Financial Management Topic 7

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INTRODUCTION TO RISK AND RETURN

QUESTION 1

1. Using a well-labelled diagram, differentiate between ‘systematic risk’ and ‘unsystematic risk’.
2. (b) Difference between systematic risk and unsystematic riskSystematic (or market) risk cannot be diversified away: it is the risk which arises from market factors and is also frequently referred to as undiversifiable risk. It is due to factors which systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of payments, inflation and interest rates). It may help you remember which it type it is if you think of systematic risk as arising from risk factors associated with the general economic and financial system.

Unsystematic (or specific) risk can be diversified away by creating a large enough portfolio of securities: it is also often called diversifiable risk or company-unique risk. It is the risk which relates, or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the discovery of a new technology or product would contribute to unsystematic risk.

The relationship between total portfolio risk, ?, and portfolio size can be shown diagrammatically as in below. The total risk diminishes as the number of assets or securities in the portfolio increases, the unsystematic risk disappears completely and that systematic risk remains unaffected by portfolio size.

3. Musa Onyango has invested in a portfolio that comprises two assets as shown below;-

 Asset C Asset S Amount invested Expected return Standard deviation Sh.4,000,000 11% 15% Sh.6,000,000 *25% 20%

Correlation coefficient between the rates of return of asset “C” and asset “S” is 0.30

Required;-

1. Portfolio expected return
2. Portfolio risk

QUESTION 2

The following information relates to two potential investments namely; A and B.

Investment A                                       Investment B

Probability             Return                   Probability             Return

0.3                          20%                       0.2                          20%

0.4                          8%                         0.6                         8%

0.3                         -4%                        0.2                         -4%

Required:

The standard deviation of each of the two investments.

QUESTION 3

1. a) The following data relate to price and related financial details of three ordinary shares for the year 2012.
 Ordinary share Beginning price Ending price Dividend paid. X Y Z Sh. 30 72 140 Sh. 34 69 146 Sh. 3.40 4.70 4.80

Required:

1. Total expected return for each of the three ordinary shares.
2. Relative return for each of the three ordinary shares.

Assuming an investor combines all the three ordinary shares X, Y, Z in a portfolio in the ratio of 4:2:4 respectively. Determine the expected return of the portfolio.

QUESTION 4

1. a) Explain the relationship between risk and return

QUESTION

1. Relation between risk and return Investors seek higher returns to compensate them for bearing higher risks. The required return would be a risk-free rate plus a risk premium to compensate the investors for the opportunity cost of not invested in the risk free investments such as treasury bills.

The higher the risks perceived by the investor, the higher the premium he will demand to invest in a

particular investment.

QUESTION 5

1. d) West Limited has forecasted the following end of period prices for its shares.

End of period price per share (Sh.)           Probability

 35 0.15 0.10 0.30 0.20 0.25 42 50 55 60 The current price per share is Sh.50. Required: (i) Expected return. (ii) Variance of end of period returns.

QUESTION 6

c) Distinguish between the following terms as used in finance.

• Perfect markets and efficient markets
• Future and forwards
• Business risk and financial risk

QUESTION 6

1. c) Distinguish between the following terms as used in finance
2. Perfect markets and efficient markets

Perfect markets is a market with the following assumptions;-

• Rational investors
• Equal access to information by all market participants
• Completely rational economic factors and no transaction costs such as taxes.
• Frictionless market

Efficient market is a financial market in which security prices reflect the available information. Information can be classified as past information (historical information) current (published) information and the future ( confidential information)

1. Futures and forwards

Futures

A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.  Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures.

Forwards

These are equivalent to tailor made futures contracts. For example, firms often enter into forward agreements with a bank to buy or sell foreign exchange or to fix the interest rate on loan to be made in the future.

• Business risk and financial risk 1. Business Risk

A company’s business risk is the risk of the firm’s assets when no debt is used. Business risk is the risk inherent in the company’s operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:

• Sales risk – Sales risk is affected by demand for the company’s product as well as the price per unit of the product.
• Input-cost risk – Input-cost risk is the volatility of the inputs into a company’s product as well as the company’s ability to change pricing if input costs change.
1. Financial Risk

A company’s financial risk, however, takes into account a company’s leverage. If a company has a high amount of leverage, the financial risk to stockholders is high – meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

QUESTION 7

1. d) An investor has two securities, A and B. with the following return characteristics’

State if the          Probability      Returns           Returns economy   Security A (%)            Security B (%)

Recession                    0.3                               12                               6

Stable                          0.4                               15                               7.5

Expansion                    0.3                               10                               5

Required

Assess the riskiness of securities A and B.

QUESTION 8

1. c) Briefly explain the following:

(i) Financial risk (ii) Asset risk

QUESTION 8

1. c) Explanation of the following;-
2. Financial risk

It is the possibility that shareholders will lose money when they invest in a company that has debt, if the company’s cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors will be repaid before its shareholders if the company becomes insolvent.

Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money.

1. Asset risk

Risk related to market changes or poor investment performance of a financial asset (e.g.

shares, options, futures, currency).

QUESTION 9

QUESTION 9

1. b) The following information relates to the forecast returns of securities A and B and their probabilities during the financial year ending 30 June 2010
 Probability A B 0.2 0.1 0.35 0.05 0.15 0.15 10% 12% 8% 15% 14% 9% 8% 10% 7% 12% 11% 8%

Required;-

1. The expected return and standard deviation
2. Based on the relative risk, which security would you recommend

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