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    Tutorial 5 Questions

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    hrfjbjrfrf
    Trudy's client wants to invest only in Trudy's top 5 stock picks rather than a diversified portfolio of 30 stocks. Trudy plans to explain to the client how diversification reduces risk according to modern portfolio theory. [Systematic and firm-specific risks are reduced as the number of stocks in a portfolio increases, lowering overall portfolio risk.] Diversifying across many stocks reduces the risks unique to each firm and exposure to macroeconomic factors affecting all firms.

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    Tutorial 5 Questions

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    hrfjbjrfrf
    35 views3 pages
    Trudy's client wants to invest only in Trudy's top 5 stock picks rather than a diversified portfolio of 30 stocks. Trudy plans to explain to the client how diversification reduces risk according to modern portfolio theory. [Systematic and firm-specific risks are reduced as the number of stocks in a portfolio increases, lowering overall portfolio risk.] Diversifying across many stocks reduces the risks unique to each firm and exposure to macroeconomic factors affecting all firms.

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    Trudy's client wants to invest only in Trudy's top 5 stock picks rather than a diversified portfolio of 30 stocks. Trudy plans to explain to the client how diversification reduces risk according to modern portfolio theory. [Systematic and firm-specific risks are reduced as the number of stocks in a portfolio increases, lowering overall portfolio risk.] Diversifying across many stocks reduces the risks unique to each firm and exposure to macroeconomic factors affecting all firms.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    35 views3 pages

    Tutorial 5 Questions

    Uploaded by

    hrfjbjrfrf
    Trudy's client wants to invest only in Trudy's top 5 stock picks rather than a diversified portfolio of 30 stocks. Trudy plans to explain to the client how diversification reduces risk according to modern portfolio theory. [Systematic and firm-specific risks are reduced as the number of stocks in a portfolio increases, lowering overall portfolio risk.] Diversifying across many stocks reduces the risks unique to each firm and exposure to macroeconomic factors affecting all firms.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 3

    Tutorial 5

    Concept Questions

    1.
    In broad terms, why is some risk diversifiable? Why are some risks non-
    diversifiable? Does it follow that an investor can control the level of unsystematic risk
    in a portfolio, but not the level of systematic risk?

    Standard deviation is fluctuation in average return


    Systematic risks – risks that investors cannot control (macroeconomic factors) /
    undiversified risks

    The objective is to ensure that if one asset or company experiences a negative


    event, the impact on the overall portfolio is minimized

    Some risks are diversifiable because they are unique to that asset and can be
    eliminated by investing in different assets. When an investor diversifies his risk by
    investing in many different assets, there is an unsystematic strategy that is executed
    that reduces the overall risk. On the other hand, some risks are non-diversifiable
    because the risk applies to all assets. When risks are non-diversifiable, it is because
    of the systematic risks which affect the investments. Therefore, you are unable to
    eliminate the total risk of an investment. Lastly, systematic risk can be controlled, but
    by a costly effect on estimated returns.

    2.
    (a) Is it possible that a risky asset could have a beta of zero? Explain.

    -returns are not influenced by market fluctuations


    -This could occur if the asset’s returns are driven by factors completely independent
    of the market
    (b) Based on the CAPM, what is the expected return on such an asset?

    (c) Is it possible that a risky asset could have a negative beta? What does the
    CAPM predict about the expected return on such an asset? Can you explain your
    answer?

    Beta is the measure of the systematic risk that is associated with the portfolio or the
    asset. It represents the volatility in the stock returns. Beta is used in the CAPM to
    calculate the value of the expected return of the asset. It is true that a portfolio can
    be constructed with a zero beta. The risk-free rate as well as the expected rate of
    return with the zero beta will be the same. Also, it is possible to construct a portfolio
    with a negative beta. In this case the return of the portfolio will be less than the risk-
    free rate. The negative risk premium is always present with a negative beta. The
    reason is its value as a diversification instrument. Lastly, to create an asset with a
    negative beta, short position is taken on the asset with positive beta.

    3.
    Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a
    master list of 30 securities drawn from several industries. After the meeting
    concluded, the client made the following statement: “I trust your stock picking ability
    and believe that you should invest my funds in your five best ideas. Why invest in 30
    companies when you obviously have stronger opinions on a few of them?” Trudy
    plans to respond to his client within the context of Modern Portfolio Theory. Discuss
    the impact of the systematic risk and firm-specific risk on portfolio risk as the number
    of securities in a portfolio is increased.

    Systematic risk refers to fluctuations in asset prices caused by macroeconomic


    factors that are common to all risky assets; hence systematic risk is often referred to
    as market risk. Examples of systematic risk factors include the business cycle,
    inflation, monetary policy, and technological changes.

    Firm-specific risk refers to fluctuations in asset prices caused by factors that are
    independent of the market, such as industry characteristics or firm characteristics.
    Examples of firm-specific risk factors include litigation, patents, management, and
    financial leverage.

    Questions and Problems

    1.
    You own 400 shares of Stock A at a price of $60 per share, 500 shares of Stock B at
    $85 per share, and 900 shares of Stock C at $25 per share. The betas for the stocks
    are 0.8, 1.2, and 0.7, respectively. What is the beta of your portfolio?

    A = 400*60 = 24,000/89,000 = 0.26966


    B = 500*85 = 42,500/89,000 = 0.47753
    C = 900*25 = 22,500/89,000 = 0.25281
    total: 24,000 + 42,500 + 22,500 = 89,000

    (0.269660.8) + (0.477531.2) + (0.25281*0.7) = 0.96573 = 0.97

    2.
    You work as a financial analyst at Detroit Investments. The expected return on the
    market portfolio is 27%. As part of your analysis, you need to calculate the expected
    returns of two stocks, Stock A and Stock B, using the Capital Asset Pricing Model
    (CAPM) Additionally, you are required to identify whether each stock is undervalued
    or overvalued based on their expected returns.

    Portfolio Forecasted Volatility Risk-free Beta


    Return Rate
    A 23% 22% 5.0% 0.9
    B 32% 28% 5.0% 1.2
    3. You are conducting an analysis of a stock using the Fama-French three-factor
    model. Based on historical data, you estimate the following factor loadings for the
    stock: Coefficient on the market's excess return (Rm-Rf) is 1.5, Coefficient on SMB
    (Small Minus Big) is 0.8 and the coefficient on HML (High Minus Low) is -0.4. The
    market premium is 10%, the one-year risk-free rate is 2%, and the expected excess
    return for SMB is 3% while HML is expected to have a -1% excess return for the next
    year. Calculate the expected return for the stock using the Fama-French three-factor
    model.

    Additional Question for student self-attempt

    1. Asset W has an expected return of 12 percent and a beta of 1.1. If the risk-free
    rate is 4 percent, complete the following table for portfolios of Asset W and a risk-
    free asset. Illustrate the relationship between portfolio expected return and portfolio
    beta by plotting the expected returns against the betas.

    Percentage of Portfolio in Asset W Portfolio Expected Return Portfolio Beta


    0%
    25
    50
    75
    100
    125
    150

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