Question

a.       What are the two components of an investor’s required rate of return? Explain.

b.      In an efficient market, a stock with a standard deviation of returns of 12% could have a higher expected return than a stock with a standard deviation of 10% because the beta for the higher standard deviation stock could be lower than the beta for the lower standard deviation stock. Do you agree? Explain.

c.       You determine that Air NZ’s ordinary shares have an expected return of 24%. Air NZ has a beta of 1.5. The risk-free rate is 5%, and the market expected return is 15%. What will most likely happen to the share price and why?

d.      Christchurch Airport is considering a new strategy that would increase its expected return from 12% to 13.9%, but would also increase its beta from 1.2 to 1.8. If the risk-free rate is 5% and the return on the market is expected to be 10%, should Christchurch Airport change its strategy? Explain.

Answer 1

Answer(a): Required rate of return- Investor wants the minimum return from a stock or any other financial product, it is called Required rate of return.

Two components of an investor’s required rate of return- Are as following:

Real Risk free rate of return- This is the return on treasury securities. This is the return that an investor can earn without risk and inflation in the economy. Real risk free rate of return assumes no inflation and no uncertainty.

Investment risk premium- Investors do not get satisfied with risk free rate of return. Most investors want higher returns. It is the expected return over the risk free rate, for getting expected return, investor has to bear the risk because more risk more gain.

Answer(b): True.

Beta- It is the measure of market risk, it measures how much a stock or portfolio is sensitive or volatile with respect to overall market.  

Standard deviation- It is also a measure of volatility, it tells the deviation from the mean return. It measures the risk of individual stock.

A volatile stock has higher standard deviation while a stable and blue chip stock has lower standard deviation. Higher standard deviation is associated with and higher risk. Beta and standard deviations both measure the risk but beta measures market risk and standard deviation meausres stock specific risk. A beta can be lower if standard deviation is higher because both have different. Market has beta of 1 so if a stock has beta 1, it means it is equally volatile as market but if a stock has beta 1.5 then it is 50% more volatile than the market.

Answer(c): From CAPM-

Er = Rf + Beta (Rm-Rf)

Where Er = Expected return, Rf= Risk free rate, Rm = Expected market return.

Putting the value in the given formula, we get:

Er = .05 + 1.5 (.15-.05)

Er = 20%

Air NZ's expected return of shares is 24% while investor's expected return is 20% o company share price can go up because of higher demand, as it is providing higher return.