Joan McKay is a portfolio manager for a bank trust department. McKay meets with two clients, Kevin Murray and Lisa York, to review their investment objectives. Each client expresses an interest in changing his or her individual investment objectives. Both clients currently hold well-diversified portfolios of risky assets.
a. Murray wants to increase the expected return of his portfolio. State what action McKay should take to achieve Murray’s objective. Justify your response in the context of the capital market line.
b. York wants to reduce the risk exposure of her portfolio but does not want to engage in borrowing or lending activities to do so. State what action McKay should take to achieve York’s objective. Justify your response in the context of the security market line.
The Correct answer is:
a. Borrow funds and invest these proportionately in existing portfolios.
b. Substitute low beta stocks for high beta stocks to reduce the overall beta of York’s portfolio
McKay should borrow funds and invest those funds proportionally in the existing portfolio (i.e. buy more risky assets on margin).
Mckay should substitute low beta stocks for high beta stocks to reduce the overall beta of York’s portfolio. This will reduce the systematic risk of the portfolio and therefore the portfolio’s volatility relative to the market. This also meets the York’s objective of reducing risk exposure.
a. Suppose you forecast that the standard deviation of the market return will be 20% in the coming year. If the measure of risk aversion in Equation 5.13is A 5 4, what would be a reasonable guess for the expected market risk premium? b. What value of A is consistent with a risk premium of 9%? c. What will happen to the risk premium if investors become more risk tolerant? (LO 5-4)
Consider the following table, which gives a security analyst’s expected return on two stocks for two particular market returns:
a. What are the betas of the two stocks?
b. What is the expected rate of return on each stock if the market return is equally likely to be 5% or 20%?
c. If the T-bill rate is 8%, and the market return is equally likely to be 5% or 20%, draw the SML for this economy.
d. Plot the two securities on the SML graph. What are the alphas of each?
e. What hurdle rate should be used by the management of the aggressive firm for a project with the risk characteristics of the defensive firm’s stock?
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