Question

Assume that you recently graduated and landed a job as a financial planner with Cicero Services, an investment advisory company. Your first client recently inherited some assets and has asked you to evaluate them. The client has $2 million invested in the stock of Blandy, Inc., a company that produces meat-and-potatoes frozen dinners. Blandy’s slogan is “Solid food for shaky times.” Unfortunately, Congress and the president are engaged in an acrimonious dispute over the budget and the debt ceiling. The outcome of the dispute, which will not be resolved until the end of the year, will have a big impact on interest rates one year from now. You have also gathered historical returns as follows for the past 10 years for Blandy, Gourmange Corporation (a producer of gourmet specialty foods), and the stock market. The risk-free rate is 4% and the market risk premium is 5%.

	Historical Stock Returns
Year	Market	Blandy	Gourmange
1	30%	26%	47%
2	7	15	−54
3	18	−14	15
4	−22	−15	7
5	−14	2	−28
6	10	−18	40
7	26	42	17
8	−10	30	−23
9	−3	−32	−4
10	38	28	75
Average return:	8.00%	?	9.20%
Standard deviation:	20.10%	?	38.60%
Correlation with market:	1	?	0.678
Beta:	1	?	1.3

Based on the information provided above, complete the following:

1. Suppose an investor starts with a portfolio consisting of one randomly selected stock. How to measure the risk and return given different scenarios for a particular stock? What are the criteria the investor should consider to choose a single stock to invest? As more and more randomly selected stocks are added to the portfolio, what happens to the portfolio’s risk? How does correlation affect your portfolio return and risk? Calculate the numbers with questions marks and the estimated correlation between Blandy and Gourmange using the data in the above Table. Does this explain why the portfolio standard deviation was less than Blandy’s standard deviation?

Answer 1

Ans :

Suppose an investor starts with a portfolio consisting of one randomly selected stock. How to measure the risk and return given different scenarios for a particular stock? What are the criteria the investor should consider to choose a single stock to invest?

Risk measured by standard deviation of its return. To measure Risk and return of any financial assets one should calculate the Return to Risk ratio. Or Sharpe Ratio of the Portfolio/assets. Sharpe ratio measure

Sharpe Ratio = ( Expected Return - Risk free rate) / Standard Deviation

Investor always should choose risk adjusted return over any higher return portfolio for any investement purpose.

Ans :

As more and more randomly selected stocks are added to the portfolio, what happens to the portfolio’s risk? How does correlation affect your portfolio return and risk?

As more and more randomly selected stocks are added to the portfolio standard deviation of return will be much less. In short, its risk will be reduced to a certain level if we keep on adding more and more randomly selected stocks in portfolio.

Suppose two stocks are positively co-related. So In good economic conditions, both will perform well. But in Bad weather, both will perform worse. This is why it is always advisable to maintain some negatively correlated stocks in portfolio to reduce overall risk.

Calculate the numbers with questions marks and the estimated correlation between Blandy and Gourmange using the data in the above Table. Does this explain why the portfolio standard deviation was less than Blandy’s standard deviation

• Average Return = We have Used Average Function in Excel to Calculate Average Return
• Standard deviation = We have Used Standard Deviation Function   in Excel to Calculate Average Return
• Correlation with market = Correlation of Return between Market and Stock. Used CORREL function
• Beta = Correlation of Stock * ( Standard Deviation of Stock /  Standard Deviation of Market)

As we have added both of the stocks in Portfolio its risk will be reduced . So overall standarddeviation of the portfolio will be less than individual stock of Blandy & Gourmange
.