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 3 1.30 a. What is the return on an investment that costs GHS 1,000 and is sold after 1 year for GHS 1,060 [1 mark] b. Graph the probability distribution for the bond returns based on the 5 scenarios. What might the graph of the probability distribution look like if there were an infinite number of scenarios (.e., if it were a continuous distribution and not a discrete distribution)? [2 marks] c. Use the scenario data to calculate the expected rate of return for the 10-year zero coupon Treasury bonds during the next year. [1 mark] 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 Blandy's stock returns. (Note: Many analysts use 4 to 5 years of monthly returns to estimate risk and many use 52 weeks of weekly returns; some even use a year or less of daily returns. For the sake of simplicity, use Blandy's 10 annual returns.) [3 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 3 1.30 a. What is the return on an investment that costs GHS 1,000 and is sold after 1 year for GHS 1,060 [1 mark] b. Graph the probability distribution for the bond returns based on the 5 scenarios. What might the graph of the probability distribution look like if there were an infinite number of scenarios (.e., if it were a continuous distribution and not a discrete distribution)? [2 marks] c. Use the scenario data to calculate the expected rate of return for the 10-year zero coupon Treasury bonds during the next year. [1 mark] 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 Blandy's stock returns. (Note: Many analysts use 4 to 5 years of monthly returns to estimate risk and many use 52 weeks of weekly returns; some even use a year or less of daily returns. For the sake of simplicity, use Blandy's 10 annual returns.) [3 marks]
