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Joyce Ann Buenavista

on 5 February 2014

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Question 6
Suppose an investor starts with a portfolio consisting of one randomly selected stock
Table 1: Estimated Total Returns
(Value Line Investment Survey)
Question 1
Question 2
Question 4
Case Overview
Peachtree Securities

regional brokerage house based in Atlanta
its goal is to provide quality personal brokerage services to small investors
Peachtree had no in-house security analysts
All stock and bond selections were base on research provided by subscription services
However, subscription services became very costly
Because of this, Peachtree hired an in-house analyst since it is cost effective
The position was created to track industry which Peachtree were heavily weighted a which is electric utilities
TECO Energy, Inc.
the stock of primary interest
holding company for Tampa Electric

Gold Hill
a domestic gold mining company

S&P 500 Fund
a mutual fund that invests in the stocks which make up the S&P 500 index
Why is the T-bond return in Table 1 shown to be independent of the state of economy? Is the return on a 1-year T-bond risk-free?
The T-bond return does not depend on the state of the economy because the treasury must (and will) redeem the bills at par regardless of the state of the economy.

T-bond is issued by the government and investors are certain to receive returns at the promised rate. T-bonds are considered to have low risk depending on the duration of the bond and compared to other marketable securities. The longer the term, the more it is sensitive to fluctuation of interest rates.
Calculate the expected rate of return on each of the four alternatives listed in Table 1. Based solely on expected returns, which of the potential investments appears best?
Expected rate of return

The rate of return expected on an asset or a portfolio.
It is calculated by taking the average of the probability distribution of all possible returns.
Question 3
Calculate the standard deviations and coefficients of variation of returns for the four alternatives. What type of risk do these statistics measure? Is the standard deviation or the coefficient of variation the better measure? How do the alternatives compare when risk is considered?
Standard Deviation
a statistical measurement in investment's volatility (risk)
used to gauge for the amount of expected volatility
high standard deviation = volatile investment
computed by getting the square root of variance
Coefficient of Variation
allows you to determine how much volatility (risk) you are assuming in comparison to the amount of return you can expect from your investment
the lower the ratio of standard deviation to mean return, the better your risk-return tradeoff.
if the expected return in the denominator of the calculation is negative or zero, the ratio will not make sense.

Suppose an investor forms a stock portfolio by investing $10,000 in Gold Hill and $10,000 in TECO
What would be the portfolio's expected rate of return, standard deviation, and coefficient of variation? How does this compare with values for the individual stocks? What characteristic of the two investments makes risk reduction possible?
What do you think would happen to the portfolio's expected rate of return and standard deviation if the portfolio contained 75% Gold Hill? If it contained 75% TECO? If you are using Lotus 1-2-3 model for this case, calculate the expected returns and standard deviations for a portfolio mix of 0% TECO, 10% TECO, 20% TECO, and so on, up to 10% TECO.
Question 5
Now consider a portfolio consisting of $10,000 in TECO and $10,000 in the S&P 500 Fund. Would this portfolio have the same risk-reducing effect as the Gold Hill-TECO portfolio considered in Question 4? Explain. If you are using Lotus model, construct a portfolio using TECO and the S&P 500 Fund. What are the expected returns and standard deviations for a portfolio mix of 0% TECO, 10% TECO, 20% TECO, and so on, up to 100% TECO?

What would happen to the portfolio's risk if more and more randomly selected stocks were added?
The more an investor adds to its portfolio, the more it spreads the risks among its investments. Since these stocks are uncorrelated, being randomly picked, the risk of the two stocks may offset each other. The more diversified a portfolio is the higher the chance of avoiding risks.
What are the implications for investors? Do portfolio effects impact the way investors should think about the riskiness of individual securities? Would you expect this to affect companies' costs of capital?
Investors must look at the portfolio as a whole and not as individual investments. Combination of seasonal and nonseasonal or combination of positively correlated and negatively correlated stocks will improve a company’s portfolio. Failure to combine the right assets will affect the company’s cost of capital. Assets should compliment each other’s return on asset performance
Explain the differences between total risk, diversifiable (company-specific) risk, and market risk
Total risk is the combination of diversifiable and non diversifiable risk. Nondiversifiable risk or market risk are the company’s risk which cannot be eliminated; examples are, war, inflation, political events and international incidents. Diversifiable risk are assets which can be eliminated since the causes of these are random. Examples are strikes, lawsuits, regulatory actions and loss of a key account.
Assume that you chose to hold a single stock portfolio. Should you expect to be compensated for all of the risk that you bear?
Every investment has its corresponding risk. Since, I chose to hold a single stock, I should expect to bear all the risk the stock brings. Every investment compensates an investor if the company knows that what it offers is considered risky. I as an investor must be responsible enough to research on assets I am investing before putting my money in it. Higher risk gives higher rate of return, lower risk gives lower rate of return.
Treasury Bond
A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.
Risk free because it is guaranteed by the US Government
Significance of Treasury:
Recession: Treasuries rates are down, demand is high because investors are willing to accept a low yield in return for lower risk
Bull Market or Economy headed for expansion: low demand on Treasuries because there are other investments which are relatively safe; rates are higher
tendency of how assets move together
Correlation Coefficient
measure the degree of relationship between two variables
Perfectly negatively correlated: -1.0

Perfectly positively correlated: +1.0

Independent: 0
TECO-GOLDHILL: negative correlation

TECO- S & P 500: positive correlation
Riskiness of portfolio does not only depend on the SD of the individual stocks, but also on the correlation between the stocks
Diversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks.
Diversification can reduce risk, but not eliminate it.
The Standard Deviation is an absolute measure of risk while the Coefficient of Variation is a relative measure. The coefficient is more useful when using it in terms of more than one investment. They have different returns on average which means the standard deviation may understate the actual risk or overstate depending
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