Case Analysis

Beta Management Company

Submitted by: Biwesh Neupane, Dev Raj Dhungana
Mingma Sherpa (Lama), Shrawan Regmi
Introduction
Analysis
Using excel, we calculated following mean and standard deviation for the two stocks
and the index. The calculations are shown in Appendix I.
Stock
Monthly Mean
Monthly Standard
Deviation (STD)

Vanguard Index
500 Trust
1.1025%
4.61%

California REIT

Brown Group

-2.265%
9.23%

-0.671%
8.17%

The two individual stocks have almost double the variability than the Vanguard
Index 500 Trust. This means that the stocks are riskier than the Vanguard Index 500
Trust in terms of the variability or deviation from the mean.
However, individual standard deviation is not a proper measure of risk. Since, we
are creating a portfolio consisting of Vanguard Index 500 Trust and one of the two
individual stocks we need to calculate the portfolio variance which is a better
measure of risk. We know that,

2p w12 12 w22 22 2w1 w2 Cov(r1 , r2 ) w12 12 w22 22 2w1 w2 1 2 12

Where,

2
= variance

= standard deviation

W = Weight for stock in the portfolio

Cov (r1,r2) = covariance between the return of the two stocks in portfolio

= coefficient of correlation among the stock

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Therefore,
Stock
Covariance
Monthly Standard
Deviation (STD)
Coefficient of
correlation

Vanguard Index
500 Trust
4.61%

California REIT

Brown Group

0.0003
9.23%

0.0024
8.17%

0.0735

0.6562

Now, we know that Ms. Wolfe is considering investing $200,000 in either California
REIT or Brown Group making her equity exposure to $20 million out of her total
investment of $25 million. For simplicity, we can safely assume that about 1% of her
equity exposure will be invested California REIT or Brown Group and rest in
Vanguard Index 500 Trust.
a) Calculation of portfolio variance (99% Vanguard, 1% California REIT)
= 0.992 x 0.04612 + 0.012 x 0.09232 + 2 x 0.99 x 0.01 x 0.0003 = 0.002081
Portfolio standard Deviation
= 0.002081 = 4.57%
b) Calculation of portfolio variance (99% vanguard, 1% Brown group)
= 0.992 x 0.04612 + 0.012 x 0.08172 + 2 x 0.99 x 0.01 x 0.0024 = 0.0021221
Portfolio standard Deviation
= 0.0021221 = 4.61%
Looking at these figures, we can see that the portfolio variance for Brown group is
greater than that for California REIT. Thus, Brown group stocks have more variability
to the portfolio than the California REIT. Thus, Brown Group stock is more risky.
However, it contradicts with the previous answer when only looking at individual
standard deviation we found that California REIT is more risky. This is because
covariance or correlation among the stocks is more important to determine the
riskiness of portfolio than the individual stocks. Since, Brown is more positively
correlated to Vanguard than the California REIT it increases the overall portfolio risk.
In other words, since Covariance between the Brown's stock and Vanguard is almost
8 times than between California REIT and Vanguard, the portfolio that includes
Brown is riskier.
Now, let us base our analysis on Capital Assets Pricing Method (CAPM). We know
that,
E(Ri) = Rf +[E(Rm)-Rf)]
Where,
E(Ri) = Expected return on capital assets
Rf = Risk free rate of return
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E(Rm) = Expected Return on market

= is the sensitivity of the expected excess asset returns to the expected excess
market returns

Now, the calculation of beta ()

a) Beta of California REIT
= Cov (Rm, Ri)/var(Rm)
= 0.0003/0.04612
= 0.1411
b) Beta of Brown
= Cov (Rm, Ri)/var(Rm)
= 0.0024/0.04612
= 1.13
We know that lower the beta, less sensitive the stock would be to market
movements. Hence, higher the beta, riskier is the stock. This is consistent with our
second analysis that Brown Group's stock is more risky since its beta is higher than
that of California REIT's.
In terms of the expected return on capital assets, we can see that the Brown
Group's stock should have higher expected return than California REIT's. One of the
major issues in determining the expected return on capital assets is to use the right
risk free rates. Different authors have different view regarding the use of risk free
rate. Some researchers use short term treasury bills rate as a risk free rate where as
some researchers use long term treasury bills rate. In our case, we have used 10
year Treasury bond rate as the measure of the risk free rate. 1
The coupon rate for 10 year US Treasury Bill is 2% (Shown in Appendix II). Likewise
we should use effective annual rate for market return.
Effective expected annual rate of return E(Rm) = (1+0.010125) 12 -1 =14.06%
a) Expected return for California REIT = 2% + 0.1411(14.06%-2%) = 3.7016%
b) Expected return for Brown Group = 2% + 1.13 (14.06% - 2%) = 15.628%
Thus, we can see that the expected return for Brown Group is higher than that of
California REIT, this is primarily because the beta for Brown Group is higher. When
an investor wants to invest in Brown Group they will demand extra premium for the
extra risk they take. Hence, the expected return for Brown is higher. This follows the
basic principle of risk and return, which is higher the risk higher the return.
Now, it depends on the risk bearing capacity of investors to decide which stock to
invest in. A risk averse investor, as a universal assumption, would choose to reduce
1 Brigham, Eugene F., Houston, Joel F., "Fundamentals of Financial Management", 7th
Edition, Cengage Learning
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its risk through portfolio diversification. In this case, it is better for Ms. Wolfe to
invest in California REIT, since it lowers the risk of the overall portfolio.

Conclusion
The case is a very good example of the use of portfolio to diversify and reduce risk.
When we consider the individual stocks, Brown and California REIT and market index
individually, the standard deviation of each is around 8.17%, 9.23% and 4.6%,
representing California REIT as risky stock. But when we add small amount of
individual stock to the market index, we find that the portfolio variance declines.
However, the portfolio riskiness declines when we add California REIT to the
portfolio. The riskiness of a stock is best measured by its covariance with the
market, rather than its own variance. As can be seen in the analysis, the covariance
between the new asset and the portfolio, rather than the variance of the assets,
matters more to the total risk of the final portfolio. In other words, individual risk
can be diversified away in a portfolio. But the market risk has to be held by the
investors and they expect some risk premium for taking the market risk. Hence, the
expected return for risky assets is greater than that of less risky assets.
To conclude, while deciding on the stock to add on portfolio, individual stock
variance matter less. Hence, investor or broker should look at the portfolio variance.
In this case as well, it is better for Ms. Wolfe to invest in California REIT than in
Brown Group's stock.

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Appendix I

1989

1990

Month

Van- Index

Jan
Feb
March
April
May
June
July
August
September
October
November
December
Jan
Feb
March
April
May
June
July
August
September
October
November
December

7.32
-2.47
2.26
5.18
4.04
-0.59
9.01
1.86
-0.4
-2.34
2.04
2.38
-6.72
1.27
2.61
-2.5
9.69
-0.69
-0.32
-9.03
-4.89
-0.41
6.44
2.72

Mean

1.1025
4.6063436
88

Standard Deviation
Covariance between Vanguard and
Individual stocks

California
REIT

-28.26
-3.03
8.75
-1.47
-1.49
-9.09
10.67
-9.38
10.34
-14.38
-14.81
-4.35
-5.45
5
9.52
-0.87
0
4.55
3.48
0
-13.04
0
1.5
-2.56
2.26541666
7
9.23073598
2
2.99628854
2

Correlation

0.07353166

Beta

0.14116252

Brown

9.16
0.73
-0.29
2.21
-1.08
-0.65
2.22
0
1.88
-7.55
-12.84
-1.7
-15.21
7.61
1.11
-0.51
12.71
3.32
3.17
-14.72
-1.91
-12.5
17.26
-8.53
-0.67125
8.1667711
21
23.655903
13
0.6561697
66
1.1293001
63

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Appendix II

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