Question

In capital markets,profits,gain,interest,dividends are the expected return sin exchange for risk assumed by the investor.
a) Discuss the concept of risk and return with respect to investment
b) Compute the expected return on a security with a beta of 1.4, risk free rate of 12%, and market rate of return of 19%.
c) Given a dividend growth rate of 5%, current dividend of GHS8 and beginning price of investment of GHS40.00, what will be the rate of return on the investment using the Gordons model?
d)Discuss five assumptions of the Capital Asset Pricing Mode

Answer 1

a. Concept of risk and return

Risk is defined as possibility of losing your investment in partial or in whole. While Return can be described as the reward of taking the risk. Risk and reward both goes hand in hand. Higher the risk, higher is the return, and vice versa. But a risk capicity of indiviual depends on many factors like income, financial stability, age, family, etc. For example, a bachelor having age 25 years and earning $25,000 per month can take higher risk because of no responsibility of any dependent, whereas a married person with two dependents (spouse and a child) and all other factors remains same can take comparatively less risk. On the other hand an individual having age 75 years can take low risk and satisfied in earning less return as he does not want to loss is lifetime savings.

Another important thing is one can increase the possibilities of earning higher return by diversifying its risk. Risk can be catgorised as systematic risk abd unsystematic risk. Systematic risk can not be diversified but unsystematic risk can be diversified, like instead of investing all monies in one security class, distribute those money in different asset classes to lower the risk and increase the rate of return. It is just like to avoid putting all eggs in one basket.

b. Expected Return

Expected Return = Risk free rate + Beta (Market rate of return - risk free rate)

= 12% + 1.4(19% - 12%)

= 0.12 + 1.4(0.19 - 0.12)

= 0.12 + 1.4*0.07

=0.12 + 0.098 = 0.218 *100 = 21.8%

c. Rate of Return

Value of Stock = D₁ / (r - g)

Value of Stock = 40

g = 5%

D₁ = D₀ + (D₀*g) = 8 + (8*0.05) = 8.4

Putting all values in formula

40 = 8.4 / (r - 0.05)

40 * (r - 0.05) = 8.4

r - 0.05 = 8.4 / 40

r = (8.4 / 40) + 0.05

r = 0.26 * 100 = 26%

Rate of return = 26%

d. Assumptions of the Capital Asset Pricing Model

1. Investors are risk averse and satisfied themselves with low risk and low return.

2. Investors can lend and borrow money at risk free rate of return.

3. It does not consider transaction costs, taxes and trade can be done smoothly without such market frictions.

4. Investor is aware about all the necessary informations and factors related to investment.

5. There are no riskless arbitrage profit opportunities.