Imagine you have the option to invest in three different opportunities: A, B and C. Let's...

Imagine you have the option to invest in three different opportunities: A, B and C. Let's also say that you have analyzed the risks and you believe you can classify them as low-risk, medium-risk and high-risk, respectively. Which of these three opportunities would you need to provide the greatest return in order to invest in it?

Now let's say the returns of opportunities A and B are highly correlated with the market as a whole but those of opportunity C have a very low correlation with the overall market. Would this information potentially change the required return you imposed on the opportunities in order to invest in them if so, why?

Now imagine that another investor views the risks to be exactly the opposite of your view (that is, she views opportunity C to be the least risky, followed by B and then A). Assume your view of the risks is the same as described earlier. Does this change the required return you need in order to invest in the different opportunities?

Solutions

Expert Solution

1. It is given that Option A, B and C are classified are Low, Medium and High risk respectively. Risk and Return are directly proportional because, more the risk, more you will expect from the opportunity as a compensation for taking high risk. Hence in the given case we can expect the greatest return from the opportunity C as it is more risky, followed by B and C.

2. Yes Correlation of an opportunity with the market plays a significant role in detereming expected return. This is the crux of the Capital Asset Pricing Model where the beta used in the formula exhibits the correlation of a particular opportunity to the marekt. Higher the correlation higher will be the expected return because since the opportunity is highly correlated with the market if there is any increase in market return the opportunity is also expected to give more return.

CAPM=> Expected Return or ke = Risk free return + Beta * (Risk Premium)

And Generally high beta means high risk and obviously, high expected risk.

3. As discussed earlier Beta is the factor which shows the level of risk. Beta is calculated by dividing security (Opportunity) Standard Deviation by Benchmark (Market) Standard Deviation multiplied by correlation between the two. Hence we can interpret that our expectation of return is based on our calculated risk factor.

(Standard Deviation is a statistcal measure used to represent risk in portfolio management)

jeff jeffy answered 2 years ago

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