9. Lorenzo is an analyst at a wealth management firm. One of his clients holds a

Question

9.

Lorenzo is an analyst at a wealth management firm. One of his clients holds a $5,000 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 0.888 and the portfolio’s expected return as 10.7720%.

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 Transfer Fuels Co. The risk-free rate is 5.0000%, and the market risk premium is 6.5000%.

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

a) 0.4462%

b) 0.6578%

c) 0.5720%

d) 0.7093%

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, Lorenzo expects a return of 11.70% 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 Transfer Fuels 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 portfolio’s risk would:

Increase

OR

Decrease

Stock Investment Allocation Beta Standard Deviation Atteric Inc. (AI) 35% 0.750 38.00% Arthur Trust Inc. (AT) 20% 1.400 42.00% Lobster Supply Corp. (LSC) 15% 1.300 45.00% Transfer Fuels Co. (TF) 30% 0.500 49.00%

Explanation / Answer

Given Portfolio Return =10.772% and beta=.888, then if weights are chenged from Atteric Inc.’s shares with the same amount in additional shares of Transfer Fuels Co. then weight of Transfer Fuels Co would be (35+30)%

therefore new return would be

Total would be 10.2%

Change =10.772-10.2=.572%

Any portfolio return greater than 10.772 % with the given weights would term it to be overvalued

Portfolio return will increase with increase in beta as expected return also increases

Company Weights Beta STD Return Atteric 0% .75 38% 0 Arthur Trust Inc. (AT) 20% 1.4 42% 2.82 Lobster Supply Corp. (LSC) 15% 1.3 45% 2.0175 Transfer Fuels Co. (TF) 65% .5 49% 5.3625

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