Question

Mr. Green faces two alternativesfor aninvestment Asset ‘A’ has a certain return of 10.25% and asset B has the following probability of return schedule

Probability of return: .25% , 20% , 20% , 15% , 10% , 10% ,

Return ( Yield): 15.0 , 12.0 , 10.0 , 9.0 , 7.5 , 0.0

If selects asset B, what is his expected rate of return?

Characterize Mr. Green's attitude toward risk.

Explain the difference between systematicriskand idiosyncraticrisk. Give one example of each.

Answer 1

(1) For asset B, Expected return = 25% x 15% + 20% x 12% + 20% x 10% + 15% x 9% + 10% x 7.5% + 10% x 0%

= (3.75 + 2.40 + 2.00 + 1.35 + 0.75 + 0)%

= 10.25%

(2) Since Mr. Green prefers Asset B with uncertainty even though Asset A offers same (and certain) return from investment, Mr. Green is a risk-seeking (risk-loving) investor.

(3) Systematic risk is the risk inherent in the market and it cannot be diversified. For example, if a country is undergoing political instability, there is an inherent systematic risk in investment opportunities of that country which cannot be lowered or eliminated by diversification. But unsystematic or idiosyncratic risk is asset-specific risk which can be reduced by diversification. For example, if in a stable economic situation, two similar assets have same risk-return profiles, systematic risk can be decreased by diversifying the portfolio among both the assets.