Question

1.‘The rate of return is more appropriate for comparing the profitability of financial assets than absolute dollar profit.’ Do you agree with this statement?Explain.

2.‘The rate of return is the most important outcome for an investment.’ Do you agree with this statement?Explain.

3.Explain how the expected rate of return and the risk of an individual asset are measured.

4.Explain how the expected rate of returnand the variance of a portfolio are calculated.

5.Explain what ‘covariance’ means.

6.Explain how the number of assets in a portfolio affects the portfolio risk.

7.Explain how the relationship between assets in a portfolio dominates the portfolio risk.

8.Under what circumstances is it possible to remove risk altogether from a portfolio oftworisky assets? Fully explain your answer.

9.Diversification pays only when the returns on securities are perfectly correlated. When the returns on securities are uncorrelated there is no benefit from diversification at all. Do you agree with this statement?Why?

10.‘Diversification enables us to reduce some of the risk in a portfolio but market risk will always remain.’ Do you agree with this statement? Discuss.

11.‘The zero risk investment will always involve positive investmentin both assetsif you plan to invest in two risky assets.’ Do you agree with this statement? Discuss.

12.Summarise the mean-variance criterion.

13.With the aid of a diagram, fully explain what is meant by the term ‘Efficient Frontier’. (Assume no short sales and no riskless borrowing and lending allowed.)

14.‘In a two-asset portfolio, when the correlation between the two assets decline, the mean-variance frontier bulges to the left.’Do you agree ordisagree? Explain.

15.‘The mean-variance efficiency criterion can identify the optimal investment’. Do you agree this statement? Explain your answer.

Answer 1

1.‘The rate of return is more appropriate for comparing the profitability of financial assets than absolute dollar profit'

Yes, I agree with this statement. Let's consider an example:

Investment 1: We invest $100,000 and we get $1,000 return in one year

The dollar return is $1,000

The rate of return in 1,000/100,000 = 1%

Investment 2: We invest $50,000 and we get $900 return in one year

Dollar return is $900

If we go by the absolute dollar return, we may say that investment 1 is better than investment 2. However, if we calculate the rate of return of investment it is 900/50,000 = 1.8%.

To see the difference, if we invest $100,000 in investment 2, we would end up getting 100,000 * 0.018 = $1,800

That is $800 more than the investment 1 dollar return. Hence, we should always consider rate of return when evaluating investment options.