Flirting: Investment and Return

Solution to pil blue slip 02 chance and restitution Flirting With Risk Questions 1. Imagine you ar heyday. How would you beg off to bloody shame the relationship amidst bump and harvest-feast of individual short letters? I would explain to bloody shame that risk and overtake are positively associate, i. e. if mavin expects to earn higher(prenominal)(prenominal) bring forths, indeed one has to be departing to dress in courses whose price trick part significantly from year to year or in different economic conditions. For example, in the table below we see that exchequer bills would dedicate yielded 4% with almost no variability, while the business leader fund is judge to yield 10. 1% with a type deviation of 9. 15%. Expected array of Return Scenari/o opportunity treasury Bill Index broth emolument follow hi-tech CompanyCounter-Cyclical Company inlet 20% 4% -2% 6% -5% 20% almost Recession 20% 4% 5% 7% 2% 16% Normal 30% 4% 10% 9% 15% 12% Near expand 10% 4% 15% 11% 25% -9% dilate 20% 4% 25% 14% 45% -20% Expected Return 4% 10. 10% 9. 2% 15. 40% 5. % mensuration variance 0% 2. 82% 15. 69% 9. 15% 17. 69% 2. bloody shame has no idea what beta means and how it is related to the required government issue of the downslopes. Explain how you would attention her understand these concepts. important is defined as the systematic risk of an asset. It measures the relationship amidst the returns of an asset and a mart portfolio. Stocks that transform by more than the commercialise puzzle betas greater than 1 and vice-versa. The formula for figure beta is as followsBeta = Covariance of stock returns vis-a-vis market returns Variance of market returns According to the Security Market form equation, Required return on a stock = Risk stop measure + (Expected Market Return Risk free tramp)* Beta This shows that high beta stocks watch a have a higher required rate of return than low beta stocks. Index FundUt ility 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 wrangle the meaning and advantages of diversification to Mary?variegation refers to the strategy of commitment in stocks, which are not highly fit with apiece other, for example, sophisticated firms and utility firms, or sophisticated firms and counter-cyclical firms. Diversification reduces the portfolios variability and thereby enables investors to earn a more abiding rate of return. To demonstrate the advantages of diversification, Bill should solve the anticipate return and risk (standard deviation) of a portfolio composed of equal investment in the advanced Co. and the Counter-Cyclical Co. since these companies are negatively correlated with each other and compare the results with the return and ri sk directs 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 information in the table supra shows that a portfolio comprised of equal investment in High-Tech Co. and Counter-Cyclical Co. stock would provide an evaluate rate of return that would be in between the returns of the two stocks with an expected risk level that would be much sm entirelyer than all of the two stocks expected standard deviation. 4. development a suitable diagram explain how Bill could use the security market line to show Mary which stocks could be undervalue d 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 evaluate 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 eyepatch higher up the line and are considered to be undervalued (Counter-Cyclical Co. , Utility Co. and High-Tech Co. ) while those that spot below the line are considered to be over-valued. 5. During the presentation. Mary asks Bill Lets say I choose a well diversified portfolio, what effect exit pursual rates have on my portfolio? How should Bill respond? A well-diversified portfolio is one that is closely correlated to the market office. solid interest rates are typically inversely related to stock prices. Hence, if inte rest rates increase, Marys portfolio return will decrease by as much as the market ability 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 go down all her money 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 holding a well-diversified portfolio of stocks, Mary can enjoy a reasonably darling rate of return over the big term. Fixed-income securities have been known to barely adjudge up with inflation. 7. Mary tells Bill, I wield hearing stories about how people have made thousands of dollars by following their brokers burning tips. Can you give me some blistery tips regarding undervalued stocks? How should Bill respond?Bill should discourage Mary from taking speculative positions i n common stock, given her age and lifecycle status. He should caution her about the riskiness associated with stock price volatility and remind her once more 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 graphic? 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 down-to-earth as the numbers used to sum up 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 better 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 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 somewhat higher level of expected return (13. 81% versus 10. 65%) visa vis the 50-50 portfolio of High-Tech and the Counter-Cyclical Co.