5. Portfolio beta and weights Aa Aa Gregory is an analyst at a wealth management

Question

5. Portfolio beta and weights Aa Aa Gregory 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: Investment Allocation 35% 20% 15% 30% Standard Deviation 53.00% 57.00% 60.00% 64.00% Stock Atteric Inc. (AI) Arthur Trust Inc. (AT) Li Corp. (LC) Baque Co. (BC) Beta 0.600 1.400 1.200 0.500 Gregory calculated the portfolio's beta as 0.820 and the portfolio's expected return as 12.15% Gregory 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 Gregory's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change? O 0.32 percentage points O 0.30 percentage points O 0.26 percentage points O 0.20 percentage points

Explanation / Answer

Since Atteric Inc are replaced by Banque Co. The new weight of Banque Co = 30% + 35% = 65%

Return of Banque Co = Rf + beta * MRP = 6 + 0.5*7.5 = 9.75%

Return of Arthur Trust Inc = 6 +1.4*7.5 = 16.5%

Return of Li Corp = 6 + 1.2*7.5 = 15%

Total weighted average return of new portfolio = 9.75%*0.65 + 16.5%*0.2 + 15%*0.15 = 11.8875%

Old return = 12.15%

Change = 12.15%-11.8875% = 0.2625 % = 0.26%

Portfolio's required return change = 0.26 percentage points (Option C)

Revised portfolio us UNDERVALUED (becuase he expects 10.38% but as per CAPM that would higher at 11.8875%)

Portfolio risk would be higher since he select a firm with a higher beta

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