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(a) What is the investment proportion, y? (b) What is the expected rate of return on the overall portfolio? Question 4: Suppose that your clients degree of risk aversion is A = 3.5. What proportion, y, of the total investment should you suggest that he invest in your fund? Question 5: You estimate that a passive portfolio (that is, one entirely invested in a risky portfolio that mimics the S&P 500 stock index) yields an expected rate of return of 13% with a standard deviation of 25%. (a) What is the slope of the CML? (b) Characterize in one short paragraph the advantage of your fund over the passive fund. (c) Your client is considering whether to switch to the passive portfolio the 70% of his wealth currently invested in your fund. Show your client that he is better off staying with you. (Hint 1: show your client the maximum fee you could charge -- as a percentage of the investment in your fund deducted at the end of the year -- that would still leave him at least as well off investing in your fund as in the passive one) (Hint 2: the fee will lower the slope of your clients CAL by reducing the expected return net of the fee) Question 6: Suppose that there are many stocks in the market and that the characteristics of Stocks A and B are given as follows: Stock Expected Return Standard Deviation ------------------------------------------------------------------------------------------A 10% 5% B 15% 10% ------------------------------------------------------------------------------------------Correlation = -1 ------------------------------------------------------------------------------------------Suppose that it is possible to borrow at the risk-free rate, Rf. What must be the value of the riskfree rate? (Hint: think about constructing a risk-free portfolio from Stocks A and B).
Question 7: The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7% and the market risk premium is 8%. What will be the market price of the security if its covariance with the market portfolio doubles (and all other variables remain unchanged)? Assume that the stock is expected to pay a constant dividend in perpetuity. Question 8: Consider the following table, which gives a security analysts expected return on two stocks for two particular market returns:
Market Return Aggressive Stock Defensive Stock ------------------------------------------------------------------------------------------5% 2% 3.5% 20% 32% 14% ------------------------------------------------------------------------------------------(a) What are the betas of the two stocks? (b) What is the expected rate of return on each stock if the market return is equally likely to be 5% or 20%? (c) If the T-bill rate is 8% and the market return is equally likely to be 5% or 20%, draw the SML for this economy. (d) Plot the two securities on the SML graph. What are the alphas of each? (e) What hurdle rate should be used by the management of the aggressive firm for a project with the risk characteristics of the defensive firms stock? Question 9: Two investment advisors are comparing performance. One averaged a 19% rate of return and the other a 16% rate of return. However, the beta of the first investor was 1.5, whereas that of the second was 1. (a) Can you tell which investor was a better predictor of individual stocks (aside from the issue of general movements in the market)? (b) If the T-bill rate were 6% and the market return during the period were 14%, which investor would be the superior stock selector? (c) What if the T-bill rate were 3% and the market return were 15%?
Professor
Michel
Thus, in order to obtain a mean return of 15%, the client must invest 80% of total funds in the risky portfolio and 20% in Treasure bills. (b) Investment proportions of the clients funds: 20% in T-bills 0.8 x 27% = 21.6% in Stock A 0.8 x 33% = 26.4% in Stock B 0.8 x 40% = 32.0% in Stock C Question 3: (a) Portfolio standard deviation = y x 27%. If your client wants a standard deviation of 20%, then y = (20%/27%) = 0.7407 = 74.07% in the risky portfolio. (b) Mean return = 7% + (17% - 7%)y = 7% + 10% (0.7407) = 7% + 7.407% = 14.407%. Question 4: y* = (Rp - Rf)/0.01A2 => y* = (17 - 7)/(0.01 x 3.5 x 272) = 10/25.515 = 0.3919
Thus, the clients optimal investment proportions are 39.19% in the risky portfolio and 60.81% in T-bills. Question 5: (a) The slope of the CML = (13% - 7%)/25% = 0.24. You can draw a graph as we did in class. (b) My fund allows an investor to achieve a higher mean for any given standard deviation than would a passive strategy, that is, a higher expected return for any given level of risk. Indeed, my funds reward-to-variability ratio is (17% - 7%)/27% = 0.37, which is much better than 0.24 (the RTRR of the S&P 500). (c) The fee would reduce the reward-to-variability ratio, that is, the slope of the CAL. Clients will be indifferent between your fund and the passive portfolio if the slope of the after-fee CAL and the CML are equal. Let f denote the maximum fee. In this case: Slope of CAL with fee = (17% - 7% - f)/27 = (10 - f)/27%. Slope of CML (which requires no fee) = (13% - 7%)/25% = 0.24 Setting these slopes equal, then we get: (10% - f)/27% = 0.24 => 10% - f = 27% x 0.24 => f = 10% - 6.48% = 3.52% per year. Question 6: Since Stocks A and B are perfectly negatively correlated, a risk-free portfolio can be constructed and its rate of return in equilibrium will be the risk-free rate. To find the proportions of this portfolio (wA invested in Stock A and wB = 1 - wA in Stock B), set the standard deviation equal to zero. With perfect negative correlation, the portfolio standard deviation reduces to: p = | wAA - wBB| => 0 = | 5wA - 10 (1-wA) | => wA =0.6667
The expected rate of return on this risk-free portfolio is: E(R) = 0.6667 x 10% + (0.3333 x 15%) 11.67%. Thus, to avoid arbitrage, the risk-free rate must also be 11.67%.
Question 7: If the covariance of the security doubles, then so will its beta and its risk premium. The current risk premium is 6% (i.e., 13% - 7%), so the new risk premium would be 12%, and the new discount rate for the security would be 19% (i.e., 12% + 7%). If the stock pays a level perpetual dividend, then we know from the original data that the dividend, D, must satisfy the equation for a perpetuity: Price = Dividend/Discount rate => $40 = D/0.13 => D = $5.20.
At the new discount rate of 19%, the stock would be worth only $5.20/0.19 = $27.37. As a consequence, the increase in stock risk has lowered the stock value by 31.58%, i.e., ($27.37 $40)/$40. Question 8: (a) The beta is the sensitivity of the stock return to the market return movements. Let A be the aggressive stock and D be the defensive one. Then beta is the change in the stock return per change in the market return. Therefore, we compute each stocks beta by calculating the difference in its return across the two scenarios divided by the difference in the market return. A = (2 - 32)/(5 - 20) = 2.00 D = (3.5 - 14)/(5 - 20) = 0.70 (b) With equal likelihood of either scenarios, the expected return is an average of the two possible outcomes. E(RA) = 0.5 (2 + 32) = 17% E(RD) = 0.5 (3.5 + 14) = 8.75% (c) The SML is determined by the market expected return of 0.5 x (20 + 5) = 12.5%, with a beta of 1, and the T-bill return of 8% with a beta of zero. The equation for the security market line is: E(R) = 8% + (12.5% - 8%) (graph to be sketched). (d) The aggressive stock has a fair expected return of: E(RA) = 8% + 2(12.5% - 8%) = 17%, and the expected return by the analyst also is 17%. Thus, its alpha is zero. Similarly, the required return on the defensive stock is:
E(RD) = 8% + 0.7(12.5% - 8%) = 11.5%, but the analysts expected return on Stock D is only 8.75%, and hence, D = actual expected return - required return given risk) = 8.75% - 11.15% = -2.4%. (e) The hurdle rate is determined by the project beta, 0.70, not by the firms beta. The correct discount rate is 11.15%, the fair rate of return on Stock D. Question 9: (a) We know that: R1 = 19%, R2 = 16%, 1 = 1.5, and 1 = 1. To tell which investor was a better predictor of individual stocks, we should look at their abnormal return, which is the ex-post alpha, that is, the abnormal return is the difference between the actual return and that predicted by the SML. Without information about the parameters of this equation (risk-free rate and the market rate of return) we cannot tell which investor is more accurate. (b) If Rf = 6% and Rm = 14%, then (using the notation of alpha for the abnormal return): 1 = 19% - [6% + 1.5(14% - 6%)] = 19% - 18% = 1% 2 = 16% - [6% + 1(14% - 6%)] = 16% - 14% = 2%. Here, the second investor has the larger abnormal return, and thus he appears to be a more accurate predictor. By making better predictions, the second investor appears to have tilted his portfolio toward underpriced stocks. (c) If Rf = 3% and Rm = 15%, then 1 = 19% - [3% + 1.5(15% - 3%)] = 19% - 21% = -2% 2 = 16% - [3% + 1(15% - 3%)] = 16% - 15% = 1%. Here, not only does the second investor appear to be a better predictor, but also the first investors prediction appears valueless (or worse).