Question

1. Explain the relation between risk and return
2. Describe the two components of a total holding period return, and calculate this return for an asset
3. Explain what an expected return is and calculate the expected return for an asset
4. Explain what the standard deviation of returns is and why it is very useful in finance, and calculate it for an asset
5. Explain the concept of diversification
6. Discuss which type of risk matters to investors and why
7. Describe what the Capital Asset Pricing Model (CAPM) tells us and how to use it to evaluate whether the expected return of an asset is sufficient to compensate an investor for the risks associated with that asset

Answer 1

Risk and return relationship determines what will be the return from the asset while taking into xonsideration the volatility of the investment. risk in investment is the standard deviation of return. Risk and Return are two vital components . Moreover it tells about the nature of the investor where he/she is risk averse, risk seeker or risk neutral. If Investor wants to take the risk given that he/she is compensated for the same then they are called as risk averse investor. If they are indifferent then they are risk neutral and if the investor is willing to take more risk with a given set of return then this investor is a risk seeker and he/she is willing to pay more for entering into the investment. Risk tells about the variation in the return. Therfore this relationship is crucial.

Two holding period components are coupan income or dividend and capital gains.

For a stock paying $2 as dividend and its current price is $ 100 therfore the dividend yield would be 2/100= 0.02

If after 1 year the stock price goes upto 110 then the capital gain would be( 110-100)/100 = 10%

Expected return is the return on investment perceived by the investor. Usually for Expected return there are different methods which are used namely HPR, CAPM etc. Eg-

return Probability

A 8% 50%

B 6% 50%

then the expected return is 8%*50%+ 6%* 50%=7%

standard deviation is the how much volatility is there in the given set of data. if the data is the set of return then standard deviation will tell us the volatility of the returns. It is very useful as it signifies the riskiness of an asset.

in the above eg the volatility comes out to be 1.41% by using calculator

Diversification helps in reducing risk by diversifying assets whose correlation with each other is low. it is a risk reducing strategy where all the eggs are not put in one single basket, if we invest all our wealth in one asset then there is high risk and if we allocate our wealth among various assets whose correlation are low eg stock and fixed income securities then there is more likelihood of meeting our expectation.

systematic risk matters the most to an investor because it is that risk which cannot be diversified. these are the risk which are driven by macro events such as interest rate, inflation rate etc which afftects all the securities but non systematic risk are those risk which arei busness risk that is which can be diversified away.

CAPM is Capital asset pricing model which can be calculated as Risk free rate + beta ( Expected market return - risk free rate). Beta is calculated as by regressing stock specific return with market returns. This shoes the movement of the stock with respect to the stock market.