Understanding the Financial Concepts

Assignment #2

Understanding the Financial Concepts

Realized Return of the Stock, Systematic and Unsystematic Risk,

Risk of the Portfolio, BETA, and WACC.

Finance 100

Understanding the Financial Concepts

Realized Return of the Sock, Systematic and Unsystematic Risk,

Risk of the Portfolio, BETA, and WACC.

1. Identify the components of a stocks realized return.

Realized return is the total return that occurs over a particular time period. The components of realized returns are individual investment realized return, and portfolio. The first has to do with the stability of the portfolio itself. If the rate of return for the portfolio overall is low or should decrease, this is a sign that some diversification in the types of investments would be a good idea. When calculating the realized return on a portfolio that includes bond issues, it is important to focus on the actual interest payments that are received on bond coupon for the period cited. For example, one must first understand the components, the stock has the dividend, the price that it was bought and the price it was sold. Moreover, in order to calculate the stocks realized return we have to get the dividend divided by the amount that it was bought, and add it to the difference between the amount that it was sold by the amount that it was bought, then divide that by the amount that it was bought. This will bring it to the last component of the realized return.

All dividends are immediately reinvested and used to purchase additional shares of the same stock or security. Furthermore, the distribution of realized returns is the standard deviation which is the square root of the variance of the distribution variance measures the variability in return by taking the differences of the returns from the average return and squaring those differences.

2. Contrast systematic and unsystematic risk.

Systematic risks are fluctuations of a stock's return that are due to market-wide news representing common risk. Unsystematic risk are fluctuations of a stock's return that are due to a firm or industry-specific news and are independent risks unrelated across stocks. The unsystematic risk for each stock will average out and be eliminated by diversification. Good news will affect some stocks and bad news will affect others. Diversification does not reduce systematic risk. Even when holding a large portfolio an investor will be exposed to risks that affect the entire economy and therefore affect all securities. You can reduce the systematic risk of a portfolio by selling stocks and investing in risk-free bonds, but at the cost of giving up the higher expected return of stocks. Therefore, systematic risk is affected from the entire market are (the problems, raw material availability, tax policy or government policy, inflation risk, interest risk and financial risk). It is managed by the use of Beta of different company shares. On the other hand, unsystematic risks are mismanagement, increasing inventory, wrong financial policy, defective marketing etc. this is diversifiable or avoidable because it is possible to eliminate or diversify this component of risk to a considerable extent by investing in a large portfolio of securities. The unsystematic risk stems from inefficiency magnitude of those factors different form one company to another.

In addition, Modern Portfolio theory states: "there are two types of risk when for investing in individual stock returns: Systematic risk and unsystematic risk. Systematic risks are risk factors that pertain to the country as a whole; however, they cannot be diversified" (n.p). Examples of this include interest rates, wars and recessions. Unsystematic risk or specific risk can be diversified by increase the number of securities in your portfolio; adding diversification can eliminate this type of risk. (Investopedia, 2006).

3. Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio.

A portfolio return is the weighted average of the returns of the securities in the portfolio. The return on your portfolio the total return of the firm is weighted averages of the return you earn holding all the stock at the firm and return you earn holding all of the debt. Since you hold all of each, your portfolio weights are just the relative amount of debt and equity issued by the firm. By holding a portfolio of the firm's equity and debt, we can get the same cash flows as if we held the assets directly. Thus, because the return of a portfolio is equal to the weighted average of the expected returns of the stocks, the volatility of a portfolio is less than the weighted average volatility, (Berk, DeMarco, Hartford, 2010) (p. 373). The risk or standard deviation of a portfolio falls when securities that are uncorrelated are combined. The lower the correlation the greater the diversification benefits as quantifies through risk reduction.

4. State