Please answer all questions from A - O

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Your current employer, Reinzenstein \& Jillian Services, an important investment advisory company located in Chicago, has many wealthy clients. One of these clients, Mr. Owen Hyness, is in your portfolio. He recently inherited some assets and has asked you to evaluate them and provide sound financial recommendations. The client presently owns a bond portfolio with $1 million invested in zero coupon Treasury bonds that mature in 10 years. The client also has $2 million invested in the stock of Paraninfo Inc. Unfortunately, taking into consideration the serious virus outbreak that is impacting the markets at a global scale and that is not expected to be solved in the short run, interest rates will suffer a huge impact one year from now. Your first task is to determine the risk of the client's bond portfolio. After conducting some preliminary analysis, you have specified five possible economic scenarios at the end of the year. For each scenario, you have estimated the probability of the scenario occurring and the impact on interest rates and bond prices if the scenario occurs. Given this information, you have calculated the rate of return on 10-year zero coupon Treasury Bond for each scenario. The probabilities and returns are shown below: You have also gathered historical returns for the past 10 years for Paraninfo inc., Octum CO., and the stock market where these companies are listed. The Treasure Bills are currently yielding a 2.8% annual rate. a. What are investment returns? What is the return on an investment that costs $3,000 and is sold after 4 years for $3,460 ? b. Use the scenario data to calculate the expected rate of return for the 10-year zero coupon Treasury bonds during the next year. c. What is stand-alone risk? Use the scenario data to calculate the standard deviation of the bond's return for the next year. d. Your client has decided that the risk of the bond portfolio is acceptable and wishes to leave it as it is. Now your client has asked you to use historical returns to estimate the standard deviation of Paraninfo's stock returns by using the provided 10 annual returns. e. Your client is shocked at how much risk Paraninfo stock has and would like to reduce the level of risk. You suggest that the client sell 25% of the Paraninfo stock and create a portfolio with 75% Paraninfo stock and 25% in the high-risk Octum stock. How do you suppose the client will react to replacing some of the Paraninfo stock with high-risk stock? Show the client what the proposed portfolio return would have been in each of year of the sample. Then calculate the average return and standard deviation using the portfolio's annual returns. How does the risk of this two-stock portfolio compare with the risk of the individual stocks if they were held in isolation? f. Explain the concept of coefficient of variation. Estimate the coefficient of variation of the two-stock portfolio and compare with the coefficient of variation of the stocks if they were held in isolation. What is the interpretation of the two-stock portfolio's coefficient of variation? g. Explain correlation to your client. Calculate the estimated correlation between Paraninfo and Octum. Does this explain why the portfolio standard deviation was less than Paraninfo's standard deviation? h. Suppose an investor starts with a portfolio consisting of one randomly selected stock. As more and more randomly selected stocks are added to the portfolio, what happens to the portfolio's risk? i. Answer the following questions: a. Should portfolio effects influence how investors think about the risk of individual stocks? b. If you decided to hold a one-stock portfolio and consequently were exposed to more risk than diversified investors, could you expect to be compensated for all of your risk; that is, could you earn a risk premium on that part of your risk that you could have eliminated by diversifying? j. According to the Capital Asset Pricing Model, what measures the amount of risk that an individual stock contributes to a well-diversified portfolio? Define this measurement. k. How is beta related to a stock's required rate of return? I. Calculate the correlation coefficient between Paraninfo and the market. Use this and the previously calculated standard deviations of Paraninfo and the market to estimate Paraninfo's beta. 1 Does Paraninfo contribute more or less risk to a well-diversified portfolio than does the average stock? m. Answer the following questions: a. Suppose the risk-free rate goes up to 6%. What effect would higher interest rates have on the returns required on high-risk and low-risk securities? b. Suppose instead that investors' risk aversion increased enough to cause the market risk premium to increase to 8%. (Assume the risk-free rate remains constant at 2.8% ) What effect would this have on returns of high-and low-risk securities? n. Your client decides to invest $1.4 million in Paraninfo stock and $0.6 million in Octum stock. What are the weights for this portfolio? What is the portfolio's beta? What is the required return for this portfolio? o. Emilia Johnson and Jeremiah Hardon are portfolio managers at your firm. Each manages a well-diversified portfolio. Your boss has asked for your opinion regarding their performance in the past year. Emilia's portfolio has a beta of 0.5 and had a return of 8.5%; Jeremiah's portfolio has a beta of 1.5 and had a return of 9.5%. Which manager had better performance? Why? the standard deviation of the market returns, and iN is the correlation coefficient between the stock i and the market. 3