Gregory is an anaylst at a wealth management firm. One of his clients holds a $5,000 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table:
Stock Investment allocation Beta Standard deviation
Atteric, Inc (AI) 35% 0.900 23.00%
Arthur Trust, Inc. (AT) 20% 1.400 27.00%
Li Corp (LC) 15% 1.200 30.00%
Transfer Fuels Co(TF) 30% 0.300 34.00%
Gregory calculated the portfolio's beta as 0.865 and the portfolio's expected return is 8.76%
Gregory thinks it will be a good idea to reallocate the funds in the client's portfolio. He recommends replacing Atteric Inc.'s shares with the same amount in additional shares of Transfer Fuels Co. The risk free rate is 4%, and the market risk premium is 5.50%.
1. According to Gregory's recommendation, assuming that the market is in equillibrium, how much will the portfolio's required return change? 1.44 percentage points, 1.33 percentage points, 0.91 percentage points or 1.16 percentage points.
Analysts' estimates on expected returns from equity investments are based on several factors. These estimations also often include subjective and judgmental factors, because different analysts interpret data in different ways.
2. Suppose, based on the earnings consensus of stock analysts, Gregory expects a return of 6.10% from the portfolio with the new weights. Does he think that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued?
3. Suppose, instead of replacing Atteric Inc.'s stock with Transfer Fuels Co.'s stock, Gregory considers replacing Atteric with the equal dollar allocation to shares of Company X's stock that has a higher beta than Atteric. If everything else remains, the portfolio's risk would _______________________.