Question

QUESTION 1

Mr Nobert is considering of taking an investment with a risk free rate return, Rf of 7%, market return portfolio of assets Rm is 10%, and beta of the portfolio is 1.50, the investment annual rate of return is 11%.

1. If the market return were to decline by 10%, what would you expect to happen to the investment return? What if the return on the market portfolio were to increase by 10%?   
2. Use the security market line (SML) to find the required return on this investment.
3. Based on question b, do you think the investment must be rejected? Give your reasons
4. Assume that as a result of investors becoming less risk averse, the market return drops by 1% to 9%. What effect would this change have on your responses in part b and c?   

Explain the difference between money market and capital market, and include different financial instruments bought and sold in each market.   

Answer 1

Part A:

Beta specifies systematic Risk. Beta 1.5 means 1% change in market leads to 1.5% change in investment.

Thus 10% change in market Ret leads to 15% change in investment.

Part B:

SML Ret = Rf + Beta ( Rm - Rf )

Rf = Risk Free Ret

Rm = Market ret

= 7% + 1.5 ( 10% - 7% )

= 7% + 1.5 ( 3% )

= 7% + 4.5%

= 11.5%

Part C:

Expected Ret = 11%

Required Ret = 11.5%

As Required Ret > Expected Ret - Reject the Project.

Part D:

SML Ret = Rf + Beta ( Rm - Rf )

Rf = Risk Free Ret

Rm = Market ret

SML Ret = 7% + 1.5 ( 9% -7%)

= 7% + 1.5 ( 2% )

= 7% + 3%

= 10%

Expected Ret = 11%

Required Ret = 10%

As Required Ret < Expected Ret - Accept the Project.

Part E:

Money Market is trade in short term debt. It is temporory adjustment between banks, Financial Institutions, corporation etc.

Capital Market is place where trade is happened in securities such as Bond and Stcok etc.

Instruments in Money Market:

T - Bills

Commercial Papers

Certificate of deposits etc.

Instruments in Capital Market:

Stock

Bond

Preference stock etc.