Section 3 deals with the impact of diversification on portfolio risk. stream a. The price The portfolio risk is not simply a measure of its weighted average risk. endstream endobj 1443 0 obj<>/W[1 1 1]/Type/XRef/Index[56 1361]>>stream Question: (Graphical representation systematic and unsystematic risk) In the examiners ‘Questions and Answers’ for May 2010, question four (a) required a diagram illustration for systematic and unsystematic risks. The concepts of systematic and unsystematic risk are introduced here. 0000003948 00000 n Thus: E(R p) = ΣW i R i where i = 1,2,3 … n. Where W i represents the weight attached to asset I and R i is the asset’s return. {\G����M�ѕ�y�C. 0000012948 00000 n %PDF-1.3 0979. (That is, required returns equal expected returns.) The expected return – beta relationship is the implication of the CAPM that security risk premiums (expected excess returns) will … Risk on Portfolio: The risk of a security is measured in terms of variance or standard deviation of its returns. View Test Prep - Risk and Return Practice Problems with Solutions.pdf from BA D1 at Brenau University. 0000003371 00000 n Some of the risk in holding any asset is unique to the asset in question. A risk-averse investor would choose the portfolio over either Stock A or Stock B alone, since the portfolio offers the same expected return but with less risk. Risk and return questions and practice problems Risk and return part 2: Questions 1. startxref 3. First we turn our attention to the concept of expected return. a) 12.4% b) 13.4% c) 14.4% d) 15.4% View Answer / Hide Answer 1420 0 obj<>stream We will suggest, as did H. Harkowitz in 1952, that the standard deviation of portfolio returns be used as a measure of total portfolio risk. You will get 30 minutes to complete the test. The possible rate of return for a portfolio for an investment is shown below. x���1 0ð4\ 0000006050 00000 n The rate of return on the annuity is the same as the rate of return on US T-Bills. • The expected return on a portfolio is given by the weighted average returns of the two assets RP =XARA +XBRB • The variance of returns of a portfolio is given by σP XAσA XBσB 2XAXBσAB 2 = 2 2 + 2 2 + RISK AND RETURN This chapter explores the relationship between risk and return inherent in investing in securities, especially stocks. 5. Expected return = 0.4(0.05) + 0.6(0.15) = 0.02 + 0.09 = 0.11 or 11% Portfolio risk is what matters to investors and portfolio risk is what governs the risk premiums they demand. Example 0 0000003621 00000 n 0000000016 00000 n book Risk and Portfolio Analysis: principles and methods is not yet fully complete. Risk and Return: Portfolio Theory and Asset Pricing Models ANSWERS TO END-OF-CHAPTER QUESTIONS Our final step would be the plot of the risk and return combined metric, return per unit of risk, which plots the portfolio risk and return for different values of portfolio allocation. Please inform us if you spot any errors. c. Portfolio return is 12.98%. Portfolio 1 is the most efficient portfolio as it gives us the highest return for the lowest level of risk. The securities consisting in a portfolio are associated with each other. 1417 27 A portfolio comprises two securities and the expected return on them is 12% and 16% respectively. Portfolio risk is increasingly dependent on the covariance of returns. 0000008875 00000 n The risk premium of an asset is proportional to its beta. a. total return … total risk b. expected return … total risk c. total return … systematic risk d. expected return … systematic risk 13. <<9677f80f1c0983448a384dbcca936b1d>]>> Risk and Return Discussion/Practice Problems … 0000006738 00000 n Define systematic risk. %%EOF If markets are efficient, the price reflects i) Tax risk j) Etc 4. Also The Expected Return On The Market Portfolio Is 15 Percent. ∴ Portfolio return is 12.98%. Open the spreadsheet and perform the required analysis to answer the questions below. Illustration 16.2: Compute the risk return characteristic of an equally weighted portfolio of three securities whose individual risk and return are given in the following table. Solutions to risk and return practice problems 4 . Let us try and find the answers to Joe’s questions. Individual ... it complicates the task of constructing portfolios with ‘efficient’ risk return trade-off due to the growth of possible asset combinations. The risk-free rate is 5.5%, and the market is in equilibrium. Answer. 0000003333 00000 n The returns and the risk of the portfolio depending on the returns and risks of the individual stocks and their corresponding shares in the portfolio. It is of little use to investors who wish to earn large returns. portfolioZwith expected return 9%, standard deviation 21% X dominates Z; it has higher reward but lower risk (III) An investor using the Mean-Variation Criterion: b. may concentrate all investments in Security B (IV) John and Jim are both risk averse and only care about the mean and standard deviation of their portfolio’s return. The portfolio return r p = 0.079 with the risk σ p = 0. Risk of Portfolio of Two Assets: The risk of a security is measured in terms of variance or standard deviation of its returns. 8. 0000007867 00000 n Since she is managing a stock mutual fund, she must remain invested in a portfolio of stocks. Visit the post for more. Explain Markowitz Portfolio Theory? The risk-return relationship will now be measured in terms of the portfolio’s expected return and the portfolio… trailer 0000002905 00000 n Expected returns Portfolio risk Portfolio 1 23.20% 9.9% Portfolio 2 19.20% 10.0%. 0000000873 00000 n Determine return of portfolio if first security constitutes 40% of total portfolio. << /Length 5 0 R /Filter /FlateDecode >> 0000008829 00000 n 0000004694 00000 n 0000038699 00000 n 0000009547 00000 n the same portfolio of risky securities is a result of: (a) diminishing marginal utility of income (b) covariance (c) the separation theorem (d) the normal distribution assumption 3. ... “Existing investment portfolio: aggressive Findings of risk-profiling questionnaire: conservative” CHAPTER 1 Exercise 1.1. When combining risk though, there is a reduction in portfolio risk relative to the weighted average of the component ... All of the answers indicate that the higher risk exposure is the in Subsidiary A. Overview Security analysts and portfolio managers are concerned about an investment’s return, its risk, and whether it is priced correctly by the market. He also derived a formula for computing the variance/SD of a portfolio. Susan is expecting the returns on the market portfolio to be negative in the near term. The data has been collected in the Microsoft Excel Online file below. 0000002372 00000 n It can greatly increase the risk of a portfolio. 0000005336 00000 n Stock Percentage Of Portfolio (%) Beta Expected Return (%) A 20 1 15 B 30 0.85 13 C 50 1.20 10 The Risk Free Is 6 Percent. In what follows we’ll define risk and return precisely, investi-gate the nature of their relationship, and find that there are ways to limit exposure to in-vestment risk. 0000001420 00000 n b. The portfolio risk is not simply a measure of its weighted average risk. 0000001558 00000 n This result occurs because returns on A and B are not perfectly positively correlated (ρAB = 0.88). Once we have risk and return for individual securities, we can then calculate portfolio risk and return. 0000010277 00000 n 2. %��������� Following are the probability distribution of returns of portfolio of Stock A and Stock B in equal proportion of weight in each state of economy. xref • Markowitz showed that the variance of the rate of return was a meaningful measure of portfolio risk under a reasonable set of assumptions. The beta is a relative measure of systematic risk. The above can be checked with the capital weightage formulas for the minimum variance (risk).Substituting %PDF-1.5 %���� CHAPTER 11 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) Answers to Concept Questions 1. portfolio components, so there is no enhancement of portfolio return. 1. The weight attached to an asset = market value of asset/market value of portfolio. Questions have also been What is the market risk premium (r M - r RF)? x�]K��Ƒ��W�e#�A�G��lP��� ɢ�q�`� �Cr�yP����_�?�_�_f�Q]��e#��*__=P����~s}���ڵ��?�O�pqw9�?7�닋�U����۽|1�����}yn�����w$���Oϊ�W�����������/�m�L!��Y1�����]����b��7u]�]�5�[�M���}��]�mM\[�UuL�+��s!��������ҭ_B/t�dl��zO��-ݡߠ�έ�Tݠ����4pqO��5���W=���+�GkW���+w�7e��v�r����� ��Uy�>���ZE'©�)5�U}�5M��������ʟW����g�8~�n����I ��T�b4V]�hl����\��CD|��ݻ@������D���{'���O!�n>�Ǳ�)��$�[wu��$N�"2ؙ,SH���Dc��՝��U������ �����mU�Mӷ4L�^��?�����:L�oߺ�W��!g\����;�r���&:�weU�j�1��.��MU���D�c�uH� �־~M�Y��&/v7_4��xe����.�uG� =��eL{w���qkBz�5��v�w]��6#ߵ͘�2���F�GN�@���B���1�F�dXU�T���1��[2��Y��uUyTW�3��. Portfolio expected return is the sum of each of the individual asset’s expected return multiplied by its associated weight. 0000001869 00000 n sponding suggested answers. ... Let us now assume investments can be combined into a two-asset portfolio. (Arbitrage in bond prices) (a) The cash ﬂow of Bond D can be generated by the portfolio consisting of 106=200 units of Bond C, 6=102 units of Bond B and (6 12=102)=100 units of Bond A. 4 0 obj By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. Portfolio risk and return Prepared by Pamela Peterson Drake, Ph.D., CFA 1. • Summaries, Key-terms, Questions and problems are provided at the end of If the portfolio is comprise of 40% X and 60% Y and if the correlation between the returns on X and Y is -0.25, what is the portfolio’s expected return and risk? ���s��6?Y��V#P9l`�'��RK�ӽ�N��_�RV*�yU���[���\��C�X��9�Ɂ�KzN�ْ�P�+��YJ����� � �V"�P�uw��0l0 The securities consisting in a portfolio are associated with each other. Mean portfolio return 12% Var(P) 0.00845 sd(P) 9.2% • The risk of the portfolio is lower than the risk of either of the two stocks! Open spreadsheet. Risk and Return Problems and Solutions is set of questions and answers for risk and expected return and its associated cash flows. Describe the CAPM and explain what it does. Question: RISK AND RETURN You Own A Portfolio Consisting Of The Following Stocks. Probability Possible rate of return 0.25 0.09 0000003870 00000 n What is the most true regarding diversification? There are 20 questions in this test from the Portfolio Management section of the CFA Level 1 syllabus. On the other hand, there are some risks that affect all investments. Since the return of a portfolio is commensurate with the returns of its individual assets, the return of a portfolio is the weighted average of the returns of its component assets.The dollar amount of an asset divided by the dollar amount of the portfolio is the weighted average of the asset and the sum of all weighted averages must equal 100%. the concept of portfolio risk. 0000007457 00000 n 10 Key Points To Remember. 0000008097 00000 n 1417 0 obj <> endobj answers you are looking at involve the examiner having algebraically-rearranged the formulae found on this sheet. 0000002012 00000 n �����]�y�*n~/M�Ev�3��X�`������І�Av��j���������V3t�8e�[�K6���e`6lˠ�Ao҈��9�*z�gzN����Uhi��� methods of investment analysis and portfolio formation, stocks and bonds analysis and valuation for investment decision making, options pricing and using as investments, asset allocation, portfolio rebalancing, and portfolio performance measures. Questions and Answers ... 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