Mini Case Chapter 6 – Week 3

A.
Any profits or losses generated from an investment, minus the original amount, are
considered investment returns. Normally these returns are a percentage.

ROR = ( Amount received – amount invested) / amount invested

= (1,100 – 1,000) / 1000
= 10%

B.
T-bill’s return rate does not depend on the state of the economy because the treasure
must, and will redeem the bills at par regardless of the state of the economy. T-bills are
risk-free in the default risk since because par will be realized in all states of the economy,
but this returned is composed of a real risk-free rate plus an inflation premium. Because
there is uncertainty about inflation, it is unlikely that the realized real rate of return would
be equal to the expected risk-free rate. In terms of purchasing power, t-bills are not
riskless. They are exposed to reinvestment rate risk.

Since many people want electronics and consider them status symbols, then Alta
Industries business will thrive in a booming economy. This is due to the consumers
having more spendable income. However in a recession then the Repo Man’s business
booms. Since many people will lose their jobs and not be able to afford everything they
bought then the Repo Man starts working.

C.
Expected ROR= ∑Pi x ri

Calculations in table 1 below

D.
When using standard deviation, only stand alone risk is calculated. The larger the
standard deviation, the higher the probability that actual realized returns will fall far
below the expected return, and that losses rather than profits will be incurred.

Calculations are in table 1 and table 2 below

 Probability of
Occurrence

T-Bills

ALTA INDS

AM FOAM

-60 -45 -30 -15 0 15 30 45 60

Rate of Return (%)

E.
Coefficient of variation accounts for risk and return which is something that the standard
deviation does not.

CV = σ / ŕ

Calculations in table 1 below

F.
Expected returns equation is:

ŕp = ∑wi x ŕi
.

Calculations in table 1 and table 3 below

Using CV as the stand-alone risk measure, the stand-alone risk of the portfolio is less
than the stand-alone risk of the individual stocks. When Alta Industries is doing poorly,
Repo Men is doing well and vice versa. These two companies cover both of the extremes
in the economy. Therefore, it is a stable and low risk portfolio combo. If either of the
companies were held individually then they would be more risky due to any change in the
economy.

G.
Diversification is the best way to eliminate or minimize risk. The more stocks that are in
a portfolio from different aspects of the market the more stable the portfolio. For
example, if all of your stocks where in the automotive industry, the recent economy
would have triggered massive losses. In addition, the number of companies in a portfolio
will help lower risk because if one performs badly then the others will offset the
underperformer.
 Density

Portfolio of stocks
with rp = 16%

One
Stock
%
0 16 Return

H.
A one-stock portfolio would expose an investor to a high degree of risk, but there would
be no compensation for it. If return is high enough to compensate for the risk involved, it
would be a bargain for more rational, diversified investors. If the investment does well, it
will increase the value of the investor’s portfolio. It is not wise, however, to build an
entire portfolio with risky stocks.

I.
Market risk, which is relevant for stocks held in a well-diversified portfolio, is defined as
the contribution of a security to the overall riskiness of the portfolio. Beta coefficients
measure market risk for individual securities. This is based on the Capital Asset Pricing
Model. Using this allows the investor to determine how much risk is added to the
portfolio when a new stock is selected.
Beta coefficients are calculated by the following formula:

Beta = standard deviation X Correlation of iM

Standard dev of market return

J.
Calculating Beta
1. Historical price data for the market and the individual stock must be collected.
2. Both sets of data must then be converted into rates of return.
3. The rates of return of the market and the stock are plotted.
4. A regression line is then added to the plot. The slope of the regression line
represents the beta.

Beta for PQU = 0.83

Calculations in table 4 below

K.
Yes market risk and expected returns are related. Lower risk portfolios or stocks usually
have a lower rate of return. This is because you can make your portfolio so stable that
nothing really happens and any gains are offset by any losses. Basically research and the
calculations form the equations mentioned above should be used to help get the best
results.

L.
SML Equation: ri = rrf + (rm - rrf)bi.

Alta Inds: 8% + (15% - 8%)1.29 = 17.03% ≈ 17.0%.

Market: 8% + (15% - 8%)1.00 = 15.0%.

Am Foam : 8% +(15% - 8%)0.68 = 12.76% ≈ 12.8%.

T-Bills: 8% + (15% - 8%)1.29 = 17.03% ≈ 17.0%.

Repo Men: 8% + (15% - 8%)-0.86 = 1.98% ≈ 2%.

M.
If investors raised their inflation expectations by 3 percentage points over current
estimates as reflected by the 8 percent t-bill rate, the SML would increase and all
securities’ required return would increase. If investors’ risk aversion increased enough to
cause the market risk premium to increase by 3 percentage points, SML would increase
and the required rate of return would rise, but very little on low-beta securities.

TABLE 1

State of Probability T-Bills Alta Repo American Market 2-Stock

Economy Industries Men Foam Portfolio Portfolio

Recession 0.1 8% -22% 28% 10% -13% 3%

Below Avg 0.2 8% -2% 14.70% -10% 1% 6.35%
Average 0.4 8% 20% 0% 7% 15% 10%
Above Avg 0.2 8% 35% -10% 45% 29% 12.50%
Boom 0.1 8% 50% -20% 30% 43% 15%

ŕ --- 8.00% 17.40% 1.70% 13.80% 15% 9.57%

σ --- 0 20 13.4 18.8 15.3 3.33
CV --- 0 1.15 7.9 1.4 1 0.35
β --- -0.86 0.68

TABLE 2
ŕ 17.40%
 Alta
Probability Industries (ri - ŕ) (ri - ŕ)2 (r1 - ŕ)2 x
Pi

0.015523
0.1 -22% -0.394 0.155 6
0.007527
0.2 -2% -0.194 0.038 2
0.000270
0.4 20% 0.026 0.001 4
0.006195
0.2 35% 0.176 0.031 2
0.010627
0.1 50% 0.326 0.106 6

Variance 0.040144

STD 0.20036

TABLE 3
ŕ 9.57%
2 Stock
Probability Portfolio (ri - ŕ) (ri - ŕ)2 (r1 - ŕ)2 x
Pi

0.000431
0.1 3% -0.066 0.004 6
0.000207
0.2 6% -0.032 0.001 4
0.4 10% 0.004 0 7.40E-06
0.000171
0.2 13% 0.029 0.001 7
0.000294
0.1 15% 0.054 0.003 8

Variance 0.001113

STD 0.033361

TABLE 4

Regression Statistics
Multiple R 0.5954966
R Square 0.3546162
Adjusted R
Square 0.2739432
Standard Error 22.037681
Observations 10

ANOVA
Significanc
df SS MS F eF
Regression 1 2134.8249 2134.825 4.395725 0.0693032
Residual 8 3885.2751 485.6594
Total 9 6020.1

Coefficient Standard
s Error t Stat P-value Lower 95%
Intercept 2.5608391 8.2199263 0.31154 0.763354 -16.394345
X Variable 1 0.8308328 0.3962766 2.096598 0.069303 -0.0829826