6. Portfolio beta and weights Aa Aa Brandon is an analyst at a wealth management

Question

6. Portfolio beta and weights Aa Aa Brandon is an analyst at a wealth management firm. One of his clients holds a $7,500 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table: Investment Allocation 35% 20% 15% 3090 Beta 0.900 1.600 1.100 0.300 Standard Deviation 38.00% 42.00% 45.00% 49.00% Stock Atteric Inc. (AI) Arthur Trust Inc. (AT) Lobster Supply Corp. (LSC) Transfer Fuels Co. (TF) Brandon calculated the portfolio's beta as 0.890 and the portfolio's expected return as 12.68% Brandon thinks it will be a good idea to reallocate the funds in his client's portfolio. He recommends replacing Atteric Inc.'s shares with the same amount in additional shares of Transfer Fuels Co. The risk-free rate is 6%, and the market risk premium is 7.50%. According to Brandon's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change? O 1.82 percentage points O 1.23 percentage points O 1.58 percentage points O 1.96 percentage points

Explanation / Answer

Part-1: Computation of Portfolio required return change Computation of Revise Portfolio Weight of TF Exisitng Portfolio Weight of TF= 30% Revised Portfolio Weight of TF after reallocate the fund of AI in TF [(7500*35%)+($7500*30%)]/$7500=65% Calutation of Portfolio Beta with revised Beta Beta= Beta AT*WA +Beta LSC*WA+Beta TF*WA = (1.60*20%) + (1.10*15%)+(0.30*65%) 0.68 Calculation of Required return on the basis of revised Beta Portfolio Return ( KE)= Rf +Beta* Market Risk Premium Ke=6%+0.68*7.50% Ke=11.1% Portfolio's Required return Change= Existing Return- Revised Return =12.68%-11.1%= 1.58% Part-2: Brandon expect a return of 9.60% from Portfolio with new weight but required return on the basis of revised beta due to new weight is 11.1%, which represent that Portfolio is giving higher return as compare with expected Return. Hence revised Portfolio will be overvalued Part-3, Expected return will be high in stock having higher beta. Hence, required return from portfolio would increase, if invest in stock with higher beta.

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