MEETING 1

MAF603

QUESTION 1

Noble Bhd has excess funds for the coming year and identified 2 investments that appear to be
feasible. Each project requires the same initial outlay. The data regarding the investments are
given below.

State of Probability Stock's return

Economy Daisy Bhd Flora Bhd
Recession 0.3 -12% -10%
Normal 0.5 9% 12%
Boom 0.2 30% 25%
Beta 1.2 0.45

Additional information:

The risk-free rate of 4%.

The expected return on the market of 12%
The correlation between Daisy Bhd and Flora Bhd is 0.98

Required:

a) Calculate the expected return and standard deviation of each stock above.

b) If you could only invest in one stock, which stock would you choose?

c) Calculate the covariance and correlation between the two stocks, Daisy Bhd and Flora Bhd.

QUESTION 2

Based on your answer in Question 1 above,

a) Calculate the expected return and standard deviation of a combination of 60% in Daisy Bhd
and 40% in Flora Bhd.

b) Recalculate the investment portfolio's expected return and standard deviation with an
equally divided between Daisy Bhd and Flora Bhd.

c) Which portfolio would be a better investment? Explain your recommendation.

QUESTION 3

Assume CAPM holds.

a) Calculate the required return of each stock.

b) State whether each stock is correctly priced. Explain your answer.

d) Which stocks would you recommend buying?

e) Construct the Security Market Line (SML) graph by indicating the position of stocks in the
diagram.

QUESTION 4

The following data is pertinent for three securities:

Stock Expected return Standard deviation Beta coefficient

A 13.5% 30% 0.80
B 15% 40% 1.84
C 25% 60% 3.00

The correlation between the securities are: Corr.[A,B] = 0.8, Corr.[A,C] = − 0.9, Corr.[B,C] = 0.1

Required:

a. Assume that you intend to hold a portfolio that is equally invested in two (2) securities only.
Calculate the expected returns of all possible 2-security portfolios.

b. Calculate the standard deviation for each of your portfolios above.

c. Apply the CAPM to evaluate whether the above portfolios are correctly priced.

(Assume that the yield on Treasury bills is 5% and the market risk premium is 7%).

d. If you could invest in only one portfolio, which one would you choose? Briefly explain.