Question

1. A) Explain concepts of firm-specific risk, systematic risk, covariance, beta and how they are relevant for portfolio construction. Discuss what CAPM model implies for investors.

2. You are considering two stocks – Stock A with expected return of 8% and CAPM beta of 1.20 and Stock B with expected return of 11% and beta of 0.80. If the risk-free rate is 3 percent and the market risk premium is 6%, discuss whether these stocks are properly valued or not based on Security Market Line. Are they under- or over-valued?

Answer 1

a)

Firm - Specific risk : - there are two types of risks one is systematci risk and another one is unsystematic risk.firms specific risk includes Bankrunptcy, Liquidity, Repution and Lawsuit, Accidents, obsolence etc. Unsystematic risk is not measured on the other hand systmatic risk it is market risk and It is measured by Beta (Example: -Inflation risk, Interest rate risk, Unexpected change in tax law, credit risk, currency risk).

If the beta of the stock is 1 that means if market moves 1% stock will alos move 1%, if beta is more than 1 that means if market moves1 % stock moves more than 1%. If beta is less than 1 % that means if market moves 1% stock moves less than one percentage.Covariance is a statistical measure of how two assets move in relation to each other. It provides diversification and reduces the overall volatility for a portfolio. A positive covariance indicates that two assets move in tandem. A negative covariance indicates that two assets move in opposite directions. All these are extremly important while making portfolio construction.

please see the below CAPM formula .

CAPM = Risk Free rate + Beta (Expected market return - Risk free rate)

Stock A

RF = 3%

RM = 6%

Beta = 1.2

Expected return = 8%

CAPM = .03 + 1.2 (.08 - .03)

=.03 + .06

= .09 that is 9%

Stock B

RF = 3%

RM = 6%

Beta = .8

Expected return = 11%

CAPM = .03 + .08 (.11 - .03)

=.03+.064

=.094 that is 9.4%

Both stocks are under valued as both stocks give more than 9 % retun while market risk premium is 6%.