Risk and Return Analysis in Investments
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Layla MainRisk and Return Analysis in Investments
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Powered by AIIf the market return drops by 1% to 9% due to a decrease in risk aversion, the required return on the project would decrease. Using the formula RF + b(km - RF), with RF = 7%, beta = 1.50, and km = 9%, the new required return would be calculated as 9%, down from the original 11.5%. This change makes the investment more attractive since the expected return of 11% now exceeds the reduced required return .
The coefficient of variation (CV) is a measure of relative risk, defined as the standard deviation divided by the expected return. In this context, with an expected return of 18.9% and a CV of 0.75, the standard deviation is calculated as 0.75 * 18.9% = 14.175%. This helps investors compare risks across different investments by focusing on risk per unit of return .
Stock C, with a beta of -0.30, would be a strategic addition during a market decline. It has an inverse relationship with market returns, suggesting it may increase in value when the market falls, providing a cushioning effect against losses .
The required return on a project according to the CAPM is calculated as RF + b(km - RF), where RF is the risk-free rate, b is the project's beta, and km is the market return. A 10% increase in km would lead to an increase in the project's required return proportional to its beta. Specifically, for a project with a beta of 1.50, if km increases by 10% (from 10% to 11%), the project’s required return would increase by 1.5%—from 11.5% to 13%. Conversely, a 10% decrease in km would lead to a decrease in the project’s required return by 1.5%, bringing it down to 9.5% .
In anticipation of a market rally, Stock B should be added due to its high beta of 1.40. This means it will have larger proportional increases in return compared to market gains, benefiting from amplified positive returns during the rally .
Stocks are ranked by beta as follows: Stock B (1.40) is most risky, followed by Stock A (0.80), then Stock C (-0.30) as least risky. If the market return increases by 12%, Stock B's return increases by 16.8%, Stock A by 9.6%, and Stock C decreases by 3.6%. Conversely, if the market decreases by 5%, Stock B decreases by 7%, Stock A by 4%, and Stock C increases by 1.5% .
Returns on international investments can differ due to changes in currency exchange rates. The local currency return may reflect a gain, while the foreign currency return may be reduced by unfavorable exchange rate changes. For Joe, the U.S. dollar return is more important as it reflects the actual purchasing power gained or lost from the investment when converting back to his home currency .
The expected rate of return can be calculated using the formula: (Cash Flow + (Ending Market Value - Beginning Market Value)) / Beginning Market Value. For investment X, this is ((1500 + (21000-20000))/20000) = 13%. Similarly, for investment Y, the return would be ((6800 + (55000 - 55000))/55000) = 12.36%. Based on this, Keel should recommend investment X due to its higher return .
Since the expected return of 11% is less than the required return of 11.5% calculated using the CAPM, the investment would not be recommended. This is because investors should expect a return that at least matches the required return to justify the risk taken .
A project with a beta greater than 1, such as 1.50, indicates it is more volatile and riskier than the market. Its returns are expected to move more dramatically than the market; therefore, it should offer higher returns to compensate investors for the additional risk. This project would experience amplified gains or losses in response to market movements .