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First alternative
$1,000,000 / ($4-$2) = $500,000
From here, we can see that Benjamin portfolio has losses half of his investment value or 50% of
it and ended up left only $500,000.
Second alternative
$500,000 / ($4-$2) = $250,000
{$500,000 X [($6.50-$5) / $5]} + $500,000 = $650,000
Total $250,000 + $650,000 = $900,000
So, if Benjamin chooses the second alternative, although he also incurs losses from choosing this
alternative, but his just loss $100,000 from the portfolios. It is because, although he loss
$250,000 by investing in his employers stock but at the same time, he gain profit of $150,000
from investing in Company PQR. Therefore, it is better for Benjamin to choose the second
alternative as he total up losses just $100,000 but if he chooses first alternative, his total losses
would be $500,000.
Then, Bill can tell Mary that advantage of diversification is that it can help to balance up the
unsystematic risk events occurs in a portfolio where positive performance of some investment
can help neutralize the negative performance of others investment.
4. Using a suitable diagram explain how Bill could use the security market line to show
Mary which stocks could be undervalued and which may be overvalued?
A security market line (SML) is a line that graphs the systematic or market risk versus the return
of the whole market at a certain point in time where x-axis representing the risk (beta), and the yaxis representing the expected return.
higher return while asset that are overvalued is because of the given amount of risk, and they
yield a lower return. In other words, asset that its expected returns are higher than their required
returns are considered as undervalued while asset that its expected return is lower than their
required return are considered as overvalued.
5. During the presentation, Mary asks Bill Lets say I choose a well-diversified portfolio,
what effect will interest rates have on my portfolio? How should Bill respond?
Bill can explain to Mary that the stock prices depend on the company profitability. If investors of
a certain company think that the company could not cope up with the lost profit due to the
increase in additional interest expense, then the stock price may drop. Thus, if there is a rising in
interest rate, the return of Marys well-diversified portfolio will decrease by as much as the
market index does. In other way round, if there is a decrease in interest rate, the return of Marys
well-diversified portfolio will increase by as much as the market index does.
6. Should Bill take Mary out of investing in stocks and preferably put all her money in
fixed-income securities? Explain.
Bill should advise Mary to stay investing in well-diversified portfolio of stock. Although fixedincome securities can be seen as safe as its carry lower risk, but they generally offer low returns.
Besides, fixed income-securities such as Treasury bonds will charge the investors for
withdrawing their premiums before maturity. But, if Mary holds on investing in well-diversified
portfolio of stock, Mary can increase the stability of her investments and decrease the risk of
losing money in the event if one of the stock decrease in value.
7. Mary tells Bill, I keep hearing stories about how people made thousands of dollars by
following their brokers hot tips. Can you give me some hot tips regarding undervalued
stocks? How should Bill respond?
Bill should advise Mary not to be too dependable on so call hot tips when making an
investment. It is because the tips given do not 100% guarantee that profit can be gain for that
investment. Yes, there is a possibility that the hot tips might be true and can help the investors to
gain profit easily but it also because of luck. If the hot tips gather is not true, it can cause the
investors to incur greater losses from the investment. Therefore, it is better for Mary to make her
own research and analysis on the company she may interested in before investing on it.
8. If Mary decided to invest her money equally in high-tech and counter-cyclical stocks,
what would her portfolios expected return and risk level be? Are these expectations
realistic? Please explain.
Scenario
recession
near
recession
normal
near boom
boom
expected
return
standard
deviation
Probabilit
y
20%
20%
30%
10%
20%
CounterHigh-Tech Cyclical
Company Company
-25%
20%
-20%
15%
25%
35%
16%
12%
-9%
-20%
5%
5.90%
23.55%
15.10%
50-50
portfoli
o
-2.50%
50-50
expected
rate of
return
-0.500%
50-50
standard
deviation
0.001264
-2%
13.50%
8%
7.50%
-0.400%
4.050%
0.800%
1.500%
0.00111
0.001944
0.000065
0.000084
5.45%
0.45%
If Mary invests her money equally in High-Tech Company and Counter-Cyclical Company
stocks, the expected return of the portfolio would be 5.45% while its expected standard deviation
would be 0.45%. Above expectations only will be as realistic as the numbers used in calculating
them. Therefore, in order to get a realistic expected return estimates, Mary should make a
realistic assumptions regarding to the probabilities and returns.
9. What would happen if Mary were to put 70% of her portfolio in the High-Tech stock and
30% in the Index Fund? Would this combination be better for her? Explain.
Probabilit
y
HighTech
Compan
y
Index
Fund
70-30
portfoli
o
70-30
expecte
d rate
of
return
recession
near
recession
20%
-25%
-10%
-20.50%
-4.10%
20%
-20%
-6%
-15.80%
-3.16%
normal
30%
15%
12%
14.10%
4.23%
near boom
10%
25%
15%
22.00%
2.20%
boom
expected
return
20%
35%
20%
30.50%
6.10%
5%
5.90%
23.55%
11.75%
Scenario
standard
deviation
70-30
standar
d
deviatio
n
0.01328
2
0.00887
9
0.00233
9
0.00279
9
0.01273
1
5.27%
4.00%
If Mary were to put 70% of her portfolio in the High-Tech Company stock and 30% in the Index
Fund, her portfolio expected level of risk will be much higher (4% versus 0.45%) as compared to
the 50-50 portfolio of High-Tech Company and the Counter-Cyclical Company. Thus, this 70-30
combination is not suitable for Mary.
10. Based on these calculations what do you think Bill should propose as a possible
portfolio combination for Mary?
Based on the calculation made above, Bill should propose Mary to have investing in the portfolio
combination of 50% High-Tech Company and 50% of Counter-Cyclical Company. Using these
portfolio combinations, Mary would have a lower expected level of risk.