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Remove or replace: Header Is Not Doc Title Focus on risk and reward valuations. In this assessment, you will explore different measures and sources of risk and how to manage it, portfolio theories, the capital asset pricing model (CAPM), and the efficient market hypothesis (EMH). Other areas of consideration include stand-alone risk versus portfolio risk, risk sources and their measure, as well as portfolio efficiencies.

Introduction This assessment focuses on risk and reward valuations.

Instructions Complete and submit the Assessment 4 Template [XLSX].

Competencies Measured By successfully completing this assessment, you will demonstrate your proficiency in the course competencies through the following assessment scoring guide criteria: Competency 1: Analyze financial environments and concepts. Describe why expected return is considered forward-looking. Competency 2: Apply financial computations and processes. Perform five risk and reward calculations correctly. Competency 3: Communicate effectively and professionally. Convey clear meaning through appropriate word choice and usage.

Paper For Above instruction

Financial decision-making in investment management necessitates a comprehensive understanding of the interplay between risk and reward. These two facets are fundamental in shaping investment strategies, portfolio construction, and risk mitigation. This paper discusses various measures of risk and reward, explores relevant financial theories such as the Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH), and explains the importance of forward-looking expected returns.

Risk and Reward Valuations

Risk and reward are inseparable components of investment analysis. While returns provide the potential for profit, risk quantifies the likelihood and magnitude of potential losses. Investors constantly evaluate this balance to maximize returns while mitigating potential downsides. Quantitative measures like standard deviation and coefficient of variation are used to assess the riskiness of individual securities. Standard deviation indicates the variability of returns and acts as a measure of total risk, whereas the coefficient of variation relates the risk to expected return, facilitating comparison across investments with different return levels.

The coefficient of variation (CV) is calculated as the ratio of standard deviation to the expected return. Higher CV values indicate higher relative risk. For instance, considering three stocks—Rail Haul, Idol Staff, and Poker-R-Us—their CVs help rank their overall riskiness. Rail Haul's CV can be calculated as 25%/12% ≈ 2.08, Idol Staff as 35%/15% ≈ 2.33, and Poker-R-Us as 20%/9% ≈ 2.22. This ranking reveals that Idol Staff presents the highest relative risk, followed by Poker-R-Us and Rail Haul.

Portfolio risk considerations involve understanding the interplay of individual asset risks and their correlations. Diversification benefits can reduce overall portfolio risk below the weighted sum of individual risks, especially when assets are imperfectly correlated. The portfolio's total return is a weighted average of component assets' returns, emphasizing the importance of diversified holdings for risk management.

The calculation of expected portfolio return involves the weighted sum of individual asset returns. For a portfolio comprising 30% Oracle, 25% Valero Energy, and 45% McDonald's, yields are 1.96%, 1.99%, and 0.39% respectively, based on past returns. The overall portfolio return thus would be approximately 30%−1.34% + 25%7.96% + 45%*0.88% ≈ 3.21%, reflecting the combined expected performance.

Applying the Capital Asset Pricing Model (CAPM) offers a way to determine the expected return of a security based on systematic risk. The formula, E(Ri) = Rf + βi(E(Rm) – Rf), incorporates the risk-free rate, the asset’s beta, and the market risk premium. For Hastings Entertainment, with a beta of 0.65, market return of 11%, and risk-free rate of 4%, the expected return computes as 4% + 0.65*(11% - 4%) = 4% + 4.55% = 8.55%.

Beta coefficient measurement is crucial for understanding a stock’s sensitivity to market movements. With given data such as a stock return of 10%, a risk-free rate of 3%, and a market return of 9%, the beta can be derived from the CAPM formula rearranged as β = [E(Ri) – Rf] / [E(Rm) – Rf], resulting in β = (10% – 3%) / (9% – 3%) = 7% / 6% ≈ 1.17. A beta above 1 indicates higher systematic risk than the market.

Finally, the notion that expected return is forward-looking stems from its basis on forecasts of future market conditions, economic indicators, and risk factors. Unlike historical returns, forward-looking expected returns integrate anticipated changes and are used in investment decision-making to predict future potential gains and losses.

References

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