Assume that after completion of your MBA you have started working as a financial planner at JS Capital Limited. In a second week of Job you have got assignment to invest Rupees 100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding period. Moreover, your manager has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (For now, disregard the items at the bottom of the data; you will fill in the blanks later.)

Estimated rate of returns

State of the

Probability

T-Bills

Nescom

Nawab

PK_Steel

Pak Market portfolio

Recession

0.1

3%

-14.25

12.25

1.75

-9.75

Below average

0.2

3%

-4.75

5.25

-8.25

-2.75

average

0.4

3%

6.25

-0.5

0.25

3.75

Above average

0.2

3%

13.75

-2.5

19.25

11.25

Boom

0.1

3%

21.25

-10

11.75

17.75

Expectred Returns

St. Deviation

0%

CV

Beta

JS Capital staff has estimated the probability values for the state of the economy, and also estimated the corresponding rate of return on each alternative under each state of the economy. Nescom. is technology firm, Nawab collects past-due debts, and PK_Steel manufactures steel products. JS capital also maintains a market portfolio that owns a market-weighted fraction of all publicly traded stocks on Pakistan exchange market; you can invest in that portfolio and thus obtain average stock market results. Given the situation described, answer the following questions:

1. Why is the T-bills return independent of the state of the economy? Do T-bills promise a completely risk-free return? Explain?

2. Why are Nescom returns expected to move with the economy, whereas Nawabs are expected to move counter to the economy?

3. Calculate the expected rate of return on each alternative.

4. You should recognize that basing a decision solely on expected returns is appropriate only for risk neutral individuals. Your client is risk-averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns. Calculate this value for each alternative.

5. What type of risk is measured by the standard deviation?

6. Suppose you suddenly remembered that the coefficient of variation (CV) is generally regarded as being a better measure of stand-alone risk than the standard deviation when the alternatives being considered have widely differing expected returns. Calculate the CVs and interpret the results.

7. Suppose you created a two-stock portfolio by investing Rupees 50,000 in Nescom and Rupees 50,000 in Nawab. Now Calculate the expected return of portfolio, the standard deviation of portfolio and the coefficient of variation of portfolio. Also write about how the riskiness of this two-stock portfolio compares with the riskiness of the individual stocks if they were held in isolation?

8. Assume that the expected rates of return and the beta coefficients of the alternatives supplied by an independent analyst are as follows:

Security

Estimated rate of returns

Beta

Nescom

5%

1.5

Market

4

1

Pk_Steel

3.5

0.75

T_Bills

3

0

Nawab

1

-0.6

What is a beta coefficient, and how are betas used in risk analysis?

Do the expected returns appear to be related to each alternatives market risk?

Is it possible to choose among the alternatives on the basis of the information developed thus far?

9. Assumes that the risk-free rate is 3.0%, and risk premium is expected return on market portfolio less risk.

Write out the security market line (SML) equation; use it to calculate the required rate of return on each alternative?

How do the expected rates of return compare with the required rates of return? Identify the undervalued companies?