You and your Team have to brief the head of a hedge fund, Mr. Moneypockets, who

ID: 2789875 • Letter: Y

Question

You and your Team have to brief the head of a hedge fund, Mr. Moneypockets, who is thinking about creating a portfolio investing just in these three stocks, for a major client of his that is willing to invest $100M in this particular portfolio. However, since this is a very large amount of money, relatively speaking, he wants your team to advise him on his idea. The volatility of his proposed market portfolio is 10% and it has an expected return of 8%, The risk free rate is 3%, and is based on appropriate U.S. government securities ("Treasuries"). The portfolio weights, volatility and correlation with the market portfolio of his three stocks are given in the table below: Portfolio Weight Volatility Correlation with Market Portfolio Yahoo 0.25 12% 0.4 Microsoft 0.35 25% 0.6 Google 0.40 13% 0.5 1. If you (and his client) expect to receive a rate of return 9% on this portfolio , would your Team recommend investing in this portfolio? Explain your team rationale to Mr. Moneypockets. 2. Assume the CAPM correctly prices risk, does your Team think the market portfolio is efficient? Explain why or why not to Mr. Moneypockets.

Explanation / Answer

Stock

Weight

Standard Deviation (Volatility)

Weight * SD

Correlation

Weight x Correlation

Yahoo

0.25

0.4

0.10

Microsoft

0.35

8.75

0.6

0.22

Google

0.40

5.2

0.5

0.20

Total

Portfolio Deviation

16.95

Portfolio correlation

0.52

Standard Deviation (volatility) of market = 10%

Return of market (Rm) = 8%

Risk free rate of return (Rf) = 3%

Beta = Cov(X, M) / Var(M)

= Cor(X, M) * SD(X) * SD (M) / SD (M) ^2

= Cor(X, M) * SD(X) / SD (M)

= 0.52 * 16.95/10

= 0.8814

Expected Return using CAPM

Er = Rf + beta (Rm –Rf)

= 3% + 0.8814 (8% -3%)

= 3% + 4.407%

= 7.407% = 7.41%

As per CAPM expected return is 7.41%, whereas the expected return of client of 9%. So, the portfolio does not meet the requirements of client is not advisable.

The market has return of 8% with SD of 10%, the portfolio has a return of 7.41% with SD of 16.95%. As both return of portfolio is low and risk is higher when compared to market it is not advisable to invest in portfolio.