Question

A. Fair, Inc. is considering an investment in one of two common stocks. Given the information that follows, which investment is better, based on risk (as measured by the standard deviation) and return? Stock A Stock B Probability Return Probability Return .30 12% .20 15% .40 16% .30 6% .30 18% .30 13% .20 21%

B. ‘Understanding the relationship between risk and return and how it’s affected by time is probably one of the most important aspects of investment’ – Discuss. i. Different types of risk ii. Diversification reduces risk iii. Common measures of risk

Answer 1

I Stoch B Stock Return erschected [6. 30x12%) + (. 40 x161) + (30x18/ 15,401 16.6.20x15) + (30 x67:)+(0.30x134.) +1,20x211) (12.901/ to Standard deviation of stock A X 12 16 18 7 x 15.40 (3.40 15.40 0.60 15.40 2.60 (x-x)² 11.56 x 0.36 x 6.76 x Prob. 0.30 0.40 0.30 Value 3.468 0.144 2.028 5.64 Variance (Stock A) = 5.64 St Deviation = √5.64 = 2.37 - stindard deviation of Stock B 15 6 13 1 21 12.90 12.90 12.90 12.90 2.10 (6.90) 0.10 8.10 4.41 x 47.61 x 0.01 X 65.61 x 0.20 0.30 0.30 0.20 0.882 14.283 0.003 13.122 28.29 - Variancel (Stock B) = 28.29 Ith Deviation = 28.29 = 5.31

B.

(i) Various types of risk associated with investment are:

1. Equity risk, due to the frequent changes in the market price of shares.

2. Interest rate risk, refers to the risk of losing money due to the changes in the rate of interest

3. Currency risk, refers to the risk of losing money due to changes in foreign exchange rate

4. Liquidity risk, unable to sell the investment at a fair price

(ii) Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event. It helps to reduce the volatility of your portfolio over time.

(iii) Some common measures of risk are:

1. Standard Deviation: It measures the dispersion of data from its mean value. Higher the standard deviation, higher the risk.

2. Beta: Beta measures the systematic risk an individual security possess relative to the whole stock market.

3. Value at Risk (VaR):It is used to assess the level of risk associated with a portfolio or a company.

4. Conditional Value at Risk (CVaR): it is used to assess the tail risk of an investment. It seeks to assess what happens to an investment beyond its maximum loss threshold.

th A trn ahetid 30x121)+(ox/161)+(30xIp .20xs1) 1.30 x6) (o.30131)+1.20,2t) 15,401 12.401 ondard ratien h A lue X-X (3.40 IS 40 11.56 x D.30 3.462 12 D 36 x D.b0 16 0.144 0.40 15.Ho 18 D. 30 6.76 X 2.022 IS.HO 2.b0 S.64 wrianel (th A5.64 Desiation 2.37 X-X 2.10 15 12.90 0.20 4.41 0.382 X 6. 90 47.61 X th.283 6 12.90 0.30 o. 30 0.0o 3 (3 0.01 X 12.90 0.10 5.61 X 8.10 13.122 0.20 12.90 21 28.29 brer reh 28.29 Mtien S.31 128.29