Case ID: 292122

Solution ID: 22753

Words: 2185

Price $ 75

A manager of a small investment company has been successfully using index funds for limited market timing. Growth has allowed her to move into picking stocks. She is considering two small and highly variable listed stocks, but is concerned about the risk that these investments might add to her portfolio. Provides a lead-in to the CAPM. Students learn about total risk, non-diversifiable or portfolio risk, and (CAPM) beta, and calculate variability of the stocks separately, and portfolio variance with and without the stocks, to see how an extremely risky (but low-beta) stock actually reduces risk; and calculate stock betas.

Investment Return Data

*Month Vanguard 500 Index California REIT Brown Group Portfolio A* Portfolio B**

Mean, Standard Deviation

Beta

Applying CAPM, Riskfree Rate, Market Risk Premium, Monthly Expected Return

What is Wolfe’s current investment strategy? What kind of adjustment is she considering?

Calculate the variability (standard deviation) of the stock returns of California REIT (CREIT) and Brown Group (BG) during the past two years. How variable are they compared with Vanguard Index 500 Trust? Which stock appears to be riskiest?

Suppose Beta’s position had been 99% of equity funds invested in the index fund, and 1% in the individual stock. Calculate the variability of this portfolio using each stock. How does each stock affect the variability of the equity investment, and which stock is riskiest? Explain how this makes sense in view of your answer to Question 2 above.

Perform a regression of each stock’s monthly returns on the Index returns to compute the “beta” for each stock. This regression is called the Market Model in the literature. How does this relate to the situation described in Question 3 above?

How might the expected return for each stock relate to its riskiness?

What do you think about the move to a more active stock-picking strategy?

Try to derive the Capital Asset Pricing Model (CAPM) equation for the two stocks. Try to work out this question by assuming that Beta’s position had been 99% of equity funds invested in the index fund, and 1% in a riskless money market account. Imagine that you can switch from the money market account to CREIT, BG, or the index fund. Think about the condition for Sarah to be indifferent between switching to CREIT (or BG) and switching to the index.