Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

The capital asset pricing model (CAPM) explains how risk should be considered when stocks and other assets are held The CAPM states that any stock's

image text in transcribed The capital asset pricing model (CAPM) explains how risk should be considered when stocks and other assets are held The CAPM states that any stock's required rate of return is the risk-free rate of return plus a risk premium that reflects only the risk remaining diversification. Most individuals hold stocks in portfolios. The risk of a stock held in a portfolio is typically the stock's risk when it is held alone. Therefore, the risk and return of an individual stock should be analyzed in terms of how the security affects the risk and returr of the portfolio in which it is held. The expected rate of return on a portfolio equals the weighted average of the expected returns on the assets held in the portfolio. A portfolio's risk calculated as the weighted average of the individual stocks' standard deviations; the portfolio's risk is generally because diversification the portfolio's risk. Two important terms when discussing are correlation and correlation coefficient. Correlation is the tendency of two variables to move together, while correlation coefficient is a measure of the degree of relationship between two variables. If a portfolio consists of two stocks that are perfectly correlated then the portfolio is riskless because the stocks' returns move countercyclically to each other. If the returns of the stocks are perfectly correlated then the stocks' returns would move up and down together and the portfolio would be exactly as risky as the individual stocks. In this situation, diversification would be completely for reducing risk. In reality, most stocks are correlated but not perfectly. So, combining stocks into portfolios reduces risk but does not completely eliminate it. This illustrates that can reduce risk, but not completely eliminate risk. Portfolio risk can be broken down into two types. risk is that part of a security's risk associated with random events. It can be eliminated by proper diversification and is also known as company-specific risk. On the other hand, risk is the risk that remains in a portfolio after diversification has eliminated all company-specific risk. Standard deviation is not a good stock's which shows the extent to which a given stock's returns move up and down with the stock market. An average stock's beta is 1 because an averagerisk stock is one that tends to move up and down in step with the general market. A stock with a beta 1 is considered to have high risk, while a stock with beta 1 is considered to have low risk. Quantitative Problem: You are holding a portfolio with the following investments and betas: %

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Contemporary Financial Management Fundamentals

Authors: R. Charles Moyer, James R. McGuigan, Ramesh P. Rao

1st Edition

0324015771, 9780324015775

More Books

Students also viewed these Finance questions

Question

2.1 Discuss what ethics means and the sources of ethical guidance.

Answered: 1 week ago

Question

8 What personal development is elearning good at providing?

Answered: 1 week ago

Question

7 What are the principles of action learning?

Answered: 1 week ago