Question

1. Why is the percentage return a more useful measure than the dollar return?

2. How do the authors of your textbook define risk? How is it measured?

3. What are the two components of total risk? Which component is part of the risk-return relationship? Why?

4. Consider that you have three stocks in your portfolio and wish to add a fourth. You want to know if the fourth stock will make the portfolio riskier or less risky. Explain how this would be assessed using beta as the measure of risk.

5. Why do we use market-based weights instead of book-value-based weights when computing the WACC?

Please answer all of the questions, if you can not answer all of the questions do not reply.

Answer 1

Answer(1): Dollar return is more significant in terms of amount invested, for e.g. $1000, $5000 etc. while percentage return tells the ratio or proportion of the profit that is received over a particular investment. Percentage return is more appropriate as it tells the return on the different investment schemes that may not be same so it is easy to compare the return on different investment products.

Answer(2): Risk is the level of uncertainty, it is the possibility of losing your hard earned money due to occurrence of any event. It is also the volatility in the returns. Risk can be measured in terms of money or valuable thing or loss of an opportunity. Risk can be measured by following measures:

1. Beta
2. Standard deviation
3. Value At Risk (VaR)
4. Probability distribution etc.

Answer(3): Two components of Risk:

Systematic risk- This risk also called market risk, this is related to overall stock, currency, commodity or any other market as whole. This risk is unpredictable and uncontrollable. This cannot be minimize by diversification.

Unsystematic risk- This is industry specific or company specific risk. This risk can be controlled by diversification of investment into different asset class group.

Systematic risk (Market risk) is a part of the risk-return relationship.

Answer(4): Beta is a measurement of risk. It is a measure of volatility or systematic risk in relation to specific security or underlying asset. It measure how much an underlying is sensitive, relative to the overall market. It is used in CAPM. High beta stock will be riskier as it will move more than the movement of market, lower beta stocks are good. Positive beta tells the positive relationship between an underlying and market while negative beta tells the negative relationship between security and market.

Answer(5): We use market based weights because market based weights are more appropriate and keep updating as per the current market conditions. By taking market based weights, we can calculate the cost of capital based on current market conditions.

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