estimating risks and returns

Running head: ESTIMATING RISKS AND RETURNS 0

Estimating risks and Returns

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Institution

Estimating risks and Returns

Question one

The expected return is regarded as forward looking since an investor have an expectation of receiving returns on his or her investment in the future. The major constraint faced by finance practioners is that the future is unpredictable .The return on an investment is also an estimate of what would be earned in future.

The role of probability distribution in calculating the expected return is to determine all the possible returns that can be earned in the future.

Question two

An investor can consider investing his or her money in risk free security. The risk free security beta is equal to zero while the market portfolio beta is equal to one. An investor can therefore achieve a desirable market risks my allocating the money from zero to 100% into the market portfolio.

Example

If an investor intends to invest 75% in the market, then the beta is equal to 0.75.Another investor can also desire to invest 25% in the market. The beta would be 0.25.The investor who decides to invest 75% be less risk averse. The investor with 25% investments in the market would show a very high risk averseness.

Question Three

Expected return=sum (return probability)

= (0.3×40%) + (0.4×10%) + (0.3×25%)

=8.5%

Recalculated expected return

Expected return= (.25 x 40%) + (.30 x 10%) + (.15 x -25%)

= 10 + 3 + -3.75

= 9.25 %

Question Four

Required return = Risk-free rate + Risk premium

= 3% + 5% = 8%

A financial security considered as a risk free rate is the treasury bills. It is because it offers low returns with no risks.

Question Five

Market risk premium = return on the market portfolio – risk-free rate

= (15.8 – 5.6)

= 10.2 %

Market risk premium

It is the return that an investor receive by investing or taking risk in the stock market.

Question six

Expected return = Risk-free rate + beta x Market risk premium

= 4 + .65 (11-4)

= 8.55%

Recalculated required returns

Expected return = Risk-free rate + beta x Market risk premium

= 4 + 1.65 (11-4)

= 15.55%

By increasing the beta of 1.0 the risk will also increase hence increasing an investor’s return on an investment.

Question seven

BP= Sum of the beta of each stock x its weight in the portfolio

BP= (.40 x 2.2) + (.28 x 1.5) + (.32 x .5) =

BP = .88 + .42 + .16

BP = 1.46

The portfolio would have a high risks because it has a beta higher than one.

References

Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance (3rd ed.). New York,

NY: McGraw-Hill.