Lecturer; Murat ERTUĞRUL
4. Demet BARIŞ
FLIRTING WITH RISK
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? A portfolio is simply a combination of investments. If an investor puts half of his funds into an engineering company and half into retail shops firm then it is possible that any misfortunes in the engineering company may be to some extent offset by the performance of the retail investment. It would be unlikely that both would suffer a strike in the same period. Both the investments would have fluctuating returns over a period of time. They might have the same amount of variability, however, owing purely to the effects of diversification, when engineering performs well retail profits might be down and vice versa. Diversification into investments with low correlations is always better in case of turbulent times. The loss incurred on one investment would be offset by profit in others. The correlation coefficient might be just higher than zero or even negative if the investments are inversely related.
To compute the correlation coefficient we need to calculate the covariance between the individual security and the market. A positive covariance reflects a positive correlation, whereas a negative covariance reflects a negative correlation.
Therefore, it could be seen that diversification plays a very important in portfolio theory. A portfolio would only be considered “worth investing in” if its returns are higher given the same level of risk as other investments.
4. Using a suitable diagram explain how Bill could use the security market line to show Mary which stocks could be undervalued and which may be overvalued?
Required/Expected Rate of Return
Security Market Line Graph
The solid line represents the required rates of return of the 5 investment alternatives as per the Security Market Line equation. Those stocks whose expected returns are higher than their required returns plot above the line and are considered to be undervalued (Counter Cyclical Co., Utility Co. and High-Tech Co.) while those that plot below the line are considered to be over-valued.
5. During the presentation. Mary asks Bill “ Let’s say I choose a well-diversified portfolio, what effect will interest rates have on my portfolio? How should Bill respond? A well-diversified portfolio is one that is closely correlated to the market index. Real interest rates are typically inversely related to stock prices. Hence, if interest rates increase, Mary’s portfolio return will decrease by as much as the market ind ex does and vice versa. In other words, her portfolio will mirror the...
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