In: Accounting
Please answer the following questions and explain the reasons based on the CAPM.
a. If security A is riskier (has a higher volatility) than security B, what can you say about the expected return on A compared to the expected return on B?
b. What should your portfolio look like?
c. Should you get a higher expected return on a stock which is positively or negatively correlated with the market portfolio?
a. There is a high correlation between risk and return. With higher rsk comes higher return and with lower risk comes lower retun. If security A is riskier, i.e, more volatile than security B it mans security A will have a higher expected return than security B.
b. It is advisable the portfolio should be contructed by investing in both securities A and B. By balancing out the portfolio this way, the risk of the portfolio can be reduced. This process is known as diversification. Although this doesnot eliminate risk totally but can help in reduction of risk involved with the high risk securities.
c. As per CAPM, Expected return = Risk free rate + (Beta * Market Risk premium)
For instnce if te risk free rate of return =2.5% and Market risk preemium = 8%.
In case the stock is positively correlated with the market portfolio, this measn Beta = 1
Expected return = 2.5% + 1*8% = 10.5%
In case the stock is negatively correlated with the market portfolio, this measn Beta = -1
Expected return = 2.5% + (-1*8%) = -5.5%
Thus keeping all other factors constant, one would get a higher expected return if the stock is positively correlated with the market portfolio and would get a lower expected return in case of negative correlation.