Question

Assuming we are using the CAPM to assess risk. There exists a security A with expected return of 13.1%, a stock beta of 1.5. Another security B has expected return of 9.25%, a stock beta of 0.8. The risk-free rate of return is 4.85%.

1. What is the difference between systematic risk and unsystematic risk? What does beta measure, systematic risk or unsystematic risk?                                                                  

2. Using the data above do determine the expected market return?                                     

c.   Suppose that among the firm A and B, one belongs to the industry of pharmaceutical (drug) research and development, while the other belongs to utilities industry equipment (such as electricity supply). Which firm is more likely to be in each industry, why did you make this choice?     

Answer 1

Ans a)

difference between systematic risk and unsystematic risk :

• systematic risk: Risk related to external factors or the environment of the company working. It may arise due to economical factors, political scenarios, or major policy-related changes in the whole industry.
• Unsystematic risk: It is due to internal factors of the company. It is related to the internal business risk of the firm. This risk can be managed in investment by diversifying the portfolio.

What does beta measure, systematic risk or unsystematic risk :

Expected Return = Risk free rate + Beta * Market Risk Premium

Here Beta measures the effective  Market Risk Premium of a stock which arise due to volatility in market. So beta measures systematic risk.

Ans b)

expected market return :

Expected Return = Risk free rate + Beta * Market Risk Premium

E(R) = Rf + Beta * ( Rm - Rf)

E(R) : Expected Return

Rf : Risk free rate = 4.85%

Rm : Expected Market Return  

For Security A :

13.1% = 4.85% + 1.5 *(Rm -   4.85%)

1.5 *(Rm - 4.85%) = 8.25%

Rm = 10.35%

For Security B :

9.25% = 4.85% + 0.8  *(Rm - 4.85%)

0.8 *(Rm - 4.85%) = 4.4%

Rm = 10.35%

For both, the Scenario Expected Market Return = 10.35% (Ans)

Ans c)

Pharmaceutical Industry is comperatively nore risky as compare to  electricity supply industry.  Even different economic scenario revenue of electricity supply remain constant. So  electricity supply firm will have lesser beta Value.

Ans : Firm B = Beta ( 0.8) : electricity supply

Firm A = Beta ( 1.5) : Pharmaceutical Industry