Assignment
You just landed a job as a financial planner with Integrity Financial, a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of one year, you have been instructed to plan for a one-year holding period. Integrity Financial's economic staff has developed probability estimates for the various scenarios of the economic state, and its financial analysts have put together a model which was used to estimate the rate of return on each alternative under each state of the economy. Your boss has also restricted you to the following investment alternatives, which are shown with their probabilities and associated outcomes in the following chart:
Returns On Alternative Investments
Estimated Rate Of Return
|
State of the economy
|
Probability
|
T-bills
|
Ace Component
|
Billers International
|
Comfortbound Mattress
|
Market portfolio
|
2 stock portfolio
|
|
Recession
|
0.1
|
8.0%
|
-22.0%
|
28.0%
|
10.0%
|
-13.0%
|
3.0%
|
|
Below Average
|
0.2
|
8.0%
|
-2.0%
|
14.7%
|
-10.0%
|
1.0%
|
6.4% (f)
|
|
Average
|
0.4
|
8.0%
|
20.0%
|
0.0%
|
7.0%
|
15.0%
|
10.0%
|
|
Above Average
|
0.2
|
8.0%
|
35.0%
|
-10.0%
|
45.0%
|
29.0%
|
12.5% (f)
|
|
Booming
|
0.1
|
8.0%
|
50.0%
|
-20.0%
|
30.0%
|
43.0%
|
15.0%
|
|
Expected Rate of Return
|
|
|
|
1.7%
|
13.8%
|
15.0%
|
|
|
Standard Deviation
|
|
0.0%
|
|
13.4%
|
18.8%
|
15.3%
|
|
|
Coefficient of Variance
|
|
0.0% (e)
|
1.7% (e)
|
7.9%
|
1.4%
|
1.0%
|
|
|
Beta
|
|
|
|
-0.86%
|
0.68
|
|
|
Here is more information about the available investments in the chart: Ace Component is an electronics firm; Billers International collects past-due debts; and Comfortbound Mattress manufactures mattresses and other foam products. Integrity Financial also maintains a portfolio which holds a market-weighted fraction of all publicly traded stocks.
Using the above situation, answer the following questions. Present your calculations, assessments, and recommendations in a typed 3 to 4 page report.
A. What are investment returns?
B. What is the return on an investment that costs $1,000 and is sold after one year for $1,100?
C. What type of risk is measured by the standard deviation?
D. What does coefficient of variation (CV) measure?
E. Calculate the missing coefficients of variation above. Does the CV produce the same risk rankings as the standard deviation?
F. Suppose you created a 2-stock portfolio by investing $50,000 in Ace Component and $50,000 in Billers International. Calculate the expected return, the standard deviation, and the coefficient of variation (cvp) for this portfolio.
G. How does the riskiness of this 2-stock portfolio compare with the riskiness of the individual stocks if they were held in isolation?
H. Should portfolio effects impact the way investors think about the riskiness of individual stocks?
I. If you decided to hold a 1 stock portfolio, and were exposed to more risk than diversified investors, could you expect to be compensated for the risk associated with this investment choice? Would it be possible to earn a risk premium on that part of your risk that you could have eliminated by diversifying?
J. How is market risk measured for individual securities?
K. Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen (1) to the riskiness and (2) to the expected return of the portfolio as more and more randomly selected stocks were added to the portfolio? What is the implication for investors?