Case Analysis
Beta Management Company
Submitted by: Biwesh Neupane, Dev Raj Dhungana
Mingma Sherpa (Lama), Shrawan Regmi

Introduction

Analysis

Using excel, we calculated following mean and standard deviation for the two stocks
and the index. The calculations are shown in  Appendix I.

Stock Vanguard Index California REIT Brown Group

500 Trust

Monthly Mean 1.1025% -2.265% -0.671%

Monthly Standard 4.61% 9.23% 8.17%

Deviation (STD)

  The two individual stocks have almost double the variability than the Vanguard
Index 500 Trust. This means that the stocks are riskier than the Vanguard Index 500
 Trust in terms of the variability or deviation from the mean.

However, individual standard deviation is not a proper measure of risk. Since, we

are creating a portfolio consisting of Vanguard Index 500 Trust and one of the two
indivi
individu
dual
al stocks
stocks we need
need to cacalcu
lculat
late
e the portfo
portfolio
lio varian
variance
ce which
which is a better
better
measure of risk. We know that,

2 2 2 2 2
σ  p = w1 σ 1 + w2 σ 2 + 2 w1 w2 Cov(r 1 , r 2 ) = w12σ 12 +
2
w2 σ 2
2
+ 2 w1 w2σ 1σ 2 ρ 12

Where,

= variance
2
σ  

= standard deviation
σ  

W = Weight for stock in the portfolio

Cov (r1,r2) = covariance between the return of the two stocks in portfolio

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= coefficient of correlation among the stock

 ρ 

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 Therefore,

Stock Vanguard Index California REIT Brown Group

500 Trust

Covariance 0.0003 0.0024

Monthly Standard 4.61% 9.23% 8.17%

Deviation (STD)

Coefficient of  0.0735 0.6562

correlation

Now, we know that Ms. Wolfe is considering investing $200,000 in either California
REIT or Brown Group making her equity exposure to $20 million out of her total
investment of $25 million. For simplicity, we can safely assume that about 1% of her
equi
eq uity
ty expo
exposu
sure
re wi
will
ll be inve
invest
sted
ed Cali
Califo
forn
rnia
ia REIT
REIT or Brow
Brown
n Grou
Groupp and
and rest
rest in
Vanguard Index 500 Trust.
a) Calculation of portfolio
portfolio variance
variance (99% Vanguard, 1% California
California REIT)
REIT)
2 2 2 2
= 0.99 x 0.0461 + 0.01 x 0.0923 + 2 x 0.99 x 0.01 x 0.0003 = 0.002081
Portfolio standard Deviation
= 0.002081 ½ = 4.57%
b) Calculation of portfolio
portfolio variance
variance (99% vanguard, 1% Brown
Brown group)
group)
2 2 2 2
= 0.99 x 0.0461 + 0.01 x 0.0817 + 2 x 0.99 x 0.01 x 0.0024 = 0.0021221
Portfolio standard Deviation
= 0.0021221 ½ = 4.61%

Looking at these figures, we can see that the portfolio variance for Brown group is
greater than that for California REIT. Thus, Brown group stocks have more variability
to the portfolio than the California REIT. Thus, Brown Group stock is more risky.
However, it contradicts with the previous answer when only looking at individual
standard deviation we found that California REIT is more risky. This is because
covariance or correlation among the stocks is more important to determine the
riskiness of portfolio than the individual stocks. Since, Brown is more positively
correlated to Vanguard than the California REIT it increases the overall portfolio risk.
In other words, since Covariance between the Brown's stock and Vanguard is almost
8 times than between California REIT and Vanguard, the portfolio that includes
Brown is riskier.

Now, let us base our analysis on Capital Assets Pricing Method (CAPM). We know
that,

E(Ri) = Rf +[E(Rm)-Rf )]β
)]β

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Where,

E(Ri) = Expected return on capital assets

Rf = Risk free rate of return

E(Rm) = Expected Return on market

β = is the sensitiv
sensitivity
ity of the expected
expected excess asset returns to the expected
expected excess
market returns

Now, the calculation of beta (β)

a) Beta of Californ
California
ia REIT = Cov (Rm, Ri)/var(
Ri)/var(Rm)
Rm)
2
= 0.0003/0.0461
= 0.1411
b) Beta of Brown
Brown = Cov (Rm, Ri)/var(
Ri)/var(Rm)
Rm)
= 0.0024/0.04612
= 1.13

We know
know that
that lo
lowe
werr the
the beta
beta,, le
less
ss se
sens
nsit
itiv
ive
e th
the
e stoc
stock
k woul
wouldd be to marke
arkett
movements. Hence, higher the beta, riskier is the stock. This is consistent with our
second analysis that Brown Group's stock is more risky since its beta is higher than
that of California REIT's.

In terms of the expected return on capital assets, we can see that the Brown
Group's stock should have higher expected return than California REIT's. One of the
major issues in determining the expected return on capital assets is to use the right
risk free rates. Different authors have different view regarding the use of risk free
rate. Some researchers use short term treasury bills rate as a risk free rate where
as some researchers use long term treasury bills rate. In our case, we have used 10
1

year Treasury bond rate as the measure of the risk free rate.
 The coupon rate for 10 year US Treasury Bill is 2% ( Shown in Appendix II). Likewise
we should use effective annual rate for market return.

(1+0.010125)12 -1 =14.06%
Effective expected annual rate of return E(Rm) = (1+0.010125)

a) Expected return
return for California REIT = 2% + 0.1411(14.06%-2%)
0.1411(14.06%-2%) = 3.7016%
b) Expected return
return for Brown
Brown Group = 2% + 1.13 (14.06%
(14.06% - 2%) = 15.628%

 Thus, we can see that the expected return for Brown Group is higher than that of 
California REIT, this is primarily because the beta for Brown Group is higher. When

1 Brigham, Eugene F., Houston, Joel F., " Fundamentals of Financial Management", 7th
Fundamentals
Edition, Cengage Learning

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an investor wants to invest in Brown Group they will demand extra premium for the
extra risk they take. Hence, the expected return for Brown is higher. This follows the
basic principle of risk and return, which is higher the risk higher the return.

Now, it depends on the risk bearing capacity of investors to decide which stock to
invest in. A risk averse investor, as a universal assumption, would choose to reduce
its risk through portfolio diversification. In this case,
case, it is better
better for Ms. Wolfe
Wolfe to
invest in California REIT, since it lowers the risk of the overall portfolio.

Conclusion

 The case is a very good example of the use of portfolio to diversify and reduce risk.
When we consider
consider the individu
individual
al stocks, Brown and Californ
California
ia REIT and market
market
index individually, the standard deviation of each is around 8.17%, 9.23% and 4.6%,
repres
represent
enting
ing Califo
Californi
rnia
a REIT
REIT as risky
risky stock.
stock. But when
when we add small
small amoun
amountt of 
individual stock to the market index, we find that the portfolio variance declines.
Howev
Ho wever,
er, the portfo
portfolio
lio riskin
riskiness
ess declin
declines
es when
when we add Califo
Californi
rnia
a REIT
REIT to the
the
portfolio. The risk
riskine
iness
ss of a sto
stock
ck is bes
bestt mea
measu
sured
red by its covaria
covarianc
nce
e wit
with
h the
market, rather than its own variance
variance.. As can be seen in the analysis, the covariance
between the new asset and the portfolio, rather than the variance of the assets,
matters more to the total risk of the final portfolio. In other words, individual risk
can be diversified away in a portfolio.
portfolio. But the market risk has to be held by the
investors and they expect some risk premium for taking the market risk. Hence, the
expected return for risky assets is greater than that of less risky assets.

  To conclude
conclude,, while
while decidi
deciding
ng on the stock
stock to add on portfo
portfolio
lio,, individu
individual
al stoc
stock
k
variance matter less. Hence, investor or broker should look at the portfolio variance.
In this case as well, it is better for Ms. Wolfe to invest in California REIT than in
Brown Group's stock.

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Appendix I

Van- California
Month Index REIT Brown
 Jan 7.32 -28.26 9.16
Feb -2.47 -3.03 0.73
March 2.26 8.75 -0.29
April 5.18 -1.47 2.21
May 4.04 -1.49 -1.08
 June -0.59 -9.09 -0.65
1989
 July 9.01 10.67 2.22
August 1.86 -9.38 0
September -0.4 10.34 1.88
October -2.34 -14.38 -7.55
November 2.04 -14.81 -12.84
December 2.38 -4.35 -1.7
 Jan -6.72 -5.45 -15.21
Feb 1.27 5 7.61
March 2.61 9.52 1.11
April -2.5 -0.87 -0.51
May 9.69 0 12.71
 June -0.69 4.55 3.32
1990
 July -0.32 3.48 3.17
August -9.03 0 -14.72
September -4.89 -13.04 -1.91
October -0.41 0 -12.5
November 6.44 1.5 17.26
December 2.72 -2.56 -8.53
-
2.26541666
Mean 1.1025 7 -0.67125
4.6063436 9.23073598 8.1667711
Standard Deviation 88 2 21
Covariance between Vanguard and 2.99628854 23.655903
Individual stocks 2 13
0.6561697
Correlation 0.07353166 66
1.1293001
Beta 0.14116252 63

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Appendix II

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