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Stock Markets and Portfolio Theory: Numerical Questions for practice Financial Markets and Institutions: KJSIMSR July

2013 Instructor: Prof. Nupur G.B. Q.1 The current price of stock A & stock B are Rs. 80 and Rs. 60 respectively. At the end of the year, the price of stocks A & B and their associated probabilities are given below. Stock A (Rs.) 74 80 85 Stock B (Rs.) 55 60 66 Probability 0.30 0.40 0.30

Given this data, which stock should an investor choose?

Q.2 On request of an investor who holds two stocks A & B, an analyst prepared ex ante probability distribution for the possible economic scenarios and the conditional returns for two stocks and the market index as shown below. Economic Scenario Probability Conditional Returns (%) A Growth Stagnation Recession 0.40 0.30 0.30 25 10 -5 B 20 15 -8 Market 18 13 -3

Risk free rate during the next year is expected to be around 11 %. Determine whether the investor should liquidate his holdings in stocks A & B or on the contrary make fresh investments in them? The assumptions of CAPM hold true.

Q. 3 The data given below relates to companies Alpha and Beta. Alpha (Rs.) Expected Dividend Current market price Expected market price after 1 year under 2 scenarios Optimistic scenario Pessimistic scenario 100 50 175 100 5 60 Beta (Rs.) 8 120

If an investors holding period is one year, which stock should he buy?

Q. 4 An investor has decided to invest Rs. 1, 00,000 in the stocks of two companies, i.e. ABC Company and XYZ Company. The projections of returns from the stocks of these two companies along with their probabilities are as follows:

Probability 0.20 0.25 0.25 0.30

ABC Company 12% 14% -7% 28%

XYZ Company 16% 10% 28% -2%

You are required to a. Comment on the return and risk of investment in individual stocks b. Compare the risk and return of these two stocks with a portfolio of these stocks in equal proportions
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Q. 5 ) Consider the data given below: Probability Stock A 0.20 0.15 0.30 0.10 0.25 -12 30 40 20 -15 Conditional Returns (%) Stock B 15 35 20 -30 -10 Market -15 20 30 35 -10

The risk free rate of returns is 4%. For the given data, compute a) Beta for Stocks A and B b) Alpha for stocks A and B c) If the risk free rate increases to 6%, which stock do you recommend? Why?

Q6) Consider the following information regarding the returns from the risk of certain stocks:

Security

Expected (%)

Return Beta

Standard Deviation of Return (%)

Stock A Stock B Stock C Stock D Stock E Stock F Stock Index

32 30 25 22 20 10 12
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1.70 1.40 1.10 0.95 1.05 0.70 1.00

50 35 40 24 28 18 20

Treasury Bills

0.00

From the above information a) Draw the SML, and plot all the stocks on the graph b) Identify which securities are under priced

Q7) The betas of two stocks, A and B are 0.50 and 2.00 respectively. Given that the SML is represented as 0.04+0.08B, where B is the beta of the security, calculate the expected return on the two securities at which they can be considered worthy of investment. Q8) Draw the Security Market Line for a risk free return of 8% and market return of 12%.