Risk and Return Assignment Example | Topics and Well Written Essays - 2000 words

Risk and Return - Assignment Example According to CAPM, r = Rf +? (Km - Rf ) Where r= Expected return of the security Rf = Risk free rate ?=beta of the security Km= expected return of the market RA= 0.06+0.27(0.25-0.06) =0.1113 =11.13% RB =0.06+0.75(0.25-0.06) =0.2025 =20.25% Characteristic Lines of Securities A and B The SCL:Ri,t -Rf =?i +?i (RM,t - Rf ) + diversifiable risk ? is the excess return ?i (RM,t - Rf ) represents the non diversifiable risk The security characteristics line is drawn to show the excess return of the investment over that that of the market. The y-axis represents the excess return over the risk free rate. The x-axis represents the excess return over the market in general. The slope of the SCL represents the beta of the individual security. The main reason for the determination of the security characteristics line is to show the performance of a security relative to that of the market. Investors who want to put their finances in investments are interested in securities that will pose performance that is higher than the market or is at par with that of the market. From the slope of the security characteristics line, it is easier for investors to see the alpha of the security and also to compare the performance of the security relative to others. Moreover, a security characteristics line reveals the quantity of both the systematic and unsystematic risk (Roll & Ross 1980). Systematic risks are those that cannot be minimized through diversification and the investors must avoid investments with higher systematic risk. Likewise, the level of unsystematic risk can also be revealed from the diagram. To interpret the diagrams, the lines with high gradients re taken to have a higher beta factor and are therefore more risky than those with lower gradients. At the same time, the return of securities with higher gradients will exhibit high return level. In the diagram as well, the y-intercept represents the alpha value i.e. the excess of the return of an investments over the risk free r ate of return (Roll & Ross 1980). On the other hand, the x-intercept represents the excess of the security return over that of the market. A security with a high value of X-intercept has a higher return than those of the lower x-intercept values. It is therefore clear that a security characteristics line is an important tool that investors rely on when making investment decisions and should be able to help in the making of investment decisions. The security characteristics line therefore reveals the properties of the respective securities. Question 2 The arbitrage pricing theory is an asset pricing model that was developed due to the limitations of the capital asset pricing model. APT is a multifactor model that considers the various macroeconomic factors affecting the pricing of a security (Roll & Ross 1980). In this model, the risk free rate is added to all the macroeconomic factors affecting the pricing of the asset with each factor having its own beta. According to the arbitrage pricing theory, the return of a security is determined by the formula: r= Rf + ?2F2+ ?3F3+†¦..+ ?nFn Where r=return of a security ? i’s=betas of respective factors Fi’s= macroeconomic factors affecting the returns The APT is therefore a multifactor model and the arbitrage process is the selling of the inefficient securities in inefficient markets in order to maximize the return on the assets. In this process the overvalued assets are sold in order to get the profits and undervalued