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Chapter 5 Case Study 1

Babita Mahat, a portfolio manager, seeks to evaluate the performance of two client portfolios against the market, leading to discussions on the superiority of the Orange portfolio over the Apple portfolio based on the capital market line. The document explores concepts of nonsystematic risk, required rates of return for stocks using CAPM, and the appropriate stocks for diversified versus single-stock portfolios. Additionally, it includes calculations for expected returns, betas, and hurdle rates for various stocks, emphasizing the importance of risk assessment in investment decisions.

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14 views8 pages

Chapter 5 Case Study 1

Babita Mahat, a portfolio manager, seeks to evaluate the performance of two client portfolios against the market, leading to discussions on the superiority of the Orange portfolio over the Apple portfolio based on the capital market line. The document explores concepts of nonsystematic risk, required rates of return for stocks using CAPM, and the appropriate stocks for diversified versus single-stock portfolios. Additionally, it includes calculations for expected returns, betas, and hurdle rates for various stocks, emphasizing the importance of risk assessment in investment decisions.

Uploaded by

sandeepsingh.y2018
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Chapter 5

Case Analysis Assets Pricing


Case 5.1 Models
Babita Mahat is a portfolio manager at Surya-Kiran & Associates. For all of her clients, Babita manages portfolios that lie on
the Markowitz efficient frontier. Babita asks Kabita Wagle, a managing director at Surya-Kiran, to review the portfolios of two
of her clients, the Apple Manufacturing Company and the Orange Life Insurance Co. The expected returns of the two
portfolios are substantially different. Kabita determines that the Orange portfolio is virtually identical to the market portfolio
and concludes that the Orange portfolio must be superior to the Apple portfolio.
a. Do you agree or disagree with Kabita's conclusion that the Orange portfolio is superior to the Apple portfolio? Justify your
response with reference to the capital market line.
b. Babita remarks that the Orange portfolio has a higher expected return because it has greater nonsystematic risk than
Apple's portfolio. Define nonsystematic risk and explain why you agree or disagree with Babita's remark.
c. Babita is now evaluating the expected performance of two common stocks, ABC Inc. and XYZ Inc for her new client. She has
gathered the following information:
• The risk-free rate is 5%.
• The expected return on the market portfolio is 11.5%.
• The beta1 of ABC stock is 1.5.
• The beta of XYZ stock is 0.8.
Based on her own analysis, Babita's forecasts of the returns on the two stocks are 13.25%for ABC stock and 11.25% for XYZ stock. Calculate
the required rate of return for ABC stock and for XYZ stock. Indicate whether each stock is undervalued, fairly valued, or overvalued.
d. Babita is using the capital asset pricing model for making recommendations to her one of the new clients. Her research
department has developed the information shown in the following exhibit.
Portfolio Forecast Return Standard Beta
Deviation
Stock X 14% 36% 0.8
Stock Y 17 25 1.5
Market Index 14 15 1.0
Risk-free rate 5 - -
i. What are the expected return and alpha for each stock?
ii. Identify and justify which stock would be more appropriate for an investor who wants to add this stock to a well-diversified equity
portfolio?
iii. Identify and justify which stock would be more appropriate for an investor who wants to hold this stock as a single-stock portfolio?

e. Babita is considering a security analyst's expected return on two stocks for two particular market returns.
Market Stock A's Return Stock B's Return
return
6% -4% 8%
30 40 16
i. What are the betas of the two stocks?
ii. What is the expected rate of return on each stock if the market return is equally likely to be 6% or 30%?
iii. If the T-bill rate is 6 percent and the market return is equally likely to be 6% or 30%, draw the SML for this economy.
iv. Plot the two securities on the SML graph? What are the alphas of each?
v. What hurdle rate should be used by the management of the aggressive firm for a project with the risk characteristics of the defensive
firm’s stock?
Solution 5-1
a. Kabita's analysis revealed that Orange portfolio is identical to the market portfolio. It implies that Orange portfolio lies on
the capital market line and any portfolio along the capital market line is perfectly correlated with the market. Thus, we agree
with Kabita's conclusion that the Orange portfolio is superior to the Apple portfolio.

B .Nonsystematic risk is the nonmarket or firm-specific risk factors that can be eliminated by diversification. It is also called
unique risk or diversifiable risk. Nonsystematic risk is unique to a specific company or industry and it is not correlated to the
market. Babita's remark that Orange portfolio has higher expected return because it has nonsystematic risk than Apple
portfolio is not acceptable remark. Since Orange portfolio is identical to the market portfolio, the nonsystematic risk remains
fully diversified away.
c. Given,
The risk-free rate = 5%
The expected return on the market portfolio, = 11.5%
Beta of ABC Stock = 1.5
Beta of XYZ Stock = 0.8
Stock Required Forecasted Returns Remarks
return

The required return on ABC Stock as per CAPM is higher


ABC 14.75% 13.25% than forecasted return. It implies that this stock offers
negative excess return meaning that it is overvalued.

The required return on XYZ Stock as per CAPM is lower than


XYZ 10.20% 11.25% forecasted return. It implies that this stock offers positive
excess return meaning that it is undervalued.
d. i. The expected return (CAPM return) and alpha (excess return) for each stock:
(1) (2) (3) Alpha
Stock Forecast Return CAPM Return E(Ri) = RF + [E(RM) - RF] (i) (2)-(3) Remarks

X 14% = 5% + [14% - 5% ](0.85)= 12.2% 1.8% Undervalued

Y 17% = 5% + [14% - 5% ](1.5)= 18.5% -1.5% Overvalued

ii. The level of systematic risk associated with Stock X as indicated by beta coefficient is lower. If an individual asset is added
to a well diversified portfolio, the risk that asset contributes to the well diversified portfolio is only the systematic risk.
Therefore, it would be more appropriate to an investor to add Stock X to a well diversified portfolio.

iii. The level of total risk associated with Stock Y as indicated by standard deviation is lower. If an investor wants to hold the
stock as a single stock portfolio, total risk is relevant. Therefore, it would be more appropriate to the investor to hold Stock
Y as a single stock portfolio.
i. Calculation of Beta coefficients for two stocks:
For Stock A For Stock B
If market return is 6%: If market return is 6%:

…… (i)

If market return is 30%:

…… (ii)

Now, solving Equation (i) and (ii), we get


ii. If the market return is equally likely to be 6% or 30%,
The expected return on stock A = (0.5)(-4%) + (0.5)(40%) = 18%
The expected return on stock B = (0.5)(8%) + (0.5)(16%) = 12%

iii. If T—bill rate (RF) is 6% and the market return is


equally likely to be 6% or 30%,
The expected market return is:

iv. Graph of the Security Market Line and position of two stocks

The alpha for Stock A


= Expected return on A - Required return on A
= 18% -28% =-10%

The alpha for Stock B


= Expected return on B - Required return on B
= 12% - 10% = 2%
the Hurdle rate is the minimum return an investment needs to earn to be considered a good
investment. When calculating alpha, the hurdle rate is usually the return you expect based on
how risky the investment is, which is predicted by a model like CAPM.

Example:
 Say you invest in a stock.
 Based on its risk (measured by beta) and the market's performance, you expect it to earn
8%. This 8% is the hurdle rate.
 If the stock actually earns 10%, the difference (10% - 8%) = 2% alpha. This means it
outperformed your expectation.

In short:
 Hurdle rate = the expected return.
 Alpha = how much the investment beats (or falls short of) this expected return.

v. The hurdle rate is determined by the project beta (0.3333), not the firm's beta. The correct discount rate is 10%, the
required return for stock B.

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