Question 6 Assume that you recently graduated and landed a job as a financial planner with Cicero Services, an investment advisory company. Your first client recently inherited some assets and has asked you to evaluate them. The client owns a bond portfolio with GHS 1 million invested in zero coupon Treasury bonds that mature in 10 years. The client also has GHS 2 million invested in the stock of Blandy, Inc., a company that produces meat-and-potatoes frozen dinners. Blandy's slogan is "Solid food for shaky times." Unfortunately, Congress and the president are engaged in an acrimonious dispute over the budget and the debt ceiling. The outcome of the dispute, which will not be resolved until the end of the year, will have a big impact on interest rates one year from now. Your first task is to determine the risk of the client's bond portfolio. After consulting with the economists at your firm, you have specified five possible scenarios for the resolution of the dispute 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 bonds for each scenario. The probabilities and returns are shown below: Return on a 10-Year Zero Coupon Probability Treasury Bond Scenario of Scenario During the Next Year Worst Case 0.10 -14% Poor Case 0.20 -4% Most 0.40 6% Likely Good Case 0.20 16% Best Case 0.10 26% 1.00 You have also gathered historical retums for the past 10 years for Blandy, Inc. and Gourmange Corporation (a producer of gourmet specialty foods) and the stock market. The Risk-free rate is 4% and the market risk premium is 5%. Year 1 2 3 4 5 6 7 8 9 10 Average return: Standard deviation: Correlation with the market Beta: Historical Stock Returns Market Blandy Gourmange 30% 26% 47% 7 15 -54 18 -14 15 -22 -15 7 -14 2 -28 10 -18 40 26 42 17 -10 30 -23 -3 -32 -4 38 28 75 8.0% 3 9.2% 20.1% ? ? 38.6% 1.00 ? 0.678 1.00 ? 1.30 c. Your client is shocked at how much risk Blandy stock has and would like to reduce the level of risk. You suggest that the client sell 25% of the Blandy stock and create a portfolio with 75% Blandy stock and 25% in the high-risk Gourmange stock. How do you suppose the client will react to replacing some of the Blandy stock with high-risk stock? Show the client what the proposed portfolio return would have been in cach 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? [4 marks] f. 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 riska [2 marks] g. 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. [2 marks] h. What is the Security Market Line (SML)? How is beta related to a stock's required rate of return? [2 marks] Question 6 Assume that you recently graduated and landed a job as a financial planner with Cicero Services, an investment advisory company. Your first client recently inherited some assets and has asked you to evaluate them. The client owns a bond portfolio with GHS 1 million invested in zero coupon Treasury bonds that mature in 10 years. The client also has GHS 2 million invested in the stock of Blandy, Inc., a company that produces meat-and-potatoes frozen dinners. Blandy's slogan is "Solid food for shaky times." Unfortunately, Congress and the president are engaged in an acrimonious dispute over the budget and the debt ceiling. The outcome of the dispute, which will not be resolved until the end of the year, will have a big impact on interest rates one year from now. Your first task is to determine the risk of the client's bond portfolio. After consulting with the economists at your firm, you have specified five possible scenarios for the resolution of the dispute 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 bonds for each scenario. The probabilities and returns are shown below: Return on a 10-Year Zero Coupon Probability Treasury Bond Scenario of Scenario During the Next Year Worst Case 0.10 -14% Poor Case 0.20 -4% Most 0.40 6% Likely Good Case 0.20 16% Best Case 0.10 26% 1.00 You have also gathered historical retums for the past 10 years for Blandy, Inc. and Gourmange Corporation (a producer of gourmet specialty foods) and the stock market. The Risk-free rate is 4% and the market risk premium is 5%. Year 1 2 3 4 5 6 7 8 9 10 Average return: Standard deviation: Correlation with the market Beta: Historical Stock Returns Market Blandy Gourmange 30% 26% 47% 7 15 -54 18 -14 15 -22 -15 7 -14 2 -28 10 -18 40 26 42 17 -10 30 -23 -3 -32 -4 38 28 75 8.0% 3 9.2% 20.1% ? ? 38.6% 1.00 ? 0.678 1.00 ? 1.30 c. Your client is shocked at how much risk Blandy stock has and would like to reduce the level of risk. You suggest that the client sell 25% of the Blandy stock and create a portfolio with 75% Blandy stock and 25% in the high-risk Gourmange stock. How do you suppose the client will react to replacing some of the Blandy stock with high-risk stock? Show the client what the proposed portfolio return would have been in cach 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? [4 marks] f. 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 riska [2 marks] g. 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. [2 marks] h. What is the Security Market Line (SML)? How is beta related to a stock's required rate of return? [2 marks]