Q1 David and Sarah, have different perspectives on how to measure risk and construct portfolios. David follows the Capital Market Line (CML) approach, believing that a well-diversified portfolio should be assessed based on total risk (standard deviation). He argues that the CML represents the best possible combination of risk and return, achievable only through a mix of the risk-free asset and the market portfolio. Sarah, however, trusts the Security Market Line (SML), insisting that risk should be measured by beta, which only considers systematic risk. How would you help David and Sarah resolve their debate? How does the Capital Market Line (CML) differ from the Security Market Line (SML) in terms of risk measurement and portfolio representation?
Q2 Explain how the combination of risky and risk-free assets can be used to construct an optimal portfolio. What role does the CML play in this process? (10 Marks)
Q3 (A) The Investor has Rs.30,000/—and decides to invest equally in mutual funds and shares. The expected return from mutual funds is 5% p.a., and from shares is 10% p.a. Calculate the total expected return for one year. (5 Marks)
Q3 (B) John is a young investor eager to build his stock portfolio. Mr. Davis, introduces him to the concept of beta.
One day, John analyzes two stocks: Stock A has a beta of 1.5, while Stock B has a beta of 0.7. Mr. Davis asks him:
“John, if the market rises by 10%, how much would you expect each stock to move? And if the market crashes by 10%, which stock would be riskier? More importantly, based on your risk tolerance, which stock should you choose?” How should John use beta to make his decision? What does beta tell him about the risk and expected return of each stock? Evaluate the significance of beta in the context of CAPM. How does beta influence investment decisions? (5 Marks)
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