Please help with Diversification, Risk and Return!! Thanks:) 3. Diversification,

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Please help with Diversification, Risk and Return!!

Thanks:)

3. Diversification, risk, and return Aa Aa Conrad holds$20,000 portfolio that consists of four stocks. His investment in each stock, as well as each stock's beta, is shown below: Stock Aramis Airlines Barrington Inc. Carrow & Co. Dartan Enterprise Investment Beta Standard Deviation 53,000 S8,000 $5,000 54,000 0.7 30% 52% 38% 33% 0.4 Which of thesc stocks has the least amount of total risk? Which of thesc stocks contributes the Icast risk to the portfolio? O Aramis Airlines O Carrow & Co. O Dartan Enterprise O Barrington Inc. O Aramis Airlines O Barrington Inc. O Dartan Enterprise O Carrow & Co. The risk-free rate is 5% and the market risk premium is 6%. what is the portfolio's beta and required return? Bcta Rcquired Rcturn Conrad's portfolio Conrad is thinking about reallocating the funds In his portfolio. He plans to sel his stake in Dartan Enterprises and put that money Into Barrington Inc. Assuming the market is in equilibrlum and Conrad changes hls portfolio, by how much ll his portfolio's expected return change? 1.08% O 1.68% 0.84% O 1.56% O 1.20% Suppose an analyst believes that the expected return on Conrad's new portfolio is actually 14.80%. Does this analyst think the portfolio is undervalued, overvalued, or fairly valued? O Fairly valued O Overvalued O Undervalued

Explanation / Answer

Total risk is measured by Std. deviation. Here, Aramis Airlines has the lowest Std. deviation hence the lowest total risk.

Risk contribution to portfolio is measured by the corresponding beta and weight of the stock in the portfolio. If we multiply each stock’s beta with its weight in the portfolio, we see that Dartan enterprise has the least contribution to portfolio risk.

Portfolio’s beta = sum of the product of individual betas and their weight.

= (3/20)*0.7 + (8/20)*1.8 + (5/20)*1.1 + (4/20)*0.4 = 1.255

Required Return = rf + beta*(Market premium)

= 5 + 1.255*6 = 12.53%

As the market is in equilibrium, expected return = Required return

= 12.53%

New portfolio will have $12000 in Barrington and 0 in Dartan.

New beta = (3/20)*0.7 + (12/20)*1.8 + (5/20)*1.1 = 1.535

New Expected return = 5 + 1.535*6 = 14.21%

Expected return increased by (14.21 – 12.53)/12.53 = 13.4%

As calculated above, the expected return is 13.4%. If an analyst believes actual expected return to be 14.8%, as per this analyst the portfolio is undervalued.

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