Question

In: Finance

Consider the following information:                                      S

Consider the following information:

  

                                  Standard Deviation     Beta

  Security K                           20%                     1.25

Security C                           30%                     0.95

1. Which security has more total risk? Explain why.

2. Which security has more systematic risk? Explain why.

3. Which security should have the higher expected return? Explain why.

Solutions

Expert Solution

Answer 1

EXPLANATION

  • Total Risk of any Company is Basically Denoted by Standard Deviation of the Returns on its Stock.
  • Standard Deviation is Interpreted as % Fluctuation/Deviation in the Returns of Stock.
  • So Higher the Standard Deviation of the Returns Means Higher the Fluctuation/Deviation Hence Higher will be the TOTAL RISK of that Stock.

?ANSWER

  • We can See that "Security C" has Higher Standard Deviation hence Higher the Total Risk.
  • It means % Fluctuation in Security C is More.

Answer 2

EXPLANATION

  • Total Risk of a Stock basically Comprises of TWO RISKS ie. Systematic Risk & Unsystematic Risk.
  • Systematic Risk is a Risk that is not under the Hands of Company or Management to Control.
  • For example: New Economic Reforms, Recession in Market, Change in Technological Advancements, Political Rallies etc. These all are Systematic Risk that hampers Stock's Return
  • Systematic Risk is measure by "BETA of Security".
  • So Higher the Beta of Stock, Higher the Stock is Prone to Systematic Factors which we discussed above.

ANSWER

  • We can See that "Security K" has Higher Beta hence MORE SYSTEMATIC RISK.

Answer 3

EXPLANATION

  • The CAPM Equation to Calculate Expected Return is :
Expected Return = Riskfree Rate + (Beta * Risk Premium)
  • So we can Conclude by Above Equation that Higher the Beta, Higher would be the Expected Return of Stock.
  • And the Logical Reason is that Since Stock is Having Higher Risk, Hence Investors would Expect MORE from that Stock for taking that EXTRA RISK.

Answer

  • "Security K" would be having Higher Expected Return due to HIGHER BETA, hence Investors would Expect More for taking Extra Risk.

HOPE THE SOLUTION IS CLEAR. IF ANY DOUBT REGARDING ANYTHING PLEASE ASK IN COMMENT :)

jeff jeffy answered 2 years ago
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