Seminar 5 Mini Case: Chapter 6

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.40 The client also has $2 million invested in the stock of Blandy,
Inc., a company that produces meat-and- potatoes frozen dinners. Blandys 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 clients 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:


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.


The risk-free rate is 4% and the market risk premium is 5%.

a. What are investment returns? What is the return on an investment that costs $1,000 and is sold after 1
year for $1,060?

A: According to the textbook on page 237, the formula is as follows:
Dollar Return = Amount to be Received Amount Invested

Therefore,

= $1,060 - $1,000
= $60

The percentage return would be 60/1000 which would be = .06 or 6%

b. Graph the probability distribution for the bond returns based on the 5 scenarios. What might the graph
of the probability distribution look like if there were an infinite number of scenarios (i.e., if it were a
continuous distribution and not a discrete distribution)?

A: I utilized the program StatDisk to find the probability distribution of the 5 scenarios. I graph it
using the scatterplot method. Below is what I found:



c. Use the scenario data to calculate the expected rate of return for the 10-year zero coupon Treasury
bonds during the next year.

A: According to page 237 of the textbook, the formula is as follows:

Rate of Return = Amount Received Amount Invested/Amount Invested

Therefore,

= $1,060 - $1,000/$1,000
= .6 or 6%
Taking that over the course of the next 10 years we can formulate the following:

= $1,060 - $1,000/(1 + .06) + $1,060 - $1,000/(1 + .06)
2
+ $1,060 - $1,000/(1 + .06)
3
+ $1,060 -
$1,000/(1 + .06)
4
+ $1,060 - $1,000/(1 + .06)
5
+ $1,060 - $1,000/(1 + .06)
6
+ $1,060 - $1,000/(1
+ .06)
7
+ $1,060 - $1,000/(1 + .06)
8
+ $1,060 - $1,000/(1 + .06)
9
+ $1,060 - $1,000/(1 + .06)
10

= 56.60377358 + 53.39978640 +50.37715698 + 47.52561979 +44.83549037 +42.29763243 +
39.90342682 + 37.64474228 + 35.51390781 + 33.50368661
= 441.6052231 or $442

d. What is stand-alone risk? Use the scenario data to calculate the standard deviation of the bonds return
for the next year.

A: According to the textbook on page 237, stand-alone risk is the risk an investor would face if
she held only this one asset. Most assets are held in portfolios, but it is necessary to understand
stand-alone risk in order to understand risk in a portfolio context (Ehrhardt & Brigham, 2014).
According to the textbook on page 240, the formula for the standard deviation is as follows:


Therefore,

= .10(-.14) + .20(-.04) + .40(.06) + .20(.16) +.10(.26)
= (-.014) + (-.008) + .024 + .032 + .026
= .06

Knowing that, the textbook states the formula for finding the standard deviation on page 240 as
well. The formula is as follows:



= [(-14 - 6)
2
(0.1) + (-4 - 6)
2
(0.2) + (6 - 6)
2
(0.4) + (16 - 6)
2
(0.2) + (26 - 6)
2
(0.1)]
0.5

= 120
0.5
= 10.95
= 3.30975092 or 3.31%

However, using the program StatDisk I found the standard deviaiton and variance to be as
follows:



Your client has decided that the risk of the bond portfolio is acceptable and wishes to leave it as it is.
Now your client has asked you to use historical returns to estimate the standard deviation of Blandys
stock returns. (Note: Many analysts use 4 to 5 years of monthly returns to estimate risk and many use 52
weeks of weekly returns; some even use a year or less of daily returns. For the sake of simplicity, use
Blandys 10 annual returns.)

A: Using the above information and the program StatDisk I formulate the variance and the
standard deviation to be the following:



Therefore the Standard Deviation = .2519347 or 25.2%

f. Your client is shocked at how much risk Blandy stock has and would like to reduce the level of risk.
You suggest that the client sell 25% of the Blandy stock and create a portfolio with 75% Blandy stock
and 25% in the high-risk Gourmange stock. How do you suppose the client will react to replacing some
of the Blandy stock with high-risk stock? Show the client what the proposed portfolio return would have
been in each of year of the sample. Then calculate the s average return and standard deviation using the
portfolios annual returns. How does the risk of this two-stock portfolio compare with the risk of the
individual stocks if they were held in isolation?

A: Based on the fact that the client is already upset with the not as risky Blandy stock,
implementation of an even riskier stock does not seem like a sound plan. I feel as though it may make
the investor unhappy about the decision. Once again using StatDisk, I combined the annuals together to
formulate a portfolio of the annual outcomes and found the following:



Therefore,

The average rate of return = .078 or 7.8 or 8% approximately
The standard deviation = .31909925 or 31.9 or 32% approximately

g. Explain correlation to your client. Calculate the estimated correlation between Blandy and
Gourmange. Does this explain why the portfolio standard deviation was less than Blandys standard
deviation?

A: According to the textbook on page 772, a correlation is the tendency of two variables to move
together. More specifically, a correlation coefficient is a standardized measure of how two
random variables convey. A correlation coefficient () of +1.0 means that the two variables
move up and down in perfect synchronization, whereas a coefficient of 1.0 means the variables
always move in opposite directions. A correlation coefficient of zero suggests that the two
variables are not related to one another; that is, they are independent (Ehrhardt & Brigham,
2014). Again using StatDisk, I found the correlation to be as follows:



Yes; the above information only supports the fact that the combination of the two portfolios did
allow for the standard deviation to increase as well as the average rate of return.

h. Suppose an investor starts with a portfolio consisting of one randomly selected stock. As more and
more randomly selected stocks are added to the portfolio, what happens to the portfolios risk?

A: According to the textbook on page 249, portfolio risk is affected by forming larger and larger
portfolios of randomly selected New York Stock Exchange (NYSE) stocks. Standard deviations
are plotted for an average one-stock portfolio, an average two-stock portfolio, and so on, up to a
portfolio consisting of all 2,000-plus common stocks that were listed on the NYSE at the time
the data were plotted. The graph illustrates that, in general, the risk of a portfolio consisting of
large-company stocks tends to decline and to approach some limit as the size of the portfolio
increases. According to data from recent years, 1, the standard deviation of a one-stock
portfolio (or an average stock), is approximately 35%. However, a portfolio consisting of all
stocks, which is called the market portfolio, would have a standard deviation of only about 20%.
Thus, almost half of the risk inherent in an average individual stock can be eliminated if the
stock is held in a reasonably well-diversified portfolio, which is one containing 40 or more
stocks in a number of different industries. The part of a stocks risk that cannot be eliminated is
called market risk, while the part that can be eliminated is called diversifiable risk.10 The fact
that a large part of the risk of any individual stock can be eliminated is vitally important, because
rational investors will eliminate it simply by holding many stocks in their portfolios and thus
render it irrelevant (Ehrhardt & Brigham, 2014).

References

Ehrhardt, M. C., & Brigham, E. F. (2014). Corporate Finance: A Focused Approach(5thth ed.). Mason,
OH: Cengage.