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    Questions from Case study risk and return

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    Questions:
    1. Imagine you are Bill. Compute the expected rate of return and standard deviation of individual stocks and explain to Mary the relationship between risk and return.
    2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these concepts.

    Case:

    Risk and Return
    When Mary Owens' husband, Ralph, passed away about three months ago he left behind a small
    fortune, which he had accumulated by living a very thrifty life and by investing in common stocks.
    Ralph had worked as an engineer for a surgical instruments manufacturer for over 30 years and had
    taken full advantage of the company's voluntary retirement savings plan. However, instead of buying
    a diversified set of investments he had invested his money into a few high growth companies. Over
    time his investment portfolio had grown to about $900,000 being primarily comprised of the stocks of
    3 companies. He was very fortunate that his selections turned out to be good ones and after numerous
    stock-splits the prices of the three companies had appreciated significantly over time.

    Mary, on the other hand, was a very conservative and cautious person. She had devoted her life to
    being a stay-home mom and had raised their two kids into fine adults, each of whom had a fairly
    successful career. Jim, 28, had followed in Ralph's footsteps. In addition to being gainfully employed
    as an engineer, he was pursuing an MBA at a prestigious business school. Annette, 26, was
    completing her residency at a major metropolitan hospital. Although Mary and Ralph had enjoyed a
    wonderful married life, it was Ralph who managed almost all the financial affairs of their family.
    Mary, like many spouses of their generation, preferred to focus on other family matters.

    It was only after Ralph's passing on that Mary realized how unprepared she was for the complex
    decisions that have to be made when managing one's wealth. Upon the advice of her close friend,
    Agnes. Mary decided to call the broker's office and request that her account be turned over to Bill
    May, the firm's senior financial advisor. Agnes, a widow herself, had been very happy with Bill's
    advice and professionalism. He had helped her rebalance and re-allocate her portfolio with the result
    that her portfolio's value had steadily increased over the years without much volatility.

    At their first meeting, Bill examined the Owens' portfolio and was shocked at how narrowly
    focused its composition had been. In fact, just during the past year - due to the significant drop in the
    technology sector - the portfolio had lost almost 30% of its value. "Ralph, certainly liked to flirt with
    risk," said Bill. "The first thing we are going to have to do is diversify your portfolio and lower its
    beta. As it stands you could make a lot of money if the technology sector takes off, but the reverse
    scenario could be devastating. I am sure you will agree with me that given your status in life you do
    not need to bear this much of risk." Mary shrugged her shoulders and looked blankly at Bill.

    "Diversify....Beta...what are you talking about? These terms are new to me and so confusing. You
    are right, Bill, I don't need the high risk but can you explain to me how the risk level of my portfolio
    can be lowered?" Bill realized right away that Mary needed a primer on the risk-return tradeoff and on
    portfolio management. Accordingly, he scheduled another appointment for later that week and
    prepared Exhibit 1 to demonstrate the various nuances of risk, expected return, and portfolio
    management.

    Exhibit 1
    Expected Rate of Return
    Scenario Probability Treasury Bill Index Fund
    Utility
    Company
    High-Tech
    Company
    Counter-
    Cyclical
    Company
    Recession 20% 4% -2% 6% -5% 20%
    Near Recession 20% 4% 5% 7% 2% 16%
    Normal 30% 4% 10% 9% 15% 12%
    Near Boom 10% 4% 15% 11% 25% -9%
    Boom 20% 4% 25% 14% 45% -20%
    Beta 0 1 0.3 1.86 -1.54

    Questions:
    1. Imagine you are Bill. Compute the expected rate of return and standard deviation of individual stocks and explain to Mary the relationship between risk and return.
    2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these concepts.

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    Solution Preview

    Questions from Case study risk and return:

    1. Imagine you are Bill. Compute the expected rate of return and standard deviation of individual stocks and explain to Mary the relationship between risk and return.
    2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these concepts.

    Please see attached file for answers:
    The total risk of a portfolio (indeed of a security) consists of two parts: 1) Market (or systematic) Risk 2) Unique (or firm-specific) Risk
    Total risk = Systematic risk + ...

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