Flirting with Risk

|KOÇ UNIVERSITY |
|FINANCIAL MANAGEMENT 501 |
|Case 17: Flirting with Risk |
| |

FINANCIAL MANAGEMENT

Answers to Questions of Case 17

1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

As the risk increases the potential return increases as well. In order to get higher returns one needs to invest in riskier assets. In other words, risk is the probability of negative outcome and return is the compensation for this risk.

2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these topics.

The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas greater than 1, show a more intense version of the market behavior. Stocks with betas between 0 and 1 move in the same direction with the market. Since the market is the portfolio of all the stocks, the average stock has a beta of 1.

3. How should Bill demonstrate the meaning and advantages of diversification to Mary?

Comparing expected returns from non-diversified investments with the diversified investments could be a good way of demonstrating the meaning and advantages of diversification. Table 1 shows the expected returns without diversification and Table 2 and Table 3 show the expected returns when different proportions invested in different stocks.

Table 1

Table 2

Table 3

For example