Flirting: Investment and Return

Solution to Case 02 take a chance of exposureiness of exposure and drive away Flirting With Risk Questions 1. Imagine you atomic number 18 Bill. How would you explain to bloody shame the relationship between risk and descend of individual argumentation of productss? I would explain to bloody shame that risk and growth ar positively related, i. e. if sensation expects to earn higher(prenominal) replicas, then one has to be leaveing to invest in farm animals whose price can pull up stakes significantly from year to year or in different economic conditions. For example, in the table below we see that treasury bills would consumption up allowed 4% with almost no variability, while the index fund is judge to yield 10. 1% with a trite deviation of 9. 15%. Expected direct of Return Scenari/o Probability Treasury Bill great power gillyflower Utility Company sophisticated CompanyCounter-Cyclical Company respite 20% 4% -2% 6% -5% 20% Near Recession 20% 4% 5% 7% 2% 16% Normal 30% 4% 10% 9% 15% 12% Near expatiate 10% 4% 15% 11% 25% -9% gravy 20% 4% 25% 14% 45% -20% Expected Return 4% 10. 10% 9. 2% 15. 40% 5. % Standard Deviation 0% 2. 82% 15. 69% 9. 15% 17. 69% 2. Mary has no idea what beta government agency and how it is related to the required return of the stocks. Explain how you would help her understand these concepts. important is defined as the systematic risk of an asset. It measures the relationship between the returns of an asset and a market portfolio. Stocks that vary by more than the market begin betas greater than 1 and vice-versa. The formula for calculating beta is as follows of import = Covariance of stock returns vis-a-vis market returns Variance of market returns According to the protection Market Line equation, Required return on a stock = Risk discharge rate + (Expected Market Return Risk free rate)* Beta This shows that high beta stocks have a have a higher required rate of return than lo w beta stocks. list FundUtility Co. High-Tech Co. Counter-Cyclical Co. Exp. Return10. 10%9. 2%15. 4%5. 9% Std. Deviation9. 15%2. 82%17. 69%15. 69% Cov (Rs, Rm)0. 00300. 0276-0. 0144Beta1. 00. 301. 86-1. 54 Required Rate10. 1%5. 84%15. 37%-5. 41% *See spreadsheet for calculations 3. How should Bill demonstrate the meaning and advantages of diversification to Mary?variegation refers to the strategy of investing in stocks, which are not extremely correlated with each some other, for example, high-tech firms and utility firms, or high-tech firms and counter-cyclical firms. Diversification reduces the portfolios variability and thereby enables investors to earn a more fixed rate of return. To demonstrate the advantages of diversification, Bill should calculate the evaluate return and risk (standard deviation) of a portfolio composed of equal enthronisation in the High-Tech Co. and the Counter-Cyclical Co. since these companies are negatively correlated with each other and compare t he results with the return and risk trains of the High-Tech Co. by itself. 50-50 Portfolio Scenario Probability High-Tech Co. Counter-Cyclical Co. 50-50 Portfolio Prob. *E(Portfolio Return) Rp-E(Rp)2 *Ps Recession 20% -5% 20% 7. 50% 1. 50% 0. 000198 Near Recession 20% 2% 16% 9. 00% 1. 80% 0. 00054 Normal 30% 15% 12% 13. 50% 4. 05% 0. 000244 Near Boom 10% 25% -9% 8. 00% 0. 80% 0. 000070 Boom 20% 45% -20% 12. 50% 2. 50% 0. 000068 Expected Return 15. 40% 5. 90% 10. 5% Standard Deviation 17. 69% 15. 69% 2. 52% The data in the table in a higher place shows that a portfolio comprised of equal investment in High-Tech Co. and Counter-Cyclical Co. stock would provide an expected rate of return that would be in between the returns of the two stocks with an expected risk level that would be much smaller than either of the two stocks expected standard deviation. 4. Using a suitable diagram explain how Bill could use the security market line to show Mary which st ocks could be undervalued and which may be overvalued? pic Stock Beta Required Return Expected Return T-Bill 0. 00 4% 4. 00% major power Fund 1. 00 10. 10% 10. 10% Utility Co. 0. 30 5. 84% 9. 20% High-Tech Co. 1. 86 15. 37% 15. 40% Counter-Cyclical Co. -1. 54 -5. 41% 5. 90% The solid line represents the required grade of return of the 5 investment alternatives as per the Security Market Line equation.Those stocks whose expected returns are higher than their required returns plot above the line and are considered to be undervalued (Counter-Cyclical Co. , Utility Co. and High-Tech Co. ) while those that plot below the line are considered to be over-valued. 5. During the presentation. Mary asks Bill Lets label I choose a well diversified portfolio, what effect will interest evaluate have on my portfolio? How should Bill move? A well-diversified portfolio is one that is closely correlated to the market index. Real interest rates are typically inversely related to stock pric es. Hence, if interest rates increase, Marys portfolio return will decrease by as much as the market index does and vice versa. In other words, her portfolio will mirror the changes in the market index. 6.Should Bill take Mary out of investing in stocks and preferably come out all her specie in fixed-income securities? Explain. Not needfully. Mary could still invest in a well-diversified portfolio such as the market index fund. The problem with fixed-income securities is that they have reinvestment and price risk. By holding a well-diversified portfolio of stocks, Mary can enjoy a reasonably good rate of return over the long term. Fixed-income securities have been known to barely agree up with inflation. 7. Mary tells Bill, I keep hearing stories about how people have made thousands of dollars by followers their brokers hot tips. Can you give me some hot tips regarding undervalued stocks? How should Bill respond?Bill should discourage Mary from taking speculative positions in popular stock, given her age and lifecycle status. He should caution her about the riskiness associated with stock price volatility and remind her again about the advantages of diversification. 8. If Mary headstrong to invest her money equally in high-tech and counter-cyclical stocks. What would her portfolios expected return and risk level be? Are these expectations realistic? interest explain. With equal investments in High-Tech and Counter-Cyclical stocks, the portfolio expected return would be 10. 65% and its expected standard deviation would be 2. 52%. (see Answer 3 above for details). These expectations are only as realistic as the verse used to calculate them.Thus, one has to make realistic assumptions regarding probabilities and returns, in position to get realistic expected return estimates. 9. What would happen if Mary were to put 70% of her portfolio in the High-Tech stock and 30% in the Index Fund? Would this combination be better for her? Explain. Scenario Probabili ty High-Tech Index Fund 70-30 Prob. *E(Portfolio) Rp-E(Rp)2*Ps Portfolio Recession 20% -5% -2% -4. 10% -0. 82% 0. 06415362 Near Recession 20% 2% 5% 2. 90% 0. 58% 0. 002380562 Normal 30% 15% 10% 13. 50% 4. 05% 2. 883E-06 Near Boom 10% 25% 15% 22. 00% 2. 20% 0. 000670761 Boom 20% 45% 25% 39. 00% 7. 80% 0. 012690722 Expected Return 15. 0% 10. 10% 13. 81% Standard Deviation 17. 69% 9. 15% 14. 89% Given the above table, it seems clear that the 70-30 portfolio composed of High-Tech and the index fund would not necessarily be better for Mary, since it has a much higher expected level of risk (14. 89% versus 2. 52%) and only a slightly higher level of expected return (13. 81% versus 10. 65%) visa vis the 50-50 portfolio of High-Tech and the Counter-Cyclical Co.