In: Finance
(Each of the following parts is independent.)
Stock |
Price Today |
Expected Price in 1 year |
Expected Dividend in 1 year |
Beta |
X |
$20 |
$22 |
$2.00 |
1.0 |
Y |
$30 |
$32 |
$1.78 |
0.9 |
Correlation |
|
Stocks A & B |
-0.66 |
Stocks A & C |
-0.42 |
Stocks A & D |
0 |
Stocks A & E |
0.75 |
(d) Explain the terms systematic risk and unsystematic risk and their importance in determining investment return.
Please provide stepping for all if possible, much appreciated.
1. Calculation of required return of portfolio:
Required return = weight risk free asset * return from risk free asset + weight market portfolio * market risk premium
= 0.60* 3 + 0.40* 7
= 1.80 + 2.80 = 4.60%
hence the required return of portfolio = 4.60%
a. Calculation of expected return:
Expected return = [Dividend + (price end of year - price today )]/ Price today
Expected return for Stock X = [2 + (22 - 20)] / 20 = 20%
Expected return for Stock Y = [1.78 + (32 - 30)] / 30 = 12.60%
b. Calculation of required return using CAPM model:
Required return = Rrf + βa∗(Rm − Rrf)
Required return Stock X = % 7+ 1 * 8% = 15%
Required return Stock Y = = 7% + 0.90 * 8% = 14.20%
From above analysis we can make out that the investor should invest in Stock X as its expected return is greater than required return whereas Stock Y expected return is less than required return.
where:
Rrf=Risk-free rate
Rm=Expected return of the market
βa=The beta of the security
(Rm−Rrf)=Equity market premium
3. Pair of stock A & B with correlation -0.66 offers the greatest diversification benefit, as the lesser the correlation between the assets in the portfolio (in this case 2 assets) the greater the benefit of diversification. As the lowest correlation among option is between pair of assets A & B (i.e., - 0.66), it will offer the maximum risk reduction.
a. Systematic risk:
Importance in determining investment return: for this type of risk the investor should demand extra compensation (Ii.e., demand higher returns for such risk).
b. Unsystematic risk:
Importance in determining investment return: The risk of loss in one asset is reduced by profit in another stock which is achieved through diversification.