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    Risk and Return in the Market Place

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    1. Calculate the weighted average beta of the portfolio of stocks.

    2. Determine if and how the portfolio construction would change by using an alternative asset allocation strategy

    Economics questions

    QUESTION 1A with examples to reinforce your ideas.


    Choose a publicly traded company, and discuss the use of derivatives as a means to manage risk and enhance returns. In your answer, discuss how options, forwards, and futures can be used to manage the risk of the selected company.


    Discuss the historical risk and return of various investments such as stock and bonds, precious metals and gems, real estate, and artwork in terms of the following:
    • Asset return and total risk
    • Return and systematic risk
    • Return and unsystematic risk

    Discuss the concept of investing including an explanation of various types of risk and return in the marketplace. To illustrate the development of a portfolio, construct a portfolio of investment securities by selecting 3 to 5 Fortune 500 stocks and 3 to 5 AAA rated corporate bonds. The goal is to diversify the portfolio as much as possible given the constraints on the number of securities used in this example. The criteria to be used include the investor demographics, asset allocation strategy and risk tolerance provided to each student individually by the instructor in the first week. Please list the characteristics provided along with your answer to the following:

    1. Calculate the weighted average beta of the portfolio of stocks.

    2. Determine if and how the portfolio construction would change by using an alternative asset allocation strategy.

    3. Assume your marital status has changed (i.e. if original single you are now married and if married you are now single), explain how this will impact your asset allocation, goals and the amount needed to invest for retirement?

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    Solution Preview

    1. Let's pick Walmart as the example. We will look at how Walmart and can use options to enhance return, and use forwards and futures (which in this particular case will be the same) to hedge risk.

    For a company like Walmart, its daily cash flows are enormous. Often Walmart sells goods to consumers (and get paid immediately) but does not pay the supplier until a certain volume of these goods are reached. As such, Walmart has lots of short term cash available which they can invest. Using options wisely can greatly increase the short term returns of Walmart (this is called leverage). Consider the following example: Walmart has some cash (say 1 million) which they don't have to pay their suppliers until 2 weeks later. Walmart decides to buy some stocks. Here note that Walmart must choose their investments carefully because they cannot suffer any loss (assume that in this case Walmart does not have any extra cash other than the 1M immediately available in case of losses) because otherwise they don't have money to pay suppliers and that would damage Walmart's reputation. Say that Walmart gets a good deal with a bank would sell Walmart a 2 week bond that costs 999K and return 1M 2 weeks later. This secures that Walmart will have at least 1M by the time it needs to pay the suppliers. There is 1K left that Walmart can invest in any way it wants. If Walmart invests this 1K by buying options, then this greatly increases their chance to achieve bigger returns. Of course the downside is options are also risky and Walmart may lose the entire 1K, but this doesn't really matter because they are going to get another 1K in the form of interest from the bond. This is an example of enhancing returns with options.

    In the second example, suppose that Walmart imports some products from Vietnam. Suppose further that Walmart expects the currency of Vietnam to appreciate in the next 6 months. To protect (or to hedge) their operations, Walmart may choose to buy some currency forwards (or futures) where they get a fixed exchange rate for the next year. This eases Walmart's planning process, because they don't have to worry about ...

    Solution Summary

    The solution discusses the risk and return in the market place.