Mini case questions
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. The client also has $2 million invested in the stock of Blandy, Inc., a company that produces meat-and potatoes frozen dinners. Blandy’s 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 client’s 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 of Scenario |
Return on a 10 year Zero Coupon Treasury Bond 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 return |
8.0% |
? |
9.2% |
|
|
Standard Deviation |
20.1% |
? |
38.6% |
|
|
Correlation with market |
1.00 |
? |
0.678 |
|
|
Beta |
1.00 |
? |
1.30 |
The risk-free rate is 4% and the market risk premium is 5%.
Questions
O. Your client decides to invest $1.4 million in Blandy stock and $0.6 million in Gourmange stock. What are the weights for this portfolio? What is the portfolio’s beta? What is the required return for this portfolio?
P. Jordan Jones (JJ) and Casey Carter (CC) are portfolio managers at your firm. Each manages a well-diversified portfolio. Your boss has asked for your opinion regarding their performance in the past year. JJ’s portfolio has a beta of 0.6 and had a return of 8.5%; CC’s portfolio has a beta of 1.4 and had a return of 9.5%. Which manager had better performance? Why?
Q. What does market equilibrium mean? If equilibrium does not exist, how will it be established?
R. What is the Efficient Markets Hypothesis (EMH) and what are its three forms?
What evidence supports the EMH? What evidence casts doubt on the EMH?
-
Rating:
/5
Solution: here you go