PLEASE SHOW ALL WORK!! 1. Diversification: True or False. Explain your answer. T
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Question
PLEASE SHOW ALL WORK!!
1. Diversification: True or False. Explain your answer.
The variances of the individual assets in the portfolio are the most important characteristic in determining the expected return of a well-diversified portfolio.
2. Portfolio Risk: Explain.
a) If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio?
b) If a portfolio has a positive investment in every asset, what about the portfolio beta? Is the portfolio beta less than that of every asset in the portfolio?
3. Short Questions:
a. What is the beta of a market portfolio?
b. If beta of a stock is one, what you can say about the riskiness of that stock compare?
c. If beta of a stock is greater than one, what you conclude about riskiness of the stock?
d. If the standard deviation of returns of a financial asset is zero, what is your best guess about that financial asset?
4. Discuss the three forms of market efficiency. Explain your point of view on which type of efficiency best represents US capital market.
5. Discuss the key theories in capital structure briefly. Please use complete sentences. No bullets please.
Explanation / Answer
1. The variances of the individual assets in the portfolio are the most important characteristic in determining the expected return of a well-diversified portfolio.
True.
Explanation: The very basis of portfolio theory is optimal allocation of investments between different assest classes. This can be acheived only by using a measureable quantitative tool. The mean variance is the quantitative tool which helps the analyst to determine the correct allocation while considering the risk return trade off.
2. Portfolio risk
It is the risk of loss that an investor has to consider while investing in stocks and bonds . This risk is due to the unfavorable and unpredictable movements that take place in the market.
a. If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio?
It is possible. It can be less than the highest standard deviation of an asset or greater than the lowest standard deviation of an asset in the portfolio.
b. If a portfolio has a positive investment in every asset, what about the portfolio beta? Is the portfolio beta less than that of every asset in the portfolio?
It is possible. It can be less than the highest beta asset or greater than the lowest beta asset in the portfolio.
3.
a. Beta of a market portfolio
Beta actually refers to co movement. It is a relative measurement. It is a measure of an asset's movement in relation to the market movement. Therefore it is also said to be a measure of an investment's relative volatility. beta of market portfolio is not subject to unsystematic risk but only to systematic risk or risk to the market as a whole.
b. If beta of a stock is one, what you can say about the riskiness of that stock compare?
The stock will move in the same way/ direction and amount as the market or index. This is less risky as compared to stocks with beta greater one.
c. If beta of a stock is greater than one, what you conclude about riskiness of the stock?
The stock will be more volatile than the market index and hence it is more risky.
d. If the standard deviation of returns of a financial asset is zero, what is your best guess about that financial asset?
In such a case the financial asset can be said to be a risk free asset.
4. The three forms of market efficiency are:
Weak
Semi strong
Strong
Weak - Market is efficient in such a manner that the current stock prices reflect the entire information of past market data.
Semi strong - Market is efficient and reflects all publibly available information in adddition to the past market data.
Strong - In this the market is highly efficient as it includes all publicly and privately available information in the stock prices.
The type of efficiency that best represents US capital markets
In US it is a strong form of efficiency because no one investor is able to earn excess returns over a long period of time by beating the market.
5. Key theories in capital strucure
NI approach - David Durand
This approach is in favor of financial leverage. An increase in debt ratio will reduce the cost of capital and hence also the firm's value. This is also called theory of relevance.
NOI approach - David Durand
In this approach the weighted average cost of capital is assumed to be constant. Market does not consider debt equity ratio but considers the firm as a whole while analysing the firm. So WACC and value of the firm are constant.
Traditional approach
Considers an optimal debt to equity ratio in the optimal capital structure where the cost of capital is minimum and the value of the firm is maximum.
MM approach - Proposition 1 and 2
Proposition 1 - Value of firm does not depend on the capital structure or the mode of finance that is adopted by the firm. The future earnings are considered to be an impiortant indicator of the value of a firm.
Proposititon 2 - Financial leverage need not add value to the firm as it gets compensated in terms of change in required rate of return because of increased earnings.
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