Reference no: EM131134786

Topic: Risk and Return, Portfolio Theory and Asset Pricing Model

Case Study: Risk and Return

Details:

You have recently graduated with a major in finance and landed a financial planner job with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds will be invested in a new business the client plans to start at the end of the year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives shown in Table 1 on the attached resource, "Topic 5 Assignment Graphic Tables." (Disregard for now the items at the bottom of the data; you will fill in the blanks later.)

Note that the estimated returns of American Foam (Am. Foam), a bedding company, do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner-spring mattress may purchase a cheaper foam mattress instead. Under these circumstances, we would expect American Foam's stock price to be higher if there is a recession than if the economy was just below average.

Barney Smith's economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program that was used to estimate the rate of return on each alternative under several state of the economy scenarios. Alta Industries (Alta Inds) is an electronics firm; Repo Men collects past-due debts; and American Foam, as per above, manufactures mattresses and various other foam products. Barney Smith also maintains an "index fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results.

Given the situation as described, answer the following questions.

1. Describe investment returns, and what "best case" and "worst case" returns you might hope to achieve for your new client. What is the return on an investment that costs $1,000 and is sold after one year for $1,100? Would you recommend this type of investment for your task at hand?

2. Explain why the Treasury bill's (aka, T-bill) return is independent of the state of the overall economy? Do T-bills promise a completely risk-free return? Provide your rationale.

3. Why are Alta Ind.'s returns expected to move with the economy whereas Repo Men's are expected to move counter to the economy?

4. Calculate the expected return (), the standard deviation (σp), and the coefficient of variation (CVp) for the portfolio profiled in Table 1. Provide your answers with calculations.

5. How does the risk of this two-stock portfolio compare with the risk of the individual stocks if those stocks were held in isolation? In what ways do "portfolio effects" impact how investors think about the risk of individual stocks?

6. If you decided to hold a simple one-stock portfolio, and consequently were exposed to more risk than diversified investors, could you expect to be compensated for all of your risk; that is, could you earn a risk premium on that part of your risk that you could have eliminated by diversifying? Explain.

7. Describe how market risk is measured for individual securities. How are beta coefficients calculated? Calculate beta using the following historical returns for the stock market and for another company, P.Q. Unlimited (PQU) as per Table 2 on the attached resource, "Topic 5 Assignment Graphic Tables." Note: Use the Excel formula function to calculate beta and interpret your results.

8. Write out the Security Market Line (SML) equation and use it to calculate the required rate of return on each alternative. Compare the expected rates of return with the required rates of return. How do these perform against your predictions?

9. Does the fact that Repo Men has an expected rate of return less than the T-bill rate of return make any sense? Why or why not?

10. What would be the market risk and the required return of a 50-50 portfolio of Alta Industries and Repo Men? Or of Alta Industries and American Foam? Based on your analysis and conclusions, which would you recommend to your client?

Prepare this assignment according to the guidelines found in the APA Style Guide, located in the Student Success Center. An abstract is not required.

This assignment uses a rubric. Please review the rubric prior to beginning the assignment to become familiar with the expectations for successful completion.

Assignment Graphic Tables

Table 1

Returns on Alternative Investments Estimated Rate of Return
State of the Economy	Prob.	Prob.	Alta Inds	Repo Men	Am. Foam	Market portfolio	2-stock portfolio
Recession	0.1	6.0%	-22.0%	28.0%	10.0%'	-13.0%	3.0%
Below avg.	0.2	6.0	-2.0	14.7	-10.0	1.0
Average	0.4	6.0	20.0	0.0	7.0	15.0	10.0
Above avg.	0.2	6.0	35.0	-10.0	45.0	29.0
Boom	0.1	6.0	50.0	-20.0	30.0	43.0	15.0
r-hat (cl		6.0%		1.7%	14.8%	15.0%	?
Std dev (o)	0.0	?		13.4	18.8	15.3	?
Coef. of var. (cv)		?		82	1.6	1.0	?
Beta (b)				-0.90	0.93

Note: Disregard for now the items at the bottom of the data; you will fill in the blanks later.)

Table 2

YEAR	MARKET	PQU
1	25.7%	40.0%
2	8.0%	-15.0%
3	-11.0%	-15.0%
4	15.0%	35.0%
5	32.5%	10.0%
6	13.7%	30.0%
7	40.0%	42.0%
8	10.0%	-10.0%
9	-10.8%	-25.0%
10	-13.1%	25.0%