Question 4 You have been recently appointed chief investment officer of a major charitable organization. The organization's large endowment fund is currently invested in a broadly diversified port- folio of stocks (60%) and (40%). The organization's board of trustees is a group of prominent individuals whose knowledge of modern investment theory and practice is superficial. You de- cide a discussion of basic investment principles would be helpful. 5 a. Explain the concepts of idiosyncratic risk, systematic risk, standard deviation and beta as they relate to investment management. (8 marks) 6. You believe that the addition of other asset classes to the endowment portfolio would im prove the portfolio by reducing risk and enhancing return. You are aware that depressed conditions in South African real estate markets are providing opportunities for property acquisition at levels of expected return that are unusually high by historical standards. You believe that an investment in real estate would be both appropriate and timely and have decided to recommend a 20% position to be established with funds taken equally from stocks and bonds. Preliminary discussions revealed that several trustees believe that real estate is too risky to include in the portfolio. The board chairman, however, has scheduled a meeting for further discussion of the matter and has asked you to provide background information that will clarify the risk issue. To assist you, the expectations data presented in Table 5 have been developed: Return Standard Correlation Matrix Asset Class (%) Deviation (%) Stocks Bonds Real Estate Treasury Bills Stocks 12.0 21.0 1.00 Bonds 8.0 10.5 0.14 1,00 Real Estate 12.0 9.0 -0.04 -0.03 1.00 Treasury Bill 4.00 0.0 -0.05 -0.03 0.25 1.00 Table 5: Assets descriptive statistics Required i. Explain the effect on both portfolio risk and portfolio return that would result from the addition of real estate. Include in your answer two reasons for any change you expect in portfolio risk. (Note: It is not necessary to compute the expected return and risk.) (5 marks) ii. Your understanding of capital market theory causes you to doubt the validity of the expected return and risk estimates for South African real estate. Justify your scepti cism. (4 marks) c. Identify and describe four criticisms that can be levelled against the Capital Assert Pricing Model. (8 marks) 10:42 Done Investments_Individua... Q 79 c. Thako Capital Inc., a client of Ms Tozi Mxenge, has entered into a transaction requiring a payment of ZAR 25,000 million in two years' time. Thako has ZAR 23,500 million avail- able to meet this liability. Tozi recommends a technique called dedication. Under certain market conditions, this technique can provide Thako with a safety margin or cushion in meeting its liability. Tozi notes that a South African government bond with a bond equiva- lent yield of 3.82% is available. Thako agrees to implement dedication using this bond. i. Identify and explain the advantages to Thako of using dedication rather than immu- nization. (2 marks) ii. Tozi discusses opportunities to use immunization with Nomxolisi Ndzelani, the finan- cial manager at Thako. Nomxolisi makes the following statements: Statement 1: "Thako should use corporate bonds for immunization in the future as this will achieve a lower cost of immunization." Statement 2 "Whenever Thako implements a multiple-liability immunization plan, the market value of the assets should be compared with the present value of the remain- ing liabilities by discounting the liabilities using zero coupon South African Treasury yields." Explain why each of Nomxolisi's statements is incorrect. (Note: Simply reversing the state- ments will not earn credit.) (4 marks) d. You are the fund manager for a large unit trust fund that specializes in fixed income. You have gathered some information, presented in Table 1, about three instruments that are of interest to you in forming a new fixed income portfolio: Call Price Yield to maturity Coupon Maturity Price (%) Year ZAR ZAR Bond 1 (new issue) 14.00 2022 101.750 114.00 Bond 2 (new issue) 6.00 2022 48.125 103.00 Bond 3 (2012 issue) 6.00 2022 48.875 103.00 (%) 13.75 13.80 13.40 Table 4: Some facts about some fixed income instruments Suppose that you expect a decline in interest rates over the next three years. Identify and justify which one of these three bonds you would select. Assume that the three bonds are of the same quality. (Show all your workings.) (9 marks)