Case 2.1-Risk and Return (20 points) Assume that you recently graduated with a m
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Case 2.1-Risk and Return (20 points) Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the client plans to invest in a business at the end of year 1, you have been instructed to plan for a 1-year holding period. Furthermore, your boss has restricted you to investment alternatives in the following table, shown with their probabilities and associated outcomes 2-Stock Market Portfolio (HT Probability T.Bills High Tech Collections US Rubber Portfolio and Coll) ·270% 0% 10% 20% 40% 20% 10% 55% 55% 5.5% 5.5% 5.5% Recession Below Average 13% 75% Above Average Boom 11% -21% 3% 41% 29% 450% 38% 5.5% 30,0% 0%-34% , Expected return Expected Std Dev Beta 0870.88 .Note that the estimated returns of US Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a new car may choose to wait and instead purchase new tires for the car they currently own. Under these circumstances, we would expect US Rubber's stock price to be higher if there was a recession than if the economy was just below average The investment advisory's economic forecasting staff has developed probability estimates for the state of the economy; and its' security analysts have developed a sophisticated computer program, which is used to estimate the rate of return on each alternative under each state of the economy. High Tech is an electronics firm. . Collections Inc. collects past due debts and US Rubber manufactures tires and various other rubber and plastic products The advisory also maintains a market portfolio' that owns a market-weighted fraction of all publicly traded stocks; you can invest in that portfolio and thus obtain average stock market results. Given this information, answer the following questions:Explanation / Answer
1.) T-Bills are considered to be risk-free return because the T-Bills do not contain the default risk. As these securities are backed by sovereign governments, hence they carry almost NIL default risk and making them safer investment instrument. But T-Bills do carry inflation risk as pointed out. In case the inflation increases or decreases, the yields on these bills get adjusted using the yield curve and the returns from these bills will be lower or higher than expectations. So, the real returns will be inflation adjusted.
2.) High Tech returns are expected to move along with the economy because of the nature of the industry it is. If the economy booms, more users are expected to spend on high technology products. More users will tend to upgrade their existing gadgets which involve the use of chips made by electronic companies. On the reverse side, if the economy is below average, many users will continue with their existing gadget devices and will not rather go for new purchase.
Similarly, the Collection Inc collects past due debts. With the economy booming, more people will be clearing their due debts. The business for Collection Inc in this state is expected to reduce and hence the negative correlation exists. Similarly, when the economy is below average, more people are likely to default on their debt payments. In such cases, Collection is expected to have booming business.
3a.) Expected Return of Hi-Tech = 0.10x(-0.27) + 0.20x(-0.07) + 0.40x0.15 + 0.20x0.30 + 0.10x0.45 =0.124 or 12.4%
Expected Return of Collections = 0.10x(0.27) + 0.20x(0.13) + 0.40x0.00 + 0.20x(-0.11) + 0.10x(-0.21) =0.01 or 1.0%
Expected Return of US Rubber = 0.10x(0.06) + 0.20x(-0.14) + 0.40x0.03 + 0.20x(0.41) + 0.10x(0.26) =0.098 or 9.8%
Expected Return of Market = 0.10x(-0.17) + 0.20x(-0.03) + 0.40x0.10 + 0.20x(0.25) + 0.10x(0.38) =0.105 or 10.5%
3b.) Standard Deviation of Hi-Tech= {0.10x(-0.27-0.124)2 + 0.20x(-0.07-0.124)2 + 0.40x(0.15-0.124)2 + 0.20x(0.30-0.124)2 + 0.10x(0.45-0.124)2 }0.5
= {0.0022 + 0.0038 + 0.0016 + 0.0008 + 0.0006 }0.5
= 0.00910.5
= 0.0957 or 9.57%
Standard Deviation of Collections= {0.10x(0.27-0.01)2 + 0.20x(0.13-0.01)2 + 0.40x(0.00-0.01)2 + 0.20x(-0.11-0.01)2 + 0.10x(-0.21-0.01)2 }0.5
= {0.0000 + 0.0000 + 0.0000 + 0.0002 + 0.0001 }0.5
= 0.0004210.5
= 0.0205 or 2.05%
Standard Deviation of US Rubber= {0.10x(0.06-0.098)2 + 0.20x(-0.14-0.098)2 + 0.40x(0.03-0.098)2 + 0.20x(0.41-0.098)2 + 0.10x(0.26-0.098)2 }0.5
= {0.0008 + 0.0032 + 0.0029 + 0.0000 + 0.0005 }0.5
= 0.00750.5
= 0.0868 or 8.68%
Expected Return of Market = 0.10x(-0.17) + 0.20x(-0.03) + 0.40x0.10 + 0.20x(0.25) + 0.10x(0.38) =0.105 or 10.5%
Standard Deviation of Market= {0.10x(-0.17-0.105)2 + 0.20x(-0.03-0.105)2 + 0.40x(0.10-0.105)2 + 0.20x(0.25-0.105)2 + 0.10x(0.38-0.105)2 }0.5
= {0.0015 + 0.0025 + 0.0017 + 0.0006 + 0.0004 }0.5
= 0.00670.5
= 0.0818 or 8.18%
Standard Deviation measures unsystematic risk as it is specific to that very company.
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