Question

1. True or false: The most important characteristics in determining the expected return of a well-diversified portfolio is the variance of the individual assets in the portfolio. Please explain your answer.

2. Suppose that the expected return of stock A is 18.5%. However, based on CAPM, the expected return of stock A should be 17.2%. Is stock A correctly priced? If not, is stock A overpriced or underpriced? Why?

Answer 1

a) The given statement is False.

The variance of the individual assets is a measure of the total risk. The variance and expected return on a well-diversified portfolio are functions of systematic risk only. As the unsystematic risk can be reduced as the portfolio is well diversified.

Systematic risk is caused by factors which are outside the control of the business such as economic policies, taxation policy, political conditions. All the securities in the market are prone to systematic risk.

Unsystematic risk is caused by the internal factors of the firm such as management, labour conditions, governance etc which are well within the control of the company.

Hence unsystematic risk can be avoided by investing in a diversified portfolio and the returns will majorly depend on systematic risk.

b) Expected return of stock A = 18.5%.

Based on CAPM, expected return = 17.2 %

The stock is not correctly priced.

The stock is Underpriced as the required rate of return as per CAPM is less than the expected return on the security.

(If the required rate of return is greater than the estimated return, then the stock is overvalued or vice versa).

Hope it helps!