You work as the assistant to Michael Brown, a CFP with Securities Services, Inc.

Question

You work as the assistant to Michael Brown, a CFP with Securities Services, Inc., an Akron, Ohio based medium-sized financial services firm. One of Michael's clients, Mr. Williamson, has $500,000 in a money market account in a local bank. Mr. Williamson is the owner of a medium- ize bottling company whose current projects are fully funded. Unhappy with the extremely lo rate he earns on the money market account, he considers investing the $500,000 in stocks. Nevertheless, he will need the money in slightly more than a year from now to finance a major expansion of his company. Furthermore, Mr. Williamson has expressed a keen interest in three U.S. stocks. The first one, ALW, is a manufacturer of luxury watches. The second one, RCA, specializes in the collection of past-due accounts receivable. The third one, ACM, is a carpet manufacturer. The three companies do business nationwide and are traded on major U.S. stock exchanges. In about a week Michael plans to meet with and suggest a portfolio to Mr Williamson for his one year investment horizon. Using several economic reports, Michael has developed probability estimates for the five states of the economy over the coming year. In addition, the security analysts at Securities Services have provided estimates of the rate of return on each of the three stocks under each state of the economy. Upon Michael's request, these analysts have also provided estimates of the rate of return under each state of the economy on the computer-run, market-weighted "Index Fund" Securities Services uses in-house to gauge the performance of the stock market as a whole. Finally, the security analysts have provided estimates of the return on T-Bills over the coming year. The following table summarizes the above information. rn Economy State Probability T-Bills ALW RCA ACM 0-10- 3.0% (20.0%) 26.5% 10.0 Index Fund 13.0% Recession Below average 0.15 (2.7) 7.0 3.0 37.3 (12.0) 45.0 3.0 48.0 (20.0) 30.0 3.0 23.3 Above average 0.15 Expansion In preparation for his meeting with Mr. Williamson, Michael wants you to provide within the First, to gain a better understanding of the three stocks and the stock market as a whole, Michael . Calculate the rate of return and total risk expected from investment in each of the three Calculate the expected beta of each of the three stocks and intuitively explain to Mr next two days a substantial amount of information which he has sorted into four different groups (AL stock and the Index Fund Willey the difference between a stock's standard deviation and beta; ACM, as well as between RCA and ACM (ALW) Calculate the covariance and the correlation between ALW and RCA, between ALW and (ALW and RCA) .

Explanation / Answer

Beta measures the sensitivity of the stock with respect to the market..

standard deviation is the volatility of the stock, deviation of the return from the mean.

Probability T-Bills ALW RCA ACM Index Fund 0.1 3.00% -20.00% 26.50% 10.00% -13.00% 0.15 3.00% -2.00% 13.00% -10.00% 1.00% 0.5 3.00% 23.30% -2.70% 7.00% 15.00% 0.15 3.00% 37.30% 12.00% 45.00% 25.00% 0.1 3.00% 48.00% 20.00% 30.00% 40.00% rate of return 19.75% 7.05% 12.75% 14.10% total expected risk 28.03% 10.91% 21.38% 20.59% beta 1.346 -0.123 0.693

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