As a finance major student of the UWI OC, you have just landed a lucrative job as a Financial Planner with First Citizens Investment Services (FCIS), a major financial services company in your home country. Your first assignment is to invest $100,000 for a reputable client of the firm. The funds are to be invested in a business at the end of one year, and you have been instructed to plan for a one-year holding period. You have been restricted by the CEO to the following investment alternatives, shown with their probabilities and associated outcomes.
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Returns on Alternative Investments
(Estimated Rate of Return)
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State of the Economy
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Probability
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T-Bills
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Phillips
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Pay-up
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Rubber- made
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Market Portfolio
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2-Stock Portfolio
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Recession
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0.2
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7.0
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-22.0
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28.0
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10.0
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-13.0
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3.0
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Below Average
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0.1
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7.0
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-2.0
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14.7
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-10.0
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1.0
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0.0
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Average
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0.3
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7.0
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20.0
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0
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7.0
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15.0
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10.0
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Above Average
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0.3
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7.0
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35.0
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-10.0
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45.0
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29.0
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0.0
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Boom
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0.1
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7.0
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50.0
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-20.0
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30.0
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43.0
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15.0
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Mean
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Fill in
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Fill in
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Fill in
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Fill in
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Fill in
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Fill in
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Standard Deviation
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Fill in
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Fill in
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Fill in
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Fill in
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Fill in
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Fill in
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Coefficient of Variation
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7.9
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1.4
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1.0
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Beta
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0.00
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1.10
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-0.50
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0.68
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1.0
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Analysts at the firm have developed probability estimates for the state of the economy, and its security manager has developed a sophisticated computer program which was used to estimate the rate of return of each alternative under each state of the economy.
Phillips Corp. is an electronics firm, Pay-up Ltd. is a debt collection agency, and Rubber-made Corp produces plastic products and household goods. FCIS maintains an index fund which owns a marketweighted fraction of all publicly traded stocks; you can invest in that fund, and obtain average stock market results. Based on the aforementioned scenario, answer the following questions.
1. What is the T-Bill rate composed of? Are T-Bills completely risk-free?
2. Why are Phillips' returns expected to move with the economy whereas Pay-up's are expected to move counter to the economy?
3. Calculate the expected rate of return on each alternative and fill in the blanks on the Row for Mean in the table above.
4. Your client is risk averse and the riskiness of each alternative is important in your decision. Calculate the standard deviation for each alternative, and fill in the row in the table above.
5. What type of risk is measured by the standard deviation?
6. You created a two stock portfolio by investing $50,000 in Phillips and $50,000 in Pay-up.
a. Calculate the expected return, standard deviation and the coefficient of variation for this portfolio and enter in the appropriate blanks in the table above.
b. How does the riskiness of this 2-stock portfolio compare to the riskiness of the individual stocks if they were held in isolation?
7. Use the security market line equation to calculate the required rate of return on each alternative.
a. How do the expected rates of return compare with the required rate of return? (State whether they were fairly valued, overvalued, undervalued)
b. Which of the stocks would you recommend purchasing and why?
c. What would be the market risk and the required return of a 50-50 portfolio of Phillips and Pay-up AND of Phillips and Rubber-made