Question

1. Assumed the betas for securities A, B, and C are shown here. Security Beta A 1.39 B .75 C -.93

A.

Calculate the change in return for each security if the market experiences an increase in its rate of return of 13.7% over the next period

B.

Calculate the change in return for each security if the market experiences a decrease in its rate of return of 10.3% over the next period

C.  ​(Select he best choice​ below.)

A.

During an economic​ downturn, it can probably be assumed that the market return would decrease. If this​ occurred, security C would perform best.​ Otherwise, security B would be best since it would be least responsive to a change in the market return.

B.

Security A is the most risky. It has the highest relevant​ risk, as determined by the beta values and the greater changes in security​ A's return for a given change in the market return.

C.

Security B is the least risky since its return is least responsive​ (regardless of​ direction) to changes in the market return.

D.

Security C could be called defensive since it moves in the opposite direction from the market​ (its return increased when the market return fell and vice​ versa).

E.

All the above statements are correct.

Answer 1

Solution:-

A. Calculation of change in return for each security if the market return goes up by 13.7%

Change in return of Security A= Beta*13.7%= 1.39*13.7% = 19.04%

Change in return of Security C= Beta*13.7%= 0.75*13.7%= 10.27%

Change in return of Security C= Beta*13.7%= -0.93*13.7%= -12.74%

B. Calculation of change in return for each security if the market return goes down by 10.3%

Change in return of Security A= Beta*-10.3%= 1.39*-10.3% = -14.32%

Change in return of Security C= Beta*-10.3%= 0.75*-10.3%= -7.73%

Change in return of Security C= Beta*-10.3%= -0.93*-10.3%= 9.58%

C. Analysis of all the given options

Option A: Since security C has a negative beta, it means that its performance goes opposite to the market's performance. So, if a market performs negatively due to a economic downturn, security C would actually generate positive returns due to the negative correlation with the market. Further, apart from security C, security B has a lower beta as compared to security A and it would perform better if the economy was to go in downturn and market returns were to become negative.

Option B: Security A has the highest beta of 1.39. This means that it has the highest risk and is most prone to any changes in the market rate of return.

Option C: Security B has the least risk as it's beta is just 0.75 while A and C have betas of 1.39 and -0.93. This means that security B is least responsive to the changes in market returns and hence carries the least risk

Option D: The securities that have negative betas act as hedging instruments in the overall portfolio and protects the portfolio's downside if the broader market was to go down. Therefore, it is fair to call it defensive.

Option E: As can be seen from above explanations, all the statements from A to D are correct. Therefore, the correct option is option E