Gregory is an analyst at a wealth management firm. One of his clients holds a $7

Question

Gregory is an analyst at a wealth management firm. One of his clients holds a $7,500 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table:

Lorenzo calculated the portfolio’s beta as 0.845 and the portfolio’s expected return as 12.34%.

Lorenzo thinks it will be a good idea to reallocate the funds in his client’s portfolio. He recommends replacing Atteric Inc.’s shares with the same amount in additional shares of Baque Co. The risk-free rate is 6%, and the market risk premium is 7.50%.

According to Lorenzo’s recommendation, assuming that the market is in equilibrium, how much will the portfolio’s required return change?

a) 0.20% points

b) 0.26% points

c) 0.30% points

d) 0.32% points

Analysts’ estimates on expected returns from equity investments are based on several factors. These estimations also often include subjective and judgmental factors, because different analysts interpret data in different ways.

Suppose, based on the earnings consensus of stock analysts, Gtrgory expects a return of 13.58% from the portfolio with the new weights. Does he think that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued?

a) Fairly valued

b) Undervalued

c) Overvalued

Suppose instead of replacing Atteric Inc.’s stock with Baque CO.'s stock , Lorenzo considers replacing Atteric Inc.’s stock with the equal dollar allocation to shares of Company X’s stock that has a higher beta than Atteric Inc. If everything else remains constant, the required return from the portfolio would

Increase

OR

Decrease

Stock Investment Allocation Beta Standard Deviation Atteric Inc. (AI) 35% 0.600 53.00% Arthur Trust Inc. (AT) 20% 1.600 57.00% Li Corp. 15% 1.100 60.00% Baque Co. 30% 0.500 64.00%

Explanation / Answer

Portfolio Return= Summation Weighti*Rreturni

i=1..4

Returns from Original allocation= 35%*(6%+0.6*7.5%)+20%*(6%+1.6*7.5%)+15%*(6%+1.1*7.5%)+30%*(6%+0.5*7.5%)

Returns from Original allocation=12.34%

He recommends replacing Atteric Inc.’s shares with the same amount in additional shares of Baque Co

Thus New Return= 20%*(6%+1.6*7.5%)+15%*(6%+1.1*7.5%)+(30%+35%)*(6%+0.5*7.5%)

New Return= 12.07%

Answer is b %change= 0.26%(12.34%-12.07%)

2)

Revised portfolio will have expected returns= 12.07% while Greogry Expectes(Required rate of return) it to be 13.58% thus portfoilo is Overvalued(option c)

3)

Lorenzo considers replacing Atteric Inc.’s stock with the equal dollar allocation to shares of Company X’s stock that has a higher beta than Atteric Inc. If everything else remains constant, the required return from the portfolio would Increase

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