week 4 assigment 1 - Strayer University Assignment 1...

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Strayer University Assignment 1: Portfolio Management Dagnew G Nega (SU200015284) Lead by: Dr. Nader Gandevani Corporate Investment Analysis FIN550 January, 2015
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1. Analyze the relationship between risk and rate of return, and suggest how you would formulate a portfolio that will minimize risk and maximize rate of return. With respect to investments, risk is simply the chance that your original investment will not grow as expected, or will even decline in value. All investments involve some level of risk. When deciding how to invest your savings, it is important to understand the risks associated with any potential investment to decide if it suits your overall goals and circumstances. Return is the amount you earn on your original investment. Return can take many forms, including interest, dividends, and capital appreciation (increase in value). Return is usually expressed as a percentage — typically a rate of interest or a percentage increase in value. Two factors can significantly affect your return. One is income tax, which reduces the amount of your return. For a taxpayer in the 25% tax bracket*, an investment return of 8% is only 6% after taxes (Gruman, 2013). The other factor is inflation, which reduces the value of your return. When inflation is 3% annually, an investment return of 8% has a purchasing value of 5%. When you factor in both income taxes and inflation, an investment return of 8% yields a real after-tax return of 3% (8% return on investment – 2% for income taxes – 3% inflation rate) (Gruman, 2013). Risk and return are directly related. The greater the risk of the investment, the greater the potential return from that investment. Conversely, with very safe, low-risk investments, the return will likely be low. The basic principle is this: To be willing to accept the risk that an investment could do poorly, investors must be compensated with the potential for greater return. Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk. Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market. Non-systematic risk is unique to a specific company and can be reduced through diversification. Capital Asset Pricing Model (CAPM) In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk. Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset's price sensitivity is greater than the market; equal to one when the asset's sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.
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