard deviation- It is the measure of dispersion of data from its mean value. It tells how much a current return is deviating from its historical return.

Beta- It is a measure of systematic/market risk. It measures the risk of a particular stock relative to the overall market. Stock market has beta 1. If a stock has beta more than 1, it means the stock is more volatile than the stock market.