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Nanyang Business School AB1201 Financial Management Seminar Questions Set 5: Risk and Rates of Return (Common Questions)

This document contains sample questions and answers for an internal seminar on financial risk and rates of return. It includes 5 multiple choice questions evaluating statements about risk, diversification, and the capital asset pricing model. It also includes sample calculations of required rates of return using the security market line and capital asset pricing model, calculating changes to a portfolio's beta, and evaluating the risk and return of individual stocks. Additional self-practice questions are provided at the end with step-by-step answers.

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79 views3 pages

Nanyang Business School AB1201 Financial Management Seminar Questions Set 5: Risk and Rates of Return (Common Questions)

This document contains sample questions and answers for an internal seminar on financial risk and rates of return. It includes 5 multiple choice questions evaluating statements about risk, diversification, and the capital asset pricing model. It also includes sample calculations of required rates of return using the security market line and capital asset pricing model, calculating changes to a portfolio's beta, and evaluating the risk and return of individual stocks. Additional self-practice questions are provided at the end with step-by-step answers.

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cccq
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Strictly for course AB1201 internal circulation only.

Nanyang Business School


AB1201 Financial Management
Seminar Questions set 5: Risk and Rates of Return
(Common Questions)
Questions 1 to 4 will be presented by students while Question 5 will be presented by
instructors.

1) Evaluate the following statements to determine whether they are TRUE or FALSE.
Explain your answers.

a) When diversifiable risk has been diversified away, the inherent risk that remains is market
risk, which is constant for all stocks in the market.

b) Portfolio diversification reduces the variability of returns on an individual stock.

c) If all the investors in the market are risk averse and hold only one stock, we can conclude
that the required rate of return on a stock whose standard deviation is 0.21 will be greater
than the required return on a stock whose standard deviation is 0.10. However, if stocks are
held in portfolios, it is possible that the required return could be higher on the stock with the
lower standard deviation.

d) An investor who holds just one stock will generally be exposed to more risk than an
investor who holds a diversified portfolio of stocks, assuming the stocks are all equally risky.
Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn
a higher rate of return to compensate for the greater risk.

e) Market risk refers to the tendency of a stock to move with the general stock market. A
stock with above-average market risk will tend to be more volatile than an average stock, and
its beta will be greater than 1.0.

2) Required rate of return. Suppose rRF = 9%, rM = 14%, and bi = 1.3.


a) What is ri, the required rate of return on Stock i?
b) Now suppose rRF increases to 10 percent and the slope of the SML remains constant. How
would this affect rM and ri?
c) Now assume rRF remains at 9 percent but rM falls to 13 percent. The slope of the SML does
not remain constant. How would these changes affect ri?

3) Security Market Line. Based on the following security market line (SML), answer the
following questions.
a) What is the equation for the Security Market Line (SML)?
b) Is Company A correctly valued? If not, what should be the expected return of Company A
when it is in equilibrium?
c) Suppose you invest 50% of your money in the market portfolio and 50% of your money in
Company A, what is the beta of the resulting portfolio? What is the expected return on your
portfolio?

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Strictly for course AB1201 internal circulation only.

Expected return of Company A

4) Portfolio Beta. You hold a diversified $100,000 portfolio consisting of 20 stocks with
$5,000 invested in each. The portfolio's beta is 1.20. You plan to sell a stock with b = 0.70
and use the proceeds to buy a new stock with b = 1.50. What will the portfolio's new beta be?

5) Evaluating risk and return. Stock X has an expected return of 10 percent, a beta
coefficient of 0.9, and a 35 percent standard deviation of expected returns. Stock Y has a
12.5 percent expected return, a beta coefficient of 1.2, and a 25 percent standard deviation.
The risk-free rate is 6 percent, and the market risk premium is 5 percent.
a) Calculate the coefficient of variation of each stock.
b) Which stock is riskier for diversified investors? Which stock is riskier for undiversified
investors?
c) Use the CAPM model to calculate each stock’s required rate of return.
d) On the basis of the two stocks’ expected and required returns, which stock would be more
attractive to a diversified investor?
e) Calculate the required return of a portfolio that has $7,500 invested in Stock X and $2,500
invested in Stock Y.
f) If the market risk premium increased to 6 percent, which of the two stocks would have the
larger increase in its required return? Why would the market risk premium increase?

Self-practice questions

Question 1
You want your portfolio beta to be 0.95. Currently, your portfolio consists of $4,000 invested
in Stock A with a beta of 1.47 and $3,000 in Stock B with a beta of 0.54. You have another
$9,000 to invest and want to divide it between an asset with a beta of 1.74 and a risk-free
asset. How much should you invest in the risk-free asset?

Question 2
You are managing a portfolio of 5 stocks, stocks M, N, O, P, and Q, which are held in equal
amounts. The current beta of the portfolio is 1.8, and the beta of stock M is 2.2. If stock M is
sold, what would the beta of the replacement stock have to be to produce a new portfolio beta
of 1.6?

Answers to self-practice questions

Question 1

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Strictly for course AB1201 internal circulation only.

Total investment = 4000+3000+9000 = 16,000


Let investment in asset with beta of 1.74 be $X

The trick to answering the question is to recognize that risk-free asset has beta of zero.

Solve the following equation for X.


4000 3000 𝑋 9000 − 𝑋
1.47 + 0.54 + 1.74 + 0 = 0.95
16000 16000 16000 16000

X = $4425.3
Therefore, investment in risk-free asset = 9000-4425.3 = $4574.7

Question 2
Step1: Find beta of portfolio of N, O, P, and Q. Let beta of this portfolio be X.

4/5X+1/5(2.2) = 1.8  X = 1.7

Step 2: Find beta of replacement stock. Let it be Y.


4/5(1.7) + 1/5Y = 1.6  Y = 1.2

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