Assume that you recently graduated with a major in finance and that you just landed a job as a financial planner with Barney Smith Inc., 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 new business that the client plans to start at the end of 1 year, you have been instructed to plan for a one year holding period. Further, your boss has restricted you to the investment alternatives shown in the table below. (Disregard for not the items at the bottom of the data: you will fill in the blanks later.)
Barney Smith’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program that was used to estimate the rate of return on each alternative under each state of the economy. Alta Industries is an electronics firm; Repo Men Inc. collects past-due debts; and American Foam manufactures mattresses and various other foam products. Barney Smith also maintains an “index fund” that owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund and thus obtain average stock market results. Given the situation as described, answer the following questions.
Table
Estimated Returns on Alternative Investments
State of the Economy
Probability
T-Bills
Alta Industries
Repo Men
American Foam
Market Portfolio
2-Stock Portfolio
Recession
0.1
8.0%
-22.0%
28.0%
10%
-13%*
3.0%
Below Average
0.2
8.0
-2.0
14.7
-10.0
1.0
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
Boom
0.1
8.0
50.0
-20.0
30.0
43.0
15.0
8.0%
1.7%
13.8%
15.0%
0.0%
13.4%
18.8%
15.3%
CV
7.9
1.4
1.0
b
-0.86
0.68
k) The expected rates of return and the beta coefficients of the alternatives, as supplied by Barney Smith’s compute program, are as follows:
Ecurity Return () Risk (Beta)
Alta Industries 17.4% 1.29
Market 15.0 1.00
American Foam 13.8 0.68
T-Bills 8.0 0.00
Repo Man 1.7 -0.86
(1) Do the expected returns appear to be related to each alternative’s market risk?
(2) Is it possible to choose among the alternatives on the basis of the information developed thus far?
L) (1) Write out the security Market Line (SML) equation, use it to calculate the required rate of return on each alternative and then graph the relationship between the expected and required rates of return? (2) How do the expected rates of return compare with the required rates of return? (3) Does it make sense that Repo Men has an expected return that is less than the T-Bill rate? (4) What would the market risk and required return of a 50-50 portfolio of Alta industries and Repo Men? Of Alta Industries and American Foam?
M) (1) Suppose investors raised their inflation expectations by 3 percentage points over current estimates as reflected in the 8% T-Bill rate. What effect would higher inflation have on the SML and on the returns required on high-and low-risk securities? (2) Suppose instead that investors’ risk aversion increased enough to cause the market risk premium to increase by 3 percentage points. (Assume inflation remains constant.) What effect would this have on the SML and on returns of high-and low-risk securities?
