Question / Mini-case 6 / Financial Management - Theory and Practice (Brigham & Ehrhardt) / pg. 284-285

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 presently owns a bond portfolio with $1 million invested in zero coupon Treasury bonds that mature in 10 years.40 The client also has $2 million invested in the stock of Blandy, Inc., a company that produces meat-and- potatoes frozen dinners. Blandys 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 clients 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 for each scenario. The probabilities and returns are shown below:

Scenario Probability Return on a 10-year Zero

of Scenario Coupon During the next year

Worst Case 0.10 -14%

Poor Case 0.20 -4%

Most Likely 0.40 6%

Good Case 0.20 16%

Best Case 0.10 26%

1.00

You have also gathered historical returns for the past 10 years for Blandy, Gourmange Corporation (a producer of gourmet specialty foods), and the stock market.

Historical Stock Returns

Year Market Blandy Gourmange

1 30% 26% 47%

2 7 15 -54

3 18 -14 15

4 -22 -15 7

5 -14 2 -28

6 10 -18 40

7 26 42 17

8 -10 30 -23

9 -3 -32 -4

10 38 28 75

Average 8.0% 12.8% 9.2%

Return

Standard 20.1% 22.3% 38.6%

Deviation

Correlation

With Market 1.00 .369 0.678

Beta 1.00 .41 1.30

The risk-free rate is 4% and the market risk premium is 5%

I need figuere out letter E and how to use Blandy's 10 annual returns to estimate the standard deviation.

e. 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 Blandys 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 Blandys 10 annual returns.)