Flirting with risk
1-Imagine your Bill. How would you explain to Mary the relationship between risk and return of individual stocks? The relationship between risk and return is believed to be positive. In other words, the return is simply considered as a compensation for bearing risk. That basically means the potential return rises as the rate of risk increases. So in order to get a higher return we need to invest in riskier project. So if we were to invest in a high risk securities the return would be higher, in return if the market falls for any economic, financial or political reason, the losses could also be quite large.
And that could be clearly illustrated in the chart below:
2-Mary has no idea what beta means and how it is related to the required rate of return of the stocks. Explain how you would help her understand these concepts.
The beta value for a share indicates the sensitivity of that share to general market movements.
A share with a beta of 1.0 tends to have returns which move broadly in line with the market index. A share with a beta greater than 1.0 tends to exhibit amplified return movements compared to the index. For example, a company has a beta of 1.55 and according to the CAPM when the market, when the market index return rises by say 10 percent the returns on that company shares will tend to rise by 15.5 percent. Conversely if the market falls by 10 percent then the returns on Tarmac shares will tend to fall by 15 percent.
3-How should Bill demonstrate the meaning and advantages of diversification to Mary? In finance, diversification means reducing risk by investing in a variety of assets. If the asset prices do not fluctuate in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets.
Diversification is also one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among
And that could be clearly illustrated in the chart below:
2-Mary has no idea what beta means and how it is related to the required rate of return of the stocks. Explain how you would help her understand these concepts.
The beta value for a share indicates the sensitivity of that share to general market movements.
A share with a beta of 1.0 tends to have returns which move broadly in line with the market index. A share with a beta greater than 1.0 tends to exhibit amplified return movements compared to the index. For example, a company has a beta of 1.55 and according to the CAPM when the market, when the market index return rises by say 10 percent the returns on that company shares will tend to rise by 15.5 percent. Conversely if the market falls by 10 percent then the returns on Tarmac shares will tend to fall by 15 percent.
3-How should Bill demonstrate the meaning and advantages of diversification to Mary? In finance, diversification means reducing risk by investing in a variety of assets. If the asset prices do not fluctuate in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets.
Diversification is also one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among
References: Corporate Financial Management by Glen Arnold (4th Ed) http://www.investopedia.com/terms/u/undervalued.asp#ixzz2HD5n8ZGE http://en.wikipedia.org/wiki/CAPM http://www.investopedia.com/university/concepts/concepts1.asp