Question

1. Frane Ltd has available two investment opportunities with the following risk return
characteristics

	A	B
Expected return	13%	20%
Risk	4%	8%

Frane Ltd plans to invest 65% of its available funds in Security A, and 35% in B.
The directors believe that the correlation coefficient between the returns of the
securities is +0.2.

(i) Calculate the expected return of the portfolio and the risk of the portfolio.

E(RP)=15.45%

σp= 4.18%

This one I have calculated, thank you.

(ii) Suppose the correlation coefficient between A and B was -1.0. How should Frane
Ltd invest its funds in order to obtain a zero risk portfolio?

by using ( a – b )² = a²-2ab+b²

I have tried, but also don't know how to do. Thank you.

σp² = (xσA)² + [(1-x) σB]² + 2x(1-x) ρAB σAσB

= (0.65 x 0.04)² + (0.35 x 0.08)² + 2(0.65)(0.35)(-0.1)(0.04)(0.08)?

(iii) According to CAPM, “The only risk that matters to an investor is
non-diversifiable risk.” Do you agree with the comment?

2. “Both trade-off theory and pecking order theory explain why companies may differ
in their levels of gearing.” Discuss this statement.

Answer 1

Like the answer or comment in case you need any clarifications.

• The only risk that matter to investor is diversiable risk as it can be reduced by making up a diversified portfolio and risk can be decreased.Meanwhile Non-diversifiable risk is risk like currency vaue changes,Government policies etc , it is not in control of the investor or the company he is investing in. So, Investor focussses on reducing diversifiable risk.
  
  
• Pecking Theory says that first use retained earnings that is money available with entity and then go for debt and at lender of last resort go for issuing more share.
• Trade-off theory provides that always has more debt as debt is cheap way of funding the higher cost of equity requirements.Debt helps in saving taxes.Debt shall be raised in limit though considering Debt-Equity Ratio and Interest coverage of the organisation.
• Both theories discuss capital structure of the entity.They both tend to focus on different source of funding.So,both diffe in the levels of gearing they tend to provide.