Flirting: Investment and Return

ascendant to Case 02 Risk and Return Flirting With Risk Questions 1. Imagine you argon Bill. How would you explain to Mary the relationship between venture and return of someone stocks? I would explain to Mary that risk and return be positively related, i. e. if one expects to earn spiriteder returns, then one has to be willing to invest in stocks whose price can vary significantly from course of study to year or in different economic conditions. For example, in the dishearten below we see that treasury bills would have yielded 4% with almost no variance, while the index fund is evaluate to yield 10. 1% with a cadence deviation of 9. 15%. Expected Rate of Return Scenari/o Probability Treasury Bill major power Fund public utility social club high tech CompanyCounter-Cyclical Company street corner 20% 4% -2% 6% -5% 20% dear Recession 20% 4% 5% 7% 2% 16% Normal 30% 4% 10% 9% 15% 12% Near Boom 10% 4% 15% 11% 25% -9% Boom 20% 4% 25% 14% 45% -20% Expected Ret urn 4% 10. 10% 9. 2% 15. 40% 5. % Standard divergence 0% 2. 82% 15. 69% 9. 15% 17. 69% 2. Mary has no idea what beta means and how it is related to the take return of the stocks. Explain how you would help her understand these concepts. Beta is defined as the systematic risk of an asset. It measures the relationship between the returns of an asset and a mart portfolio. takes that vary by more than the market have betas greater than 1 and vice-versa. The formula for calculating beta is as followsBeta = Covariance of stock returns similitude market returns Variance of market returns According to the Security Market reap equation, Required return on a stock = Risk clean-handed rate + (Expected Market Return Risk free rate)* Beta This shows that high beta stocks have a have a higher(prenominal) inevitable rate of return than low beta stocks. Index FundUtility Co. High-Tech Co. Counter-Cyclical Co. Exp. Return10. 10%9. 2%15. 4%5. 9% Std. Deviation9. 15%2. 82%17. 69%1 5. 69% Cov (Rs, Rm)&8212&82120. 00300. 0276-0. 0144Beta1. 00. 301. 86-1. 54 Required Rate10. 1%5. 84%15. 37%-5. 41% * let out spreadsheet for calculations 3. How should Bill debate the meaning and advant get alongs of diversification to Mary?Diversification refers to the outline of drop in stocks, which are not highly correlated with each 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 stable rate of return. To demonstrate the advantages of diversification, Bill should write in code the expected return and risk (standard deviation) of a portfolio calm of equal coronation in the High-Tech Co. and the Counter-Cyclical Co. &8212since these companies are negatively correlated with each other and compare the results with the return and risk levels 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 above 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 a great deal 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 stocks could be undervalued and which may be overvalued? pic Stock Beta Required Return Expected Return T-Bill 0. 00 4% 4. 00% Index 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 pass judgment 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 say I carry a well diversified portfolio, what effect will interest rates have on my portfolio? How should Bill respond? A well-diversified portfolio is one that is intimately correlated to the market index. Real interest rates are typically inversely related to stock prices. Hence, if interest rates increase, Marys portfolio return will decrease by as much as the market index does and vice versa. In other w ords, her portfolio will mirror the changes in the market index. 6.Should Bill take Mary out of investing in stocks and preferably put all her bills in fixed-income securities? Explain. not necessarily. 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 attribute a well-diversified portfolio of stocks, Mary can enjoy a reasonably strong rate of return over the long term. Fixed-income securities have been known to nevertheless keep up with inflation. 7. Mary tells Bill, I keep hearing stories astir(predicate) how people have made thousands of dollars by following their brokers hot tips. flush toilet you give me some hot tips regarding undervalued stocks? How should Bill respond?Bill should deter Mary from taking speculative positions in common stock, given her age and lifecycle status. He should caution her about the riskiness associated with stock pr ice irritability and remind her again about the advantages of diversification. 8. If Mary decided 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 possible? Please 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 numbers used to calculate them.Thus, one has to make realistic assumptions regarding probabilities and returns, in order 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 get out for her? Explain. Scenario Probability 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 serene 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.