Overview

Assessment 8

Respond to two questions and solve five computational problems related to estimating risk and return.

By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:

• Competency 1: Evaluate the global financial environment.

o Identify challenges for practitioners in using expected return.

o Explain how different allocations between the risk-free security and the market portfolio can achieve any level of desired market risk.

o Calculate expected return, considering the possibility of differing economic states.

o Calculate required return, considering the risk-free rate and the risk premium.

o Calculate the market risk premium of the Standard and Poor’s 500 Index, showing applicable input values, computational steps, and formulas.

o Explain why expected return is considered forward-looking.

o Calculate the beta of a portfolio, showing applicable input values, computational steps, and formulas.

• Competency 2: Define finance terminology and its application within the business environment.

o Calculate required return, using the capital asset pricing model.

Assessment Instructions

Answer the following questions and complete the following problems:

Questions

In a Word document, respond to the following. Number your responses 1–2.

1. Explain why expected return is considered forward-looking. What challenges arise in using expected return?

2. Explain how differences in allocations between the risk-free security and the market portfolio can determine the level of market risk.

Use references to support your responses as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.

Problems

In either a Word document or Excel spreadsheet, complete the following problems.

• You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet.

• If you choose to solve the problems algebraically, be sure to show your computations.

• If you use a financial calculator, show your input values.

• If you use an Excel spreadsheet, show your input values and formulas.

1. Based on the probability and percentage of return for the three economic states in the table below, compute the expected return.

Economic State Probability Percentage of Return

Fast Growth 0.10 60

Slow Growth 0.50 30

Recession 0.40 -23

2. If the risk-free rate is 7 percent and the risk premium is 4 percent, what is the required return?

3. Suppose that the average annual return on the Standard and Poor’s 500 Index from 1969 to 2005 was 14.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?

4. Conglomco has a beta of 0.32. If the market return is expected to be 12 percent and the risk-free rate is 5 percent, what is Conglomco’s required return? Use the capital asset pricing model (CAPM) to calculate Conglomco’s required return.

5. Calculate the beta of a portfolio that includes the following stocks:

o Conglomco stock, which has a beta of 3.9 and comprises 35 percent of the portfolio.

o Supercorp stock, which has a beta of 1.7 and comprises 25 percent of the portfolio.

o Megaorg stock, which has a beta of 0.3 and comprises 40 percent of the portfolio.

Suggested Resources

The following optional resources are provided to support you in completing the assessment or to provide a helpful context.

Library Resources:

• Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.

• Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.

Course Library Guide

You are encouraged to refer to the resources in the BUS-FP3062 – Fundamentals of Finance Library Guide to help direct your research.

Other Resources

• Cornett, M., Adair, T., & Nofsinger, J. (2019). M: Finance (4th ed.). New York, NY: McGraw-Hill. Available in the courseroom via the VitalSource Bookshelf link.

** ****Estimating Risk And Return**

** ****1.**

An expected return is the anticipated value of an investment’s return, either as a profit or loss, given a specific return rate. The term forward-looking is used in corporate finance to identify publicly-traded corporations’ predictions about the overall business and industry, including earnings estimates and forthcoming business conditions. Often, scholars consider expected return as forward-looking because it represents investors’ predictions of the expected return value in the future after making a current investment and bearing the market risks.

Scholars attribute expected returns to multiple challenges, among them high reliance on historical data (“Expected return,” n.d.). Notably, the approach utilizes historical returns to predict future returns which sometimes may not be a guarantee because of changes in market conditions. Moreover, when using the expected return, individuals must strategize that a specific investment will behave in a specific manner, which can sometimes be challenging because of market changes.

Scholars define market portfolio as a “portfolio with risky assets that provides the highest expected return over risk-free rate per unit of risk for any available portfolio with risky assets” (Omisore et al., 2012, p.24). Simply put, a market portfolio is a bundle of asset investments weighted according to their proportions in the market. On the other hand, risk-free securities are assets that have a known and guaranteed future rate of return (Oosthuizen & Rooyen, 2013). The certainty in these fixed income securities makes them less risky than other assets. Often, allocations between risk-free security and market portfolios may help an investor determine assets that are likely to earn then maximum returns or those with a low return rate but have no risk. Measuring the standard deviation of investment in the two assets may also help an investor determine the market risk level and select the best investment option.

References

“Expected return” (n.d.). *Finance Management.* https://efinancemanagement.com/financial-analysis/expected-return

Omisore, I., Yusuf, M., & Christopher, N.I. (2012). The modern portfolio theory as an investment decision tool. *Journal of Accounting and Taxation, 4*(2), 19-28. https://doi.org/10.5897/JAT11.036

Oosthuizen, A.V., & Rooyen, V.J.H. (2013). Risk-free assets: Are they truly risk-free? A comparative study of South African rates and instruments. *Risk Governance and Control Financial Markets and Institutions, 3*(3), 127-148. https://www.researchgate.net/deref/http%3A%2F%2Fdx.doi.org%2F10.22495%2Frgcv3i3c1art5