Question

Suppose you are acting as a financial adviser for a client. The client wishes to build aportfolio of sharesand has sought your service. The client wishes to invest in the following companies' shares, and you have the following information (sourced from https://au.finance.yahoo.com/) about these shares:

Company	Closing Price: 2 Jul 2018	Closing Price: 28Feb 2020	Dividend Payments between 2 Jul 2018 and28 Feb 2020
Westpac Banking Corporation (WBC.AX)	$29.18	$23.64	12 Nov 2019: $0.80 16 May 2019: $0.94 13 Nov 2018: $0.94
Commonwealth Bank of Australia (CBA.AX)	$72.70	$81.78	19 Feb 2020: $2.00 14 Aug 2019: $2.31 13 Feb 2019: $2.00 15 Aug 2018: $2.31
National Australia Bank Limited (NAB.AX)	$27.41	$25.10	14 Nov 2019: $0.83 14 May 2019: $0.83 08 Nov 2018: $0.99

The client will purchase 500 shares of WBC.AX, 1,000 shares of CBA.AX, and 800 shares of NAB.AX at respective closing prices of 28 Feb 2020.

Then answer the following.

1. Suppose an investor bought some shares of each of these companies on 2 Jul 2018 for the respective closing prices. The investor then sold these shares on 28 Feb 2020for the respective closing prices. The investor also received any dividends paid between these dates for each of the companies. What is the holding period return for each of these companiesconsideringthe stated purchase and sale prices and dividends?                                                           [3 Companies x 1 marks = 3 marks]
2. Assume that the holding period returns for these companies' shares, as determined in (a), are also the expected returns of these shares (i.e., assets) for the foreseeable future. With such an assumption, determine the expected return of your client's portfolio.                                [4.5 marks]
3. Suppose the risk-free rate of return is 2.50%, and the expected rate of return from the market is 17%. For the expected return of the portfolio determined in (b), determine the beta of the portfolio.      
                                                                                                                                                                                   [3 marks]
4. You may have noted that your client wishes to invest in companies all belonging to the same industry (i.e., banking and financial institutions). Do you think such type of diversification with all investments in the same industry is a good idea to reduce risks? Why or why not? Explain.       [4.5 marks]

Answer 1

Solution:

a) Holding period yield(HPY) = (Dividend + Change in price) / Purchase price * 100

Company	Cl. Price 2 Jul 2018	Cl. price 28 Feb 2020	Change in price	Dividend	Holding period return
WBC.AX	29.18	23.64	-5.54	2.68	-9.80%
CBA.AX	72.7	81.78	9.08	8.62	24.34%
NAB.AX	27.41	25.1	-2.31	2.65	-1.24%

b) Weights of each share in the client's portfolio.

Company	No. of shares	price	Total	weight (W) = total / 113,680
WBC.AX (A)	500	23.64	11,820	0.1040
CBA.AX (B)	1000	81.78	81,780	0.7194
NAB.AX (C)	800	25.1	20,080	0.1766
	Total		113,680

Assuming the client will hold shares in the portfolio for the same holding period as was in (a) above

Therefore Expected return on portfolio based on HPY calculated in (a) above are

Rp = WA * HPYA + WB * HPYB  + Wc * HPYc

= 0.1040 * -9.8% + 0.7194 * 24.34% + 0.1766 * -1.24%

= -1.02% + 17.51% + (-0.22)

= 16.27%

So, Return on portfolio = 16.27%

c) we have Rf= 2.5%, Return from maarket(Rm) = 17%, Expected return on portfolio in (b) above Rp = 16.27%

So as per CAPM

Rp = Rf + (Rm - Rf) * beta

16.27 = 2.5 + (17 - 2.5) * beta

16.27 - 2.5 = 14.5 * beta

beta = 13.77 / 14.5

beta = 0.9496 i.e 0.95

d) The diversification in the same industry is not a good idea to reduce risks because with such type of diversification there remains an unsystematic risk that is specific to company or industry. There is a two type of risk involved in this diversification which is the business risk & financial risk.

For eg: If there are consistent willful defaulters are arising in banking due to falling GDP or slowdown in an economy this will affect the financial position of banks and will have an impact on its stock & your entire portfolio will drop.

On the other hand, if you diversify in various sectors such as FMCG, Pharmaceuticals, Chemicals industry, etc. it will eliminate unsystematic risk thereby reducing risk substantially.