The Different Types of Assets - Essay Example

I agree to this because diversification spreads the risk over the different types of assets. Given the fact that the two assets are uncorrelated to each other, it would be rational to invest in both assets. The higher risk of asset S will be compensated with the less risky return of asset B. on the other hand investing in one asset will be riskier because of unsystematic factors like seasonal and market variations. By combining the two assets in a portfolio, any potential unsystematic risk will be compensated because any unexpected, pessimistic variation in the highly volatile asset S will be netted out by the uncorrelated yet optimistic variation in the asset B, to a considerable extent, and thus the overall risk of the portfolio will be reduced. 2. I totally disagree to the statement; it is quite opposite of the fact that there is a direct relationship between correlation of the portfolio assets and its risk. The higher the correlation between the portfolio assets, the more chances will be that the downside movement of one asset will accompany the same in the other and thus the investment will turned to be the worst. Thus, a rational investor should invest in uncorrelated or atleast less correlated assets in order to reduce the overall risk of the portfolio (Ross et. al, 2013). 3. I agree to this argument. Since the expected return of portfolio is the weighted average of the expected returns of the individual assets, it must lie in between the range of these two individual expected returns. However, the standard deviation of the return on portfolio doesn’t need to be in b/w the individual standard deviations of the two assets, especially when the stocks are uncorrelated, because the standard deviation of a portfolio is not just the weighted average of individual standard deviations but is computed using the standard deviation formula to the return on portfolio assets rather than just the returns for one asset; it is thus the weighted average of individual variances (weights are squared) plus the weighted co-variances b/w the two assets. Since weights are squared, the portfolio standard deviation doesn’t necessarily lie in between the component standard deviations and can even be lower than the lowest individual standard deviation when the correlation between the two assets is zero (Ross et. al, 2013). 4. I agree to this statement. When capital market consists of all risky assets, a rational investor should hold large number of assets in portfolio in order to diversify risks to a large extent. Risk diversified over the large number of stocks will tend to reduce the portfolio risk more significantly because a large portfolio tends to behave more like the market portfolio which compensates unsystematic risks (Ross et. al, 2013). 5. I agree to this statement. The variance of the return on a portfolio is function of both the component variances of the individual assets as well as co-variances among the assets’ returns (Ross et. al, 2013). That is, even if the individual variances of the assets are very low though their returns are highly correlated, the portfolio will be highly volatile and risky and there won’t be any advantage of such diversification. 6. I disagree. Although increasing the number of assets reduces the variance of portfolio return because of diversification, the reduction in risk occurs at a diminishing rate (not at a constant rate) with the increase in number of assets in the portfolio. It is even said that to attain the maximum benefits of diversification, 10-15 assets are enough for a portfolio since this amount of diversified assets can resemble the market portfolio. Adding more assets won’t contribute to any further reduction in the portfolio risk. So, the variance will be more or less same but won’t be zero even when N is very large. Also, it’s not just the added number of assets which reduces the portfolio variance but the correlation between the assets does that too. Theoretically, a mix of negatively and positively correlated assets or a mix of uncorrelated assets can drive portfolio variance to zero but solely the large number of assets can’t contribute in this regard. 7. I agree to this statement. The small stock portfolio is riskier because smaller companies have narrower, less diversified product offerings which make their business and financial risk more unique as compared to the larger companies which are engaged in diversified product chains and have well structured finance base that makes their risk less unique. Since smaller companies face high unsystematic, or unique, risk they tend to be highly sensitive to changing market conditions, illiquidity, and other company-specific risks. 8. I agree to this statement. The variance of the return on portfolio can be stated as follows: Portfolio variance = 1 average variance + [1 – 1] average covariance N N It can be seen that as the number of assets in the portfolio increases, the term 1/N will decrease and thus the effect of increase in individual variances on the portfolio variance will become less significant. Also, with the increase in N, the term (1 – 1/N) converges to 1, and thus, the effect of co-variance on the portfolio variance will become more significant. This implies that it is the covariance which matters to a large portfolio (Ross et. al, 2013). 9. I agree to this statement. Since investors are usually risk averse, introduction of risk-free asset will make most of the investors to add that asset in their portfolio in order to reduce the portfolio risk and thus improve the investment prospects. 10. I agree because a portfolio with large number of randomly selected assets behaves like market portfolio; it won’t be affected by any unsystematic risk and will only be subjected to the systematic market risk. Though, this requires that the assets of the portfolio are well diversified. Thus, it is the extent of diversification among the assets which matters for a large portfolio to make it resemble the market portfolio (Ross et. al, 2013). 11. I agree to this statement. When a risk free asset is made available, all investors are better off mixing the risky portfolio with that risk-free asset. Without the risk-free asset, each investor chooses a unique risky portfolio, whereas with the risk-free asset, all investors choose the same risky portfolio in combination because the best risky portfolio is the same for all investors, regardless of risk aversion. The difference will then only be in how much each investor allocates to this optimal risky portfolio and to the risk-free asset – and that depends on the risk aversion. This can also be illustrated by the following graph (Ross et. al, 2013): E(r) CAL (P*) P* rF ?P P* is the optimal risky portfolio chosen by all investors when there is a risk-free asset. Without a risk-free asset, there is no one tangency portfolio which is best for all investors. Then, investors have to choose a portfolio from the efficient frontier of risky assets along the curve and thus they end up choosing their unique portfolios of the risky assets according to their risk aversion. 12. I don’t agree to this statement. Rational investors always tend to diversify their portfolio with larger number of diversified assets. Those who are risk lovers, hold larger portion of risky assets – ones with high standard deviations – than the portion of the risk-free asset. On the other hand risk-averse investors tend to direct their portfolio more towards the risk-free asset than to the risky ones. In short, unless the non-diversified portfolio is offering a higher expected return, diversification doesn’t hurt expected returns of the portfolio. So, even a rational risk-averse investor will also hold a large number of risky assets in portfolio. 13. I don’t agree. Adding one more capital asset to an already large portfolio won’t affect the variance of its returns since with the increase in number of assets in the portfolio its variances reduces at a diminishing rate and ultimately a point comes when the variance of the portfolio doesn’t change with the number of assets and thus won’t make it further diversified. 14. I agree to this statement. Every investor requires a risk premium in exchange for risk i.e. demands high return to compensate high risk. Since AT is willing to take such a high risk to develop the new chemical, it must be expecting a very high return from this new chemical. 15. I don’t agree. In order to have high expected return, investors put a large portion of risky assets into their portfolio as compared to the portion of risk-free asset rather than putting small number of the risky capital assets. Investors demand high return by having a larger portion of the risky portfolio than the portion of the risk free asset. That is they increase their portfolio risk thru having greater portion of the optimal risky portfolio and thus of the risky assets, not thru having their smaller portion. 16. I agree to this. SML represents the relationship b/w expected return and risk (beta) of a particular portfolio. CML shows the relationship b/w risk (standard deviation) and return of efficient portfolio (market portfolio) rather than of a single portfolio or asset since CML is formed by connecting risk-free rate to the optimal portfolio (tangency of the efficient frontier). That is, CML is the efficient portfolio after the risk free asset has been added to it. The efficient frontiers don’t show up on SML graphs but only on the CML graphs. Thus, CML only graphs efficient portfolios while SML graphs any portfolio including the inefficient ones too; on the CML graph all these inefficient portfolios lie below the CML. That is why a particular portfolio can be on the SML but not the CML, though a portfolio on the CML must lie on the SML too. E(r) Efficient frontier P* CML rF ?P E(r) SML rF ? Work Cited Ross, S. et. al. (2013). Corporate Finance (10th ed.). New York, NY: McGraw-Hill Higher Education. Read More