Flirting with Risk

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|KOÇ UNIVERSITY | |FINANCIAL MANAGEMENT 501 | |Case 17: Flirting with Risk | | |


Answers to Questions of Case 17

1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

As the risk increases the potential return increases as well. In order to get higher returns one needs to invest in riskier assets. In other words, risk is the probability of negative outcome and return is the compensation for this risk.

2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these topics.

The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas greater than 1, show a more intense version of the market behavior. Stocks with betas between 0 and 1 move in the same direction with the market. Since the market is the portfolio of all the stocks, the average stock has a beta of 1.

3. How should Bill demonstrate the meaning and advantages of diversification to Mary?

Comparing expected returns from non-diversified investments with the diversified investments could be a good way of demonstrating the meaning and advantages of diversification. Table 1 shows the expected returns without diversification and Table 2 and Table 3 show the expected returns when different proportions invested in different stocks.

Table 1

Table 2

Table 3

For example when total 100% is invested to High Tech Company, the expected return is 0,05 whereas when only 5% is invested in HighTech and the remaining of the investment is diversified among other stocks, the expected return is 0,05975 and when 15% is invested in High-Tech the expected return is 0,05735. Using the tables above similar comparisons can be made to explain the advantages of diversification.

4. Using a suitable diagram explain how Bill could use the security market linet o show Mary which stocks could be undervalued and which may be overvalued?

Security Market Line is a straight line which gives the relationship between the expected rate of return and the market risk of over all market.


The x-axis represents the market risk or beta, and the y-axis represents the expected rate of return. The risk free rates (T-Bills) are represented with a horizontal line.

Security Market Line is a useful tool to determine whether a stock is under- or overvalued. On the plot, if the expected return of a stock is above the SML for a specified beta, then this stock is considered as undervalued and expected to give high return for the risk taken. On the other hand, if the expected return of the stock lies below the SML, this indicates that this stock is overvalued, and it is very likely to offer lower returns.

5. During the presentation, Mary asks Bill “Let’s say I choose a well diversified portfolio, what effect will the interest rates have on my portfolio?” How should Bill respond?

When the portfolio is diversified, the interest rates will have less effect on the portfolio than that they would have on a non-diversified portfolio. Because their positive effect on one part of the portfolio will be neutralized by their negative effect on another part. However the amount that would be neutralized would change in relation the diversification ratios as well as the corelation between them. Correlation...
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