Risk and Return Including Portfolio Management
1. a). This is undiversified risk which is also called systematic risk affects all the bonds or securities of the investor in the industry (Kent and Hirshleifer,2001). It is caused by the fluctuation of the expected earnings due to micro economic factors which affect all the companies in the industry. Therefore unexpected increase in inflation affects all the companies in the industry and it is a micro economic problem affects all the companies.
b).The major recession in US is also a systematic risk since the problem affects all the companies in the industry in the in US. The problem has a possibility of causing fluctuation of the expected earnings of the assets of the investor because it is a micro economic factor affecting all the firms in the industry.
c) A major lawsuit is filed against one large publicly traded corporation is a diversified risk that affect the investors assets in the company since the factor can only cause fluctuation in the earnings of a specific company in the industry (Kent and Hirshleifer,2001). The factor cannot affect any other company since it is specific to that one company which it belongs.
2) CAPM is a model which elaborates the manner in which the risk associated with the asset and the targeted rate of return of the most risky asset of the investor are related in the investment plan of the investor .Its formula indicates that the outcomes of the risky investment is the risk free rate added together with premium of risk attained from investing in a security which is very risky.The risk premium is the additional outcome above the risk free rate which is to be paid back for involvement in a risky project more than that of a risk free rate while beta is a risk which cannot be diversified in any manner of the investment.
In the CAPM model, it is a requirement that the targeted rate of return of the asset be equivalent to the rate found in the risk free investment added together with risk premium. The investment can only be done when the targeted returns are equal or more than the result of the sum of the risk premium and the risk free asset.
The formula for the expected rate of return on the market portfolio=
E (Ri) =Rf+Bi (E (Rm)-Rf)
In which=E (Ri) is the required return of the investment asset
Rf=The risk free rate which could be the interest rate which comes from the Government securities.
Bi= the beta
E (Rm) =the targeted income on the prevailing market
E (Rm)-Rf =the premium of the market
E (Ri)-Rf=the risk premium of the asset
E (Ri) =4% +1.2(12%-4%)
=0.136 or 13.6%
0.09=Rf +0.8(0.1- Rf)
0.09=Rf +0.08 -0.8Rf
0.09 -0.08 =Rf-0.8Rf
=0.05 or 5%
c) The investment of the income of the investor proportionately in a risky investment with some cash held with the intention to realize interest at the risk free rate, the total income cannot be ascertained because the relationship of this equation is linear. Therefore the returns for this investment can be obtained by either investing all the capital of the investor in a single risky portfolio or partially invest in each of the investment. In the above scenario one of the portfolios is expected to be optimal since the asset with free risk is not correlated with any particular asset of the investor in any kind. Half investment is therefore have a more reduced variance hence has higher efficiency than any other portfolio (French and Craig, 2003). However high risky investment added together with cash is highly efficient than investment on lower portfolio since there will be reduced risk for all the expected incomes.
3). The CAPM is a very important model for the investor since it can be used to ascertain the price of the individual asset for investment using the SML and the way it is relates to the required rate of earnings of the security (Bodie and Kane, 2008).Its relationship with market risk can also help the investor to find the price of the security since it has the possibility of ascertaining the way in which the market places the price of a bond in relation to the risk associated with it. The model also has a very essential work to the investor since it can be used to compute the benefits of the risk ratio in comparison to the market situation.
The CAMP model is also very important to the investor in many aspects since it helps him to theoretically realize the best expected rate of return for the investment asset. In the case of addition of the asset to a diversified investment portfolio with a systematic risk, the sensitivity of the asset will be considered in the industry together with the targeted market returns. Furthermore it is very useful to ascertain whether the asset used for investment portfolio purposes can give a good required risk returns for the investor (French and Craig, 2003).This is achieved when SML graph is plotted where the targeted returns against the risk is placed above the graph and undervalued because the investor can demand for higher returns for the case of inherent risk of the project (Arnold, 2005). The value of the security is plotted below the graph with its value overstated to allow the investor to accept less returns for the risk which has been ignored during the investment.
The model can also help the investor to make rationalize decision on the best investment project which can earn more returns to him hence getting more income from his assets. This would be possible since the investor will be able to ascertain the projects which is more risky and has the ability to yield highest returns (Arnold, 2005). The investor's asset will be invested in that project which has been obtained to have high returns by using the CAMP model.