Question

a) Explain the concepts of variance (total risk) and beta (systematic risk) in portfolio theory and the capital asset pricing model. b) Discuss why according to the capital asset pricing model that total risk should not be rewarded by the capital market. You may use diagrams in your explanation if you wish.

Answer #1

Part A:

Total Risk = Systematic Risk and Unsystematic Risk

Systematic risk is associated with market and it is common for all companies in same industry. This risk at macro level.

Unsystematic risk is company specific.

Beta 2 for a company means, Systematic risk of company is two times to systematic risk of market.

PArt B:

According to CAPM Model,. Expected Return = Risk Free Ret + Beta ( Market Ret - Risk free Ret )

Beta is Systematic Risk.

While computing Expected Ret in CAPM, You are supposed toexpect Premium return for Sysytematic Risk. Because Unsystematic risk Organiozation specific and can be made to Zero through proper diversificaton strategy.

DISCUSS THE CAPITAL ASSET PRICING MODEL, INCLUDING SYSTEMATIC
RISK, BETA, THE RELATIONSHIP BETWEEN RISK AND RETURN, HOW TO AVOID
RISK, AND THE RELATIONSHIP BETWEEN OF BETA TO STOCK PRICES

a) Suppose the risk-free rate is 4.4% and the market portfolio
has an expected return of 10.9%. The
market portfolio has variance of 0.0391. Portfolio Z has a
correlation coefficient with the market of 0.31
and a variance of 0.3407. According to the capital asset pricing
model, what is the beta of Portfolio Z?
What is the expected return on Portfolio Z?
b) Suppose Portfolio X has beta of 1 with expected return of 11.5%.
Draw the SML and comment...

Find out the values of total risk, systematic and
nonsystematic risk of stock j in variance term.
The mean of excess market return is 1.33%
The mean of excess return on asset j is 3.0%
The variance of excess market return is 2.89%
The variance of excess returns on asset j is 2.0%
The covariance of excess market returns and excess returns on
asset j is 2.33%

Conceptual questions on beta
A stock’s contribution to the market risk of a well-diversified
portfolio is called risk. According to the Capital
Asset Pricing Model (CAPM), this risk can be measured by a metric
called the beta coefficient, which calculates the degree to which a
stock moves with the movements in the market.
Based on your understanding of the beta coefficient, indicate
whether each statement in the following table is true or false:
Statement
True
False
A stock that is...

1. Pick 4 stocks and create a portfolio. Discuss how and why the
combination will reduce portfolio risk compared to holding these
stocks individually and separately. What would be the portfolio’s
beta? (You can find stock’s beta on each stock’s homepage at
http://finance.yahoo.com (Links to an external site.)Links to an
external site.) Is your portfolio still subject to market risk? And
why?
2. Discuss and comment on CAPM(Capital Asset Pricing Model).
Give an example of it.

Question B4
(a) The beta of a stock is 1.25, the risk-free rate is 3%, and
the expected return on the market is 15%. If the actual returns of
the stock and the market are 15% and 12% respectively, calculate
the systematic portion and unsystematic portion of the unexpected
returns of the stock.
(b) Identify and explain briefly TWO disadvantages of
Fama-French Three-Factor Model over Capital Asset Pricing Model
(CAPM).

Suppose the risk-free
rate is 4.8 percent and the market portfolio has an expected return
of 11.5 percent. The market portfolio has a variance of .0442.
Portfolio Z has a correlation coefficient with the market
of .34 and a variance of .3345
According to the
capital asset pricing model, what is the expected return on
Portfolio Z? (Do not round intermediate calculations and
enter your answer as a percent rounded to 2 decimal places, e.g.,
32.16.)

Explain the concepts of company unique risk and market risk,
and how the total level of a portfolio’s risk can change by adding
stocks to a portfolio.

You form a portfolio by investing 55% of your money in a risky
stock with a beta of 1.4 and the rest of your money in a risk-free
asset. The risk-free rate and the expected market rate of return
are 0.06 and 0.12, respectively. According to capital asset pricing
model (CAPM), the expected return of the resulting portfolio
is:
A.
10.62%
B.
14.40%
C.
9.78%
D.
9.30%
E.
6.60%

Suppose you have a portfolio that has $100 in stock A with a
beta of 0.9, $400 in stock B with a beta of 1.2, and $300 in the
risk-free asset. You have another $200 to invest. You wish to
achieve a beta for your whole portfolio to be the same as the
market beta. What is the beta of the added security? Give an
example of a firm that may have such a beta.

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