Business Finance, Computational and mini question - Essay Example

Mrs Sensible has recently sold her holiday home for the sum of 100,000 and is considering investing this money in the Stock Market. After studying the Stock Market she has obtained information on two companies, Curtain plc and Blind plc, both of which have been trading for a number of years. Curtain plc has a beta factor of 0.6 and has a correlation coefficient with the market portfolio of 0.27, whilst Blind plc has a beta factor of 1.4 and a correlation coefficient with the market portfolio of 0.21. The correlation coefficient between Curtain plc and Blind plc is 0.32.Assume that the market is in equilibrium and that the market portfolio has a return of 15% and a standard deviation of 7%.

The return on the risk free asset is 6%.Required(a)(i) Determine what proportion of Mrs Sensible's 100,000 should be invested in Curtain plc and Blind plc in order to create a portfolio with a beta coefficient of 1.2. Calculate the expected return of such a portfolio.The SML equation is expressed as follows: where E[Ri] = the expected return on asset i, Rf = the risk-free rate, E[Rm] = the expected return on the market portfolio, i = the Beta on asset i, and E[Rm] - Rf = the market risk premium.

E[Ri] = 6% + (15% - 6%)1.2 = 16.8%Expected Return on Stock i (E[Ri]): %Risk Free Rate (Rf):%Expected Return on the Market (E[Rm]):%Beta for Stock i (i):(ii) Calculate the total risk of the portfolio constructed in part (i) above.Risk Premium = RETe - RETf= (RETe-ReTf)beta= (16.8% - 6%)1.2= .1296(iii) Specify a more efficient portfolio with the same return characteristics as the portfolio identified in (i) above, and calculate the beta and total risk characteristics of such a portfolio.

Fully explain your answerExpected Return on a Portfolio of Stocks A and BNote: E[RA] = 12.5% and E[RB] = 20% Portfolio consisting of 50% Stock A and 50% Stock B Portfolio consisting of 75% Stock A and 25% Stock B (b) Given the the Arbitrage Pricing Theory (APT) considers more then one factor when attempting to explain the expected return on a security it is thus a more realistic and superios model to the CAPM. Discuss. The recognition of systematic risk makes an asset less desirable. The Capital Asset Pricing Model or CAPM is useful because it provides an explanation for the magnitude of an asset's risk premium, the difference between an asset's expected return and the risk-free interest rate.

The CAPM equation provides the commonsense result that when an asset's beta is zero, meaning there is no systematic risk, its risk premium will be zero. Although the CAPM has proved useful in real-world applications, it assumes that there is only one source of systematic risk that is found in the market portfolio. However, an alternative theory, Arbitrage Pricing Theory, takes the view that there are several sources of risking the economy that cannot be eliminated by diversification. This is a better option over CAPM because it takes into consideration that sources of risks can be though of as related to economy-wide factors such as inflation and changes in aggregate output.

Instead of calculating a single beta like CAPM, APT calculates many betas by estimating the sensitivity of an asset's return to changes in each factor. Arbitrage Pricing Theory thus indicates that the risk premium for an asset is related to the risk premium for each factor and that an asset's sensitivity to each factor increases, its risk premium will increase as well.REFERENCE:Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues, Journal of Finance, 32 (177)