Question

Question Two

James is aspiring to become an MP (Member of Parliament) in Ghana and he has realized a basic knowledge in Development Finance would help him to be effective in the House even though this is not a condition precedent to him receiving his salary and something called ex-gratia at the end. He however, developed an extra interest in portfolio theory from financial management lecture. His friend, who is already an MP had a certain amount of money to invest in a microfinance institution but James impressed on his friend to wait until he was done with the Development Finance programme. He sat his friend down and advised him to invest 1/3 of his money in Political Party A with an expected return of 20% and a standard deviation of 16% and the rest in Political Party B with an expected return of 18% and a standard deviation of 12%. James told his friend correlation coefficient between political parties is fundamental to risk reduction and that the figure for these political parties is 0.4. James assured his friend this is a better investment than investing in a microfinance institution. His friend however told James he would only take his advice after he has been able to pass the MDEF 625: Corporate Finance, Governance and Investment

1. What are the expected return and standard deviations of this portfolio?
2. Is this portfolio better or worse off than one invested entirely in political party A, or is not possible to say?
3. The Treasury bill rate is 14 percent, and the expected return on the market           portfolio is 22 percent. Using the capital asset pricing model answer the following:
4.      i.        What is the required return on an investment with a beta of 1.5?

      ii. If an investment with a beta of 0.8 offers an expected return of 9.8 percent, does it have a positive NPV?

iii. If the market expects a return of 21.2 percent from stock X, what is its beta?

Answer 1

a. Expected Return and SD = 18.86% & 11.47 %

b. It is better than entirly invested in Security A or B as the standard deviation is less.

c. According to CAPM Required Return = Riskfree return + Beta (Market Return - Risk free Return)

i) Ret = 14% + 1.5 (22-14) = 26%

(ii) Ret = 14% + 0.8(22-14) = 20.4%. Since expected return (9.8%) is less than CAPM Return (20.4), the NPV would be negative.

(iii) 21.2 = 14 + Beta(22-14) => Beta = 21.2-14 / 8 = 0.9

Calculations are shown below:

Portfolio Return and Portfolio Standard Deviation with 2 Securities

Portfolio Standard Deviation =

where Wa = Weight of stock a ; Wb = Weight of Stock B; σa = Standard deviation of stock A; σb = Standard deviation of stock B; rab = Correlation Coefficient between a & b