Define each of the following terms, risk-free rate of return, market portfolio,

Question

Define each of the following terms, risk-free rate of return, market portfolio, security market line, required expected the rate of return, and beta. Add a comprehensive fictitious example to better clarify each of the preceding mentioned terms. Include the evaluation of the expected rate of return. What would be a good candidate for the market portfolio in reality? Provide your explanations and definitions in detail and be precise. Provide references for the content.

Examples in numerals is required

Explanation / Answer

Risk free rate of return: It is the minimum return with no profit or loss that an investor requires. For eg. US Treasury rates are considered as risk free rates. Bond yields are also used as risk free rates. Eg. 6% is the risk free rate of return for a long term govt. Bond.

2. Market portfolio and Security market line: The theoretical bundle of financial assets that include every asset available in the financial market. The expected return of market portfolio is a representative of the expected return of the whole market.

CAPM and market portfolio have a relationship which is defined as CAPM tells about the expected return of market with only systematic risk which is termed as beta .

The equation is : expected return= rf+ ( rm- rf)×beta

For eg. Rf= 6%, Rm= 10%, beta,= 1.2

Security market line= 6+(10-6)*1.2= 10.8% is the expected return.

4. Required rate of return: It is actually given by CAPM or the different dividend discount models. such as RR= rf+ Rp* beta.

This is the minimum annual return required by investors to induce them to put more money in that investment. For eg. Earlier mentioned RR= 10.8% addressing for the systematic risks only.

5. Expected Return:

It is calculated by using different outcomes that are likely to happen in the market as per investors perception. For eg.

Return Outcomes: 10%, 15%, 12% Probabilities: 20%, 40%, 40%

Expected Return: (0.10*0.20)+ (0.15*0.4)+ (0.12*0.40)=

0.128 or 12.8%

5. Beta

It is a measure of systematic risk of a stock in comparison to the market as a whole. Beta of 1 indicates security moves with the market. Beta of less than 1 means security is less risky than the market. Beta of more than 1 means security is more risky than market.

beta can be calculated as = covariance security, market is divided by variance of market.

beta= 2/ 2= 1

Good candidates for market portfolio are ETF or exchange traded fund, US goverment long term bonds, gold bonds.

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