a.
To compute: (i) Expected return on portfolio, (ii) Covariance of ABC stock return with initial return and (iii) standard deviation of new portfolio.
Introduction: An investor may invest in various stocks to reduce the risk of losses. Such a theory is called correlation theory. It is believed that an investor takes a lot of risk to achieve higher
a.
Explanation of Solution
Let,
OP = Original (initial) portfolio
ABC = New stock
NP = New portfolio
Given:
Weights can be computed as:
Total = $900,000 + $100,000
Total = $1,000,000
Weight of Original portfolio:
Weight of ABC:
(i) Expected return on NP (new portfolio) that includes ABC (new) stock has been computed below:
(ii) Covariance of ABC stock return with return on original portfolio has been computed below:
(iii) Standard deviation of new portfolio that includes ABC stock has been computed below:
b.
To compute: (i) Expected return on portfolio that includes government securities, (ii) Covariance of government securities return with initial return and (iii) standard deviation of new portfolio that includes government securities.
Introduction: An investor may invest in various stocks to reduce the risk of losses. Such a theory is called correlation theory. It is believed that an investor takes a lot of risk to achieve higher returns on their investment portfolio.
b.
Explanation of Solution
Let,
OP = Original (initial) portfolio
GS = Government securities
NP = New portfolio
Given:
Weights can be computed as:
Total = $900,000 + $100,000
Total = $1,000,000
Weight of Original portfolio:
Weight of ABC:
(i) Expected return on NP (new portfolio) that includes ABC (new) stock has been computed below:
(ii) Covariance of ABC stock return with return on original portfolio has been computed below:
(iii) Standard deviation of new portfolio that includes ABC stock has been computed below:
c.
To state: If systematic risk of new portfolio with government securities would be more than the original portfolio.
Introduction: An investor may invest in various stocks to reduce the risk of losses. Such a theory is called correlation theory. It is believed that an investor takes a lot of risk to achieve higher returns on their investment portfolio.
c.
Explanation of Solution
The beta for new portfolio would be weighted average of beta of individual securities in the portfolio. So, risk free securities (security with standard deviation as 0) would decrease the weighted average.
Thus, the systematic risk for new portfolio with government securities would be lower than that of the original portfolio.
d.
To comment: If exchanging ABC stock with XYZ stock makes no difference on the portfolio, keeping expected return and standard deviation same for both the stocks.
Introduction: An investor may invest in various stocks to reduce the risk of losses. Such a theory is called correlation theory. It is believed that an investor takes a lot of risk to achieve higher returns on their investment portfolio.
d.
Explanation of Solution
Given,
As per the given information, standard deviation and expected return of stock ABC and XYZ are same. The covariance of each stock with the original portfolio is unknown. Thus, it would be difficult to draw conclusion on the same.
If covariance of each stock with the original portfolio would have been provided then the stock that would lead to lower standard deviation for the entire portfolio would have been selected, keeping all other factors constant.
e.
To discuss: (i) One limitation of standard deviation being used as a measure of risk when investor is concerned about loss than high returns, and (ii) Any other measure of risk in such a situation
Introduction: An investor may invest in various stocks to reduce the risk of losses. Such a theory is called correlation theory. It is believed that an investor takes a lot of risk to achieve higher returns on their investment portfolio.
e.
Explanation of Solution
(i) If the investor is more concerned about the loss due to risk of investment than higher returns, then the investor should avoid using standard deviation of return as a measure of risk.
One limitation of using standard deviation of return measure risk is that it does not differentiate between positive and negative movement in the prices.
(ii) Besides variance, range of returns could be used to measure the risk.
Range of returns: It considers the highest and lowest expected return in the future. Higher range indicates greater variability and risk whereas lower range indicates less variability and risk.
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Chapter 7 Solutions
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- Rachel is a financial investor who actively buys and sells in the securities market. Now she has aportfolio of all blue chips, including: $13,500 of Share A, $7,600 of Share B, $14,700 of Share C, and$5,500 of Share D. Required:a) Compute the weights of the assets in Rachel’s portfolio? b) If Rachel’s portfolio has provided her with returns of 9.7%, 12.4%, -5.5% and 17.2% over the pastfour years, respectively. Calculate the geometric average return of the portfolio for this period. c) Assume that expected return of the stock A in Rachel’s portfolio is 13.6% this year. The riskpremium on the stocks of the same industry are 4.8%, betas of these stocks is 1.5 and the inflationrate was 2.7%. Calculate the risk-free rate of return using Capital Market Asset Pricing Model(CAPM). d) Following is forecast for economic situation and Rachel’s portfolio returns next year, calculate theexpected return, variance and standard deviation of the portfolio. State of economy…arrow_forwardRachel is a financial investor who actively buys and sells in the securities market. Now she has aportfolio of all blue chips, including: $13,500 of Share A, $7,600 of Share B, $14,700 of Share C, and$5,500 of Share D.Required:a) Compute the weights of the assets in Rachel’s portfolio? b) If Rachel’s portfolio has provided her with returns of 9.7%, 12.4%, -5.5% and 17.2% over the pastfour years, respectively. Calculate the geometric average return of the portfolio for this period. c) Following is forecast for economic situation and Rachel’s portfolio returns next year, calculate theexpected return, variance and standard deviation of the portfolio. State of economy Probability Rate of returnsMild Recession 0.35 - 5%Growth 0.45 15%Strong Growth 0.20 30%arrow_forwardRachel is a financial investor who actively buys and sells in the securities market. Now she has a portfolio of all blue chips, including: $13,500 of Share A, S7,600 of Share B, $14,700 of Share C, and $5,500 of Share D. Required: a) Compute the weights of the assets in Rachel's portfolio? . b) If Rachel's portfolio has provided her with returns of 9.7%, 12.4%, -5.5% and 17.2% over the past four years, respectively, calculate the geometric average return of the portfolio for this period. c) Assume that expected return of the stock A in Rachel's portfolio is 13.6% this year. The risk premium on the stocks of the same industry are 4.8%, betas of these stocks is 1.5 and the inflation rate was 2.7%. Calculate the risk-free rate of return using Capital Market Asset Pricing Model (CAPM). d) Following is forecast for economic situation and Rachel's portfolio returns next year, calculate the expected return, variance and standard deviation of the portfolio.(arrow_forward
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