Finance- Chapter 13 HW
Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?
Beta is the measure of the systematic risk that is associated with the portfolio or the asset. It represents the volatility in the stock returns. Beta is used in the CAPM to calculate the value of the expected return of the asset. It is true that a portfolio can be constructueed with a zero beta. The risk-free rate as well as the expected rate of return with the zero beta will be the same. Also, it is possible to construct a portoflio with a negative beta. In this case the return of the portfolio will be less than the risk-free rate. The negative risk premium is always present with a negative beta. The reason is its value as a diversification insturment. Lastly, to create an asset with a negative beta, short position is taken on the asset with positive beta.
Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2 percent in the coming year, as compared to 5 percent for the past year. Will security prices increase, decrease, or stay the same following this announcement? Does it make any difference whether the 2 percent figure was anticipated by the market? Explain.
If the market expected the growth rate in the coming year to be 2 perecent, then there would be no change in security prices if this expectation had been fully aniticipated and priced. However, if the market had been expecting a growth rate different than 2 percent and the expectation was incorporated into security prices, then the government's annoucnement would most likely cause security prices in general to change; prices would drop if the anticiapted growth rate had been more than 2 percent, and prices would rise if the anticipated growth rate had been less than 2 percent.
In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?
Some risks are diversifiable because they are unique to that asset and can be eliminated by investing in different assests. When an investor diversifies his risk by investing in many different assets, there is an unsysmtematic strategy that is executed that reduces the overall risk. On the other hand, some risks are nondiversifiable because the risk applies to all assets. When risks are nondiversifiable, it is because of the systematic risks which affect the investments. Therefore, you are unable to eliminate the total risk of an investment. Lastly, systematic risk can be controlled, but by a costly effect on estimated returns.
If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer.
The answer is no for both. The answer is no because the expected return of the portfolio is a weighted average of the returns from its assets, so the expected return must be less than the returns from the largest asset and greater than the returns from the smallest asset.
If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?
The standard deviation can be less than that of every asset in the portfolio. This is because thats the whole point of modern portfolio theory. However, the portfolio's beta can not be less than the smallest beta because the portfolio beta is a weighted average of the individual asset betas.
True or false: The most important characteristic in determining the expected return of a well-diversified portfolio is the variance of the individual assets in the portfolio. Explain.
This statement is false. The variance of the individual assets is a measure of the total risk. However, in a well-diversified portfolio, the unsystematic risk of indidvidual assets is eliminated and only the systematic risk matters. Therefore, the variance on a well-diversified portfolio is a function of systematic risk only, which can be measured by beta.
Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.'s stock to change price: a. The government announces that inflation unexpectedly jumped by 2 percent last month. b. Big Widget's quarterly earnings report, just issued, generally fell in line with analysts' expectations. c. The government reports that economic growth last year was at 3 percent, which generally agreed with most economists' forecasts. d. The directors of Big Widget die in a plane crash. e. Congress approves changes to the tax code that will increase the top marginal corporate tax rate. The legislation had been debated for the previous six months.
a. If the goverenment announces that inflation unexpectedly jumped by 2 percent last month then an unexpected, systematic event occured. Therefore, markets prices, in gneral, will most likely decline. b. No unexpected event occurred. Therefore, company price will most likely stay constant. c. No unexpected, systematic event occured. Therefore, market prices, in general, will most likely stay constant. d. If the director of Big Widget dies in a plane crash then an unexpected, unsystematic event occurred. Therefore, company price will most likely decline. e. No unexepcted, systematic event occured unless the outcome was a surprise. Market prices, in general, will therefore most likely stay constant.
