Part A:

(1). Since the return of the t bills are fixed by the government and central bank will redeem the t bills at
pre-determined rate of 3% regardless the state of the economy, the rate of return for t bills are
independent of the state of the economy.
The t bills are completely free of default risk since these are backed by the government, and any
government is highly unlikely to default at the time of payment as promised earlier.
(2). Since High Tech is a purely electronics firm, the growth of profitability of this company is assumed
to be positively correlated with the economic boom as the technological advancement is a major
component of positive economic movement. As such, High Tech is expected to move with the economy.
However, Collections Inc. collects the overdue debts and in the time of below average and recession, it is
expected that the overdue debts will increase and Collections Inc. will get a lot of orders and will increase
profitability. Also, at the time of above average and Boom, people are expected to have less overdue debts
and Collections Inc. is expected to have less work orders and less profits. Hence, it is expected that the
returns of Collections Inc. will move counter the economy.

Part B:

Estimated Rate of Return

State of Prob T- High Collectio US Market 2 stock
Economy . bills Tech ns Rubbe Portfolio portfolio
r
Recession 0.1 3.0% -29.5% 24.5% 3.5% -19.5% -2.5%
Below Avg 0.2 3.0% -9.5% 10.5% -16.5% -5.5% 0.5%
Avg 0.4 3.0% 12.5% -1.0% 0.5% 7.5% 5.8%
Above Avg 0.2 3.0% 27.5% -5.0% 38.5% 22.5% 11.3%
Boom 0.1 3.0% 42.5% -20.0% 23.5% 35.5% 11.3%

r hat 3.0% 9.9% 1.2% 7.3% 8.0% 5.6%

Part C:
(1).

Estimated Rate of Return

State of Prob T- High Collectio US Market 2 stock
Economy . bills Tech ns Rubbe Portfolio portfolio
r
Recession 0.1 3.0% -29.5% 24.5% 3.5% -19.5% -2.5%
Below Avg 0.2 3.0% -9.5% 10.5% -16.5% -5.5% 0.5%
Avg 0.4 3.0% 12.5% -1.0% 0.5% 7.5% 5.8%
Above Avg 0.2 3.0% 27.5% -5.0% 38.5% 22.5% 11.3%
Boom 0.1 3.0% 42.5% -20.0% 23.5% 35.5% 11.3%

r hat 3.0% 9.9% 1.2% 7.3% 8.0% 5.6%

Std Dev 0.0% 20.0% 11.2% 18.8% 15.2% 4.6%

(2). Standard deviation measures the dispersion of expected return which is the indicator of uncertainty or
risk. Higher the standard deviation, higher the risk and higher the gap between expected return and actual
return, which might turn the profit into losses. As such, the standard deviation refers to the stand alone
risk only.

(3).

Probabilities T bill

High Tech

US Rubber

0 3% 7.3% 9.9% Rate of return

Part D:

Estimated Rate of Return

State of Prob T- High Collectio US Market 2 stock
Economy . bills Tech ns Rubbe Portfolio portfolio
r
Recession 0.1 3.0% -29.5% 24.5% 3.5% -19.5% -2.5%
Below Avg 0.2 3.0% -9.5% 10.5% -16.5% -5.5% 0.5%
Avg 0.4 3.0% 12.5% -1.0% 0.5% 7.5% 5.8%
Above Avg 0.2 3.0% 27.5% -5.0% 38.5% 22.5% 11.3%
Boom 0.1 3.0% 42.5% -20.0% 23.5% 35.5% 11.3%

r hat 3.0% 9.9% 1.2% 7.3% 8.0% 5.6%

Std Dev 0.0% 20.0% 11.2% 18.8% 15.2% 4.6%
CV 0.0 2.0 9.8 2.6 1.9 0.8
CV resembles the stand alone risk per unit of return. Considering the standard deviation, US rubber was
the less risky stock and as per CV, it becomes the most risky stock. CV is more appropriate measure of
risk compared to Standard Deviation, since it considers the amount of dispersion in the returns along with
the expected return. As per CV, a stock with low standard deviation and low return might become the
most risky investment compared to any stock with comparatively high standard deviation and high return.

Part E:

Estimated Rate of Return

State of Prob T- High Collectio US Market 2 stock
Economy . bills Tech ns Rubbe Portfolio portfolio
r
Recession 0.1 3.0% -29.5% 24.5% 3.5% -19.5% -2.5%
Below Avg 0.2 3.0% -9.5% 10.5% -16.5% -5.5% 0.5%
Avg 0.4 3.0% 12.5% -1.0% 0.5% 7.5% 5.8%
Above Avg 0.2 3.0% 27.5% -5.0% 38.5% 22.5% 11.3%
Boom 0.1 3.0% 42.5% -20.0% 23.5% 35.5% 11.3%

r hat 3.0% 9.9% 1.2% 7.3% 8.0% 5.6%

Std Dev 0.0% 20.0% 11.2% 18.8% 15.2% 4.6%
CV 0.0 2.0 9.8 2.6 1.9 0.8
Sharpe Ratio --- 0.34 -0.16 0.23 0.33 0.54

Sharpe ratio usually refers to the units of returns generated excess of the risk free rates against per unit of
total risk. This ratio is used to measure the performances of the portfolio managers on a risk adjustment
basis.
Part F:
(1):

Estimated Rate of Return

State of Prob T- High Collectio US Market 2 stock
Economy . bills Tech ns Rubbe Portfolio portfolio
r
Recession 0.1 3.0% -29.5% 24.5% 3.5% -19.5% -2.5%
Below Avg 0.2 3.0% -9.5% 10.5% -16.5% -5.5% 0.5%
Avg 0.4 3.0% 12.5% -1.0% 0.5% 7.5% 5.8%
Above Avg 0.2 3.0% 27.5% -5.0% 38.5% 22.5% 11.3%
Boom 0.1 3.0% 42.5% -20.0% 23.5% 35.5% 11.3%

r hat 3.0% 9.9% 1.2% 7.3% 8.0% 5.5%

Std Dev 0.0% 20.0% 11.2% 18.8% 15.2% 4.6%
CV 0.0 2.0 9.8 2.6 1.9 0.8
Sharpe Ratio --- 0.34 -0.16 0.23 0.33 0.54

(2): We find that both the Standard Deviation and CV of the 2 stock portfolio is much lower compared to
each of the stocks in isolation. The main reason is that the companies are of different industries and if we
look into the returns we get a negative correlation between them. AS such, both the companies will not be
doing poor at the same time and vice versa, which reduces the inherent risks of the stocks if we combine
them in a portfolio.

Part G:
(1):
Since more and more stocks will be added to the portfolio, the expected return will come closer to the
market return of 8.0% and the risk in terms of Standard Deviation will go down due to diversification of
the portfolio. As more and more randomly selected stocks will be added to the portfolio, the dispersion of
the return will become smaller.
(2):
The implication for the investors is to create well diversified portfolios to minimize the risk. If the
portfolio is created with the stocks of same industry, then the portfolio will move with the industry and
the risk will remain as it is. If the stocks in the portfolio are somewhat negatively correlated, it can be
referred to as well diversified portfolio and it will reduce the standalone risk for the stocks.

Number of stocks
Portfolio with greater number of stocks

Portfolio with lower number of stocks

8%

Part H:
(1):
Creating portfolio of stocks would definitely change the way of thinking of the investors regarding the
riskiness of the individual stocks. The standalone risk or the diversifiable risk resembled by Standard
deviation or CV would not be more relevant since it can be omitted by preparing well diversified
portfolio. Alternatively the investor should be concerned about beta or market risk while dealing with
portfolio rather standalone risks.
(2):
Any investor will not be compensated for any standalone or diversifiable risk. Since any standalone stock
would be providing the same return with less risk if that is included in a portfolio, there is no scope for
additional compensation if the diversifiable risk is not diversified.

Part I:
(1):
The beta coefficient of any stock or portfolio refers to the expected movement of the return of the stock or
portfolio with respect to the market returns. Here market return denotes to the return of a portfolio
consisting of all the stocks in the market. To illustrate, it can be said that how the return of a stock or
portfolio changes against the return of the market. For example, if the beta of a stock is 1, then the return
of the stock will rise by 1% if the market return increases by 1% and vice versa. If the beta is negative,
then the return of the stock will move in the opposite direction to the market return.
Usually beta coefficient is used to measure the risk or the volatility in the return of any stock or portfolio.
Higher the beta higher the gain or loss compared to market return. From a portfolio perspective, beta
provides us an insight regarding inclusion or exclusion of any particular stock in the portfolio.
(2):
The expected return is strongly related to the market risk or beta. Higher the beta, higher the volatility in
the return and thus higher the expected return. Since High tech has the highest return, the beta is also
highest and so on for all the alternatives.
(3):
Since the information on required rate of return is not available, it is not possible till now to choose the
best alternative. If the required rate of return exceeds the expected return, we reject the alternative and if
expected return is greater than required rate of return, we keep the alternative under consideration.

Part J:
(1):
Equation of Security Market Line is as follows:
ri = rf + (rm – rf) × β
Where, ri = Required Rate of Return
rf = Risk free rate
rm = market rate of return
β = Beta coefficient of that stock

Stocks Calculation
Required
Rate
High Tech =0.03+(0.08-0.03)1.31 9.55%
Market Portfolio =0.03+(0.08-0.03)1 8.00%
US Rubber =0.03+(0.08-0.03)0.88 7.40%
T-bills =0.03+(0.08-0.03)0 3.00%
Collections =0.03+(0.08-0.03)-0.5 0.50%
 SML & Expected Returns
15.00%
Required & expected return (%)

9.9%
10.00%
8.0%

7.3%
5.00%

3.0%
1.2%

0.00%
-2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5

-5.00%

-10.00%
SML High Tech Market Portfolio US Rubber T-bills Collections

(2):

Stocks
Required Expected Calculation
Comment
Rate Rate
High Tech =0.03+(0.08-0.03)1.31 9.55% 9.9% Undervalued
Market Portfolio =0.03+(0.08-0.03)1 8.00% 8.0% Properly Valued
US Rubber =0.03+(0.08-0.03)0.88 7.40% 7.3% Overvalued
T-bills =0.03+(0.08-0.03)0 3.00% 3.0% Properly Valued
Collections =0.03+(0.08-0.03)-0.5 0.50% 1.2% Undervalued
If the expected rate of return is higher than the required rate of return, then the stock is considered as
undervalued, On the other hand, if the required rate of return is higher than the expected rate of return
then the stock is considered as overvalued.
(3):
Since the beta of Collections Inc., is negative, the required rate of return is less than the risk free rate. This
is highly unlikely in real life scenario, since it is almost impossible to find any stock with negative beta.
However, the stock of Collections Inc., will provide a huge diversification opportunity to the investors.
The risk of the portfolio will be drastically minimized if this stock is added to any portfolio due to its
negative beta.
(4):

Stocks Weight Beta Weighted Average

High Tech 50% 1.31 0.66
Collections 50% -0.5 -0.25
Portfolio Beta 0.41

Stocks Weight Beta Weighted Average

High Tech 50% 1.31 0.66
US Rubber 50% 0.88 0.44
Portfolio Beta 1.10

50-50 Portfolios Calculation Required Rate

Hight Tech and Collections =0.03+(0.08-0.03)0.405 5.03%
High Tech and US rubber =0.03+(0.08-0.03)1.095 8.48%

Part K:
(1):
If the investors raised their inflation expectation by 3%, then the risk free rate and market return will also
be increased by 3% individually but the market risk premium will be unchanged. As such, there will be an
upwards shift of SML by 3%. Subsequently, the upward shift of SML will increase the required rate of
return for all the low and high risk stocks by 3% as well.
(2):
If inflation remains constant and the market risk premium increases by 3%, then the SML will rotate
upwards, meaning the risk free rate will be same as before but the slope of the SML will be increased.
Due to the increase in slope, the SML will be much steeper which will lead to a rise in the required rate of
return for all the low and high risk securities. However, the required rate of return will rise higher for the
high risk securities compared to the low risk securities.