ABMF4024 Business Finance
Tutorial 10 Answer
January 5, 2011
Question 1 The tendency of a stock to move up and down with the market causes the investors to confuse estimating the rate of return require by a stock, and th us its market risk, reflected in beta coefficient, b . Beta is a key element of the CAPM, to help investors to calculate th e expected rate of return o f a stock . Beta is calculated based on historical price movements - which which may have hav e little to do with how a compan y's stock is poised to move in the future. And because the measure relies o n historical prices it's not even possible to accurately calculate the beta of newly issued stocks. Beta also doesn't tell us if the stock's movements were more volatile during bear markets or b ull markets - it doesn't distinguish between large upswing or downside movements. So while beta can tell us something about the past risk of a s ecurity, it tells us very little about the attractiv eness or the value of the i nvestment today.
Question 2 The estimated beta is 1.4, which is more than Beta 1.0; it indicates that an Amrep Co. security is riskier than normal securities. When the market drops 10%, Amrep Company¶s security will move down 14%, greater than the market. So, it is riskier than the average stock .
Question 3 When increase inflation expectation, the investors will require more return on their investment to catch up the inflation. The require rate of return on stock will increase, and cause the stock value decrease. As a result, investors will unwilling to buy the stock at this value.
Question 4
R isk isk
of individual asset - some individual stocks are riskier than others, so some stocks will help more than others in terms of reducing the portfolio¶s risk . Proportion of asset in the po rtfolio . Correlation between the return of the stock s tock in portfoliotfolio - in the real world, the correlation among the stock are generally positive but less than +1.0. so some but not all risk can b e eliminated.
Question 5 Security A is less risky if held in a diversified portfolio p ortfolio because of its negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because W A> WB and CVA> CVB.
Question 6 According to the Security Market Line (SML) equation, an increase in beta will increase a compan y¶s expected return by an amount equal to the market risk premium times the change in beta. For example, assume that the risk-free rate is 6%, and the market risk premium is 5%. If the company¶s beta doubles from 0.8 to 1.6 its expected return increases from 10% to 14%. Therefore, Therefore, in general, a co mpany¶s expected return will not double when its beta doubles.
ABMF4024 Business Finance
Tutorial 10 Answer
January 5, 2011
Question 7
A1
Required return on stock P=Risk Free Rate+ (Market Risk Premium) (Stock Ps beta) rp=r RF+(r-r RF)(b) rp =6%+(14%-6%)(0.7625)=12.1%
A2
Question 8 (a) CV= (Standard deviation)/(Expected Return) =/r
Bear 3.5% of risk to earn 1% return (risk per unit of return)
Bear 2.0% of risk to earn 1% return (risk per unit of return)
Question 8 (b) Stock X - 3.5 higher change to get low return (higher risk per unit of return)
Question 8 (c) Required rate of return = risk-free rate + (market risk premium)(beta)
Question 8 (d) Stock Y - Higher chance to get high return
Question 8 (e)
Question 8 (f)
Stock Y would have largest increase in their required return.
ABMF4024 Business Finance
Tutorial 10 Answer
January 5, 2011
Question9 rRF=r* +IP
=2.5 + 3.5 =6% rp=rRF+(r-rRF )(b)
=6 + 6.5(1.7) =17.05%
Question 10 rp=rRF+(r-rRF )(b)
12.0= 5.2 + RP m(1.25) RPM = 5.4% bP= (500,000/5.5)(0.75)+(5,000 (500,000/5.5)(0.75)+(5,000,000/5,500,000)(1.25) ,000/5,500,000)(1.25) = 11.73% rp=rRF+(r-rRF )(b)
= 5.25% + 1.2(5.4)
= 11.73%
Question 11 a) rp=rRF+(r-rRF )(b)
=9+ (14 - 9) (1.3) =17.05% b) i) rp=rRF+(r-rRF )(b) =10+ (15 - 10) (1.3) =16.5% ii) rp=rRF+(r-rRF )(b) =8+ (13 - 8) (1.3) =14.5% c) rp=rRF+(r-rRF )(b) =9+ (16 - 9) (1.3) =18.1%
Question 12 Aversion risk increase, investor affair/ dislike risks . So, need offer more return to attract them to invest. To get higher return, investment risk increase, thus risk pr emium increase . The risk premium on a high-beta stock would increase more than that on a low-beta stock . RP j = Risk Premium for Stock j = (r M ± r RF RF)b j. If risk aversion increases, the slope of t he SML will increase, and so will the market risk premium th (r M ± r RF . If b j is low (say, 0 .5), then RF). The product (r M ± r RF RF)b j is the risk premium of the j stock the product will be small; RP j will increase by only half the increase in RP M. However, if b j is large (say, 2.0), then its risk premium will rise by twice the increase in RP M.
