Case 3

Topics: Investment, Modern portfolio theory, Rate of return Pages: 2 (416 words) Published: June 21, 2011

Q1.Imagine your Bill. How would you explain to Mary the relationship between risk and return of individual stocks? Find Expected Return and Standard Deviation for each stock in the Ralph’s portfolio.

As the risk increases the potential return increases as well. In order to get higher returns one needs to invest in riskier assets. In other words, risk is the probability of negative outcome and return is the compensation for this risk.

Q2.Mary has no idea what Beta means and how it is related to the required rate of return of the stocks. Explain how you would help her understand these concepts.

The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas greater than 1, show a more intense version of the market behavior. Stocks with betas between 0 and 1 move in the same direction with the market. Since the market is the portfolio of all the stocks, the average stock has a beta of 1.

Q3.How should Bill demonstrate the meaning and advantages of diversification to Mary? Find Expected Return and Standard Deviation of a portfolio that comprises 50% of High-Tech stocks and 50% of Counter-Cyclical stocks.

Q4.Using a suitable diagram explain how Bill could use the Security Market Line (SML) to show Mary which stocks could be undervalued and which may be overvalued? Find Expected Return and Required Return of each stock and plot them on SML.

Q5.During the presentation Mary asks Bill “Let’s say I choose a well diversified portfolio, what effect interest rates will have on my portfolio?” How should Bill respond?

Q6.Should Bill take Mary out of investing in stocks and preferably put all her money in fixed-income securities? Explain.

Q7.Mary tells Bill, “I keep hearing stories about how people have made thousands of dollars by following their brokers’ hot tips. Can you give me some hot tips regarding undervalued stocks?” How should Bill respond?

Q8.If Mary decided to invest her money equally...
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