Question

Question 3 BHP Ltd has a beta of 0.765, if the expected return of the market is 11.5% and the risk-free rate is 7.5%. Required: a) What is the appropriate required return of BHP Ltd? b) What does a beta coefficient measure? Define beta. c) What is the fundamental motivation behind portfolio theory? That is, what are people trying to achieve by investing in portfolios of securities rather than in a few individual shares or debentures?

Answer 1

a) Under Capital Asset Pricing Model (CAPM)

Required Return = Rf + b* ( Rm - Rf )

where

Rf - Return on risk free return (here 7.5%)

b - Beta (Here 0.765)

Rm - expected return of the market (here 11.5%)

Required Return = Rf + b* ( Rm - Rf )

= 7.5 + 0.765 * (11.5 - 7.5 )

= 10.56%

b) In general, there are two types of risk - Diversifiable and non diversifiable risk.Diversifiable risk can be eliminated through diversification, whereas non- diversifiable risk can not .

Beta is the measure of non- diversifiable risk. It measures the sensitivity of the stock with reference to market index. for example beta of 1.5 means, the stock is 50% riskier than the index. Similarly, beta .8 means  the stock is 20% (100-80) less risky than the index.

C) The primary motive behind portfolio theory is to Reduce Risk. This is achieved by investing in more than one security. It seeks only to reduce risk and not to enhance return. If we need to enhance return, identify the best security and invest all our fund into it. it is just like the precept - ''do not put all your eggs in one basket''