Question

a)Discuss the meaning and fundamentals of risk and return. Review the two types of risk, diversification concept and the role of standard deviation and beta in measuring the risk of an individual security and also a portfolio

B) A firm wishes to assess the impact of changes in the market return on an asset that has a beta of 1.20.   

i. If the market return increased by 15%, what impact would this change be expected to have on the asset’s return?

ii. If the market return decreased by 8%, what impact would this change be expected to have on the asset’s return?

iii. If the market return did not change, what impact, if any, would be expected on the asset’s return?

iv. Would this asset be considered more or less risky than the market? Explain

Answer 1

Risk - Risk means variation of actual return over expected return. If the expected return is 10%, and actual return is 8%, it will be termed as risk. It measures the voltality of the stock. As a general rule, higher the level of risk, higher will be the required rate of return, and vice a versa. Both risk and return have positive correlation.

Risk can be classified into two categories

a. Systematic Risk - It is the risk associated with the systematic factors, which affect all the firms in the market and cant be diversified.

b. Non systematic Risk - It is the risk associated with specific firm and can be diversified by investing in different kind of companies / class of assets. It includes operating risk and financial risk.

Diversification means investing the total capital in more than one class of assets or class of companies. With diversification, non systematic risk can be avoided.

Role of standard deviation

Standard deviation of a stock / portfolio measure the volatality of the stock/portfolio return over its mean or expected return. The SD is used as a measure of risk. Higher the standard deviation, higher will be the inheriant risk.

Beta Measure the voltaity of the stock/portfolio vis a vis market return (e.g index return). As a general rule if beta is more than 1, the security is classified as more risky than market.