Question

13. Explain the terms commonly used in finance such as required return on investment, beta, systematic risk, the market risk, volatility, the security market line, beta, covariance and variance.

Answer 1

• The required rate of return on investment- it is the minimum return an investor expects to achieve. Every investor put his money to earn some returns. However the returns depends upon the risk appetite of the investor. The required rate of return is therefore calculated by adding a risk premium to the interest that can be earned by investing funds in a risk-free investment ( like govt. bonds or treasury bills etc. )
• Beta- It is a measure of the risk arising from the exposure to general market movements. It indicates that the investment made is more volatile or Less volatile as compare to the market as a whole.A beta of less then one indicates that the investment is less volatile than the market and a beta of more than one indicates that the investment is more volatile than the market. It is an integral part of capital asset pricing model(CAPM).
• Systematic risk- systematic risk is the risk inherent to the entire market or market segment. it affects the overall market as a whole and not just a particular stock or a company. It is unpredictable and impossible to completely avoid.
• Market risk-  market risk is the possibility of an investor experiencing losses due to factors that affect the entire market or asset class. It is an example of systematic risk. It cannot be eliminated completely but it can be hedged against through diversification.
• volatility - it is the rate at which the price of a security increase or decrease for a given set of returns. It is a statistical measure of dispersion of returns. It can be either measured by using standard deviation variance of the security or market .It is commonly noted that more the volatility , the riskier the security.
• The security market line- it shows different levels of systematic risk of various marketable securities plotted against the expected return of the entire market at a given point in time. It is The graphical representation of Capital Assets Pricing Model (CAPM).
• Covariance- it is the measure of directional relationship between returns of two assets. A positive covariance represents that assets move in the same direction where as a negative covariance represents that assets move in opposite directions. Cov_x,y=
• Variance- it measures how far each number in the set is from the mean. It is the expectation of square deviation of a random variable from its mean. it is the square of standard deviation. .