Risk and Return: Portfolio Basics, Beta, Systematic vs Unsystematic Risk (Overview) Questions

Question 1

Define return.

Accepted Answer

Return is the gain from an investment (income + price change) over a period, usually expressed as a **percentage**.

Question 2

Define risk in finance.

Accepted Answer

Risk is the **uncertainty/variability** of returns from an investment compared to the expected return.

Question 3

What is systematic risk?

Accepted Answer

Systematic risk is **market-wide risk** that affects all securities and cannot be eliminated through diversification.

Question 4

What is unsystematic risk?

Accepted Answer

Unsystematic risk is **company/industry-specific risk** that can be reduced by diversification.

Question 5

What is beta (β)?

Accepted Answer

Beta (β) measures **systematic risk** as the sensitivity of a security’s return to market return.

Question 6

Diversification eliminates systematic risk completely.

Accepted Answer

False. Diversification reduces **unsystematic** risk, but systematic (market) risk remains.

Question 7

Differentiate between systematic and unsystematic risk (any three points) using a table.

Accepted Answer

Systematic vs unsystematic risk:

| Basis | **Systematic risk** | **Unsystematic risk** |
|---|---|---|
| Source | economy/market factors | firm/industry factors |
| Diversification | **not reducible** | reducible |
| Example | interest rate, recession | strike, product failure |

Hence, only unsystematic risk can be diversified away.

Question 8

Compute expected portfolio return: 60% in A (10%), 40% in B (15%).

Accepted Answer

Portfolio return (Rp) = **wA×RA + wB×RB**

= 0.60×10% + 0.40×15%
= 6% + 6% = **12%**.

| Weight | Return | Contribution |
|---:|---:|---:|
| 0.60 | 10% | 6% |
| 0.40 | 15% | 6% |
| **Rp** |  | **12%** |

Question 9

Interpret beta values β=0.8, β=1, β=1.5 using a small table.

Accepted Answer

Beta interpretation:

| β | Meaning |
|---:|---|
| **0.8** | less volatile than market (defensive) |
| **1.0** | market-average risk |
| **1.5** | more volatile than market (aggressive) |

Thus, higher β implies higher **systematic risk** and higher required return.

Question 10

Write CAPM formula and explain how beta affects required return (brief) with a flow.

Accepted Answer

CAPM: **Ke = Rf + β(Rm − Rf)**

Beta effect: higher **β** increases the risk premium β(Rm−Rf), so required return rises.

Flow: β ↑ → risk premium ↑ → **Ke ↑**

Question 11

Compute required return using CAPM: Rf=5%, β=1.1, Rm=13%.

Accepted Answer

Ke = **Rf + β(Rm − Rf)**

Rm − Rf = 13% − 5% = 8%
Ke = 5% + 1.1×8% = 5% + 8.8% = **13.8%**.

| Rf | β | Rm | **Ke** |
|---:|---:|---:|---:|
| 5% | 1.1 | 13% | **13.8%** |

Question 12

Explain why only systematic risk is priced (rewarded) in expected returns (brief) with a flow/table.

Accepted Answer

Unsystematic risk can be reduced through **diversification**, so investors are not rewarded for bearing it.
Systematic risk cannot be diversified away, so it is priced.

Flow: Diversify → **unsystematic risk ↓** → only market risk remains → expected return depends on **systematic risk (β)**

| Risk | Diversifiable? | Priced in return? |
|---|---|---|
| **Systematic** | No | **Yes** |
| Unsystematic | Yes | No |

Hence, CAPM links expected return to β (systematic risk).

Question 13

Explain risk–return relationship and why investors demand risk premium (exam-style) with a table and conclusion.

Accepted Answer

### Meaning
Risk–return relationship states that higher **risk** requires higher expected **return**.

### Why risk premium exists
Investors face uncertainty in cash flows and prices, so they demand compensation over the risk-free return.

| Component | Meaning |
|---|---|
| **Risk-free return (Rf)** | return with minimal default risk |
| **Risk premium** | extra return demanded for taking risk |

### Conclusion
Therefore, risky investments must offer higher expected returns to attract investors, otherwise they will prefer safer alternatives.

Question 14

Explain diversification and how it reduces unsystematic risk (exam-style) with a flow and conclusion.

Accepted Answer

### Meaning
Diversification means spreading investment across different securities so that negative outcomes in one may be offset by others.

### How it reduces risk
Company-specific events are not perfectly correlated across firms. By holding many securities, **unsystematic risk** is averaged out.

Flow:
Single stock → high specific risk → add more stocks → specific risks offset → **unsystematic risk ↓**

| Risk type | Diversification effect |
|---|---|
| **Unsystematic** | reduces |
| **Systematic** | does not reduce |

### Conclusion
Diversification improves the risk profile of a portfolio by reducing specific risk, but market risk remains.

Question 15

Explain beta and its significance in investment decisions (exam-style) with a table and conclusion.

Accepted Answer

### Meaning **Beta (β)** measures systematic risk, i.e., how sensitive a security is to market movements. ### Significance - used in **CAPM** to estimate required return (cost of equity) - helps classify securities as defensive (β<1) or aggressive (β>1) - supports portfolio risk assessment and comparison | β range | Interpretation | |---|---| | **β < 1** | defensive (lower market sensitivity) | | **β = 1** | market-average | | **β > 1** | aggressive (higher sensitivity) | ### Conclusion Beta is important because it focuses on **market risk** which cannot be diversified away and directly influences the required return.

Basis	Systematic risk	Unsystematic risk
Source	economy/market factors	firm/industry factors
Diversification	not reducible	reducible
Example	interest rate, recession	strike, product failure

Risk and Return: Portfolio Basics, Beta, Systematic vs Unsystematic Risk (Overview)

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