Question

1. Explain how risk affects the valuation of financial instruments.

2. Define beta, elaborate on the determinants of beta and present the range of values

Answer 1

1. The risk associated with financial instruments affects it's value.

For example, the risk associated with stocks, can bring the value of the stocks down. The risk of the market, can bring the value of the stocks down. The company specific risks, for example the risk of strikes and lockout can also bring down the value of shares and thus the shareholders loses their money as they are a part of the company.

The interest rate risk in bonds can bring the value of bonds down. As the interest rate rises, the value of bond falls and as the interest rate falls, the value of bond rises. So, the risk associated with bonds as bring the value of bonds down.

The call risk in the bonds can make a bond holders lose money as the company calls back the bonds before the bond matures. So, the call risk inherent in bonds make the yield offered higher and the price of the bonds are lower.

2. Beta is also called the systematic risk. It measures the volatility of the stock returns in relation to the market returns. This risk cannot be reduced by diversification and it affects all the stocks in the market.

Beta = Covariance of stock returns and the market returns divided by the variance of the market returns.

The beta is less than 1, when the stock moves in the opposite direction to the market and so it is less volatile than the market  the beta is 1, when it moves in the same direction as the market moves and moves exactly as the market. A security with beta greater than 1 for example beta is 1.3,  indicates that it is more volatile than the market. If the market moves by 10%, the stock is expected to move by 13% ( 1.3* 10).