FIN 2102 WEEK 7 EXAM QUESTIONS AND ANSWERS

FIN 2102 WEEK 7 EXAM QUESTIONS AND ANSWERS 1. What is risk? Give the examples the risks that face by business organizations. Risk is possibility that actual future returns will be different from expected return. Risk implies that there is a chance for some unfavourable event to occur. There is systematic risk and unsystematic risk. Systematic risk cannot be fully avoided and affects the overall market. Systematic risk such as interest rate risk, inflation, recession and so on. For unsystematic risk, this kind of risk can be avoided or reduced through diversification. Systematic risks are including a new competitor, a regulatory change and a management change. 2. How the risk can be measured? The risk can be measured by using standard deviation. 3. Assuming you are holding Stock ‘G’. The following details will assist you to identify the risk of your investment. Rate of Return Probability 18.5% 25% 12.0% 25% 10.5% 25% 7.8% 25% 100% Required: Calculate the standard deviation of stock G. Solution: Step 1: calculate the expected return 0.185 x 0.25 = 0.04625 0.12 x 0.25 = 0.03 0.105 x 0.25 = 0.02625 0.078 x 0.25 = 0.0195 0.122 = 12.2% Step 2: find the variance Following the rest of the formula: (0.185 – 0.122)2 x 0.25 = 0. (0.12 – 0.122)2 x 0.25 = 0. (0.105 – 0.122)2 x 0.25 = 0. (0.078 – 0.122)2 x 0.25 = 0. 0. Step 3: find the standard deviation = 3.94% 4. You wish to diversify your money for 2 separate investments. However, you wish to know the effect of risk upon grouping these assets together as your portfolio investment. Suppose the shares of two companies, F & G, have the following probability distributions: Economy Probability Return F Return G Boom 0.3 20% 15% Growth 0.4 10% 12% Slump Required 0.3 15% 20% a) Calculate the expected return and the expected risk for each security separately and b) Calculate the expected return and expected risk for a portfolio comprising 50 per cent for F and 50 percent G. Solution: a) Economy Prob. Return ri x pi ri ri – ri (ri – ri)2pi Stock F Boom 0.3 20 6 14.5 5.5 9.075 Growth 0.4 10 4 14.5 -4.5 8.1 Recession 0.3 15 4.5 14.5 0.5 0.075 Expected Return 14.5 Variance 17.25 Standard Deviation 4.15%