MAF 603

PORTFOLIO MGMT & APT (RISK & RETURN)

EXERCISE 2

Question 1 (Test 1 – MAY 2020)

Erin plans to invest in the stock market and is considering two stocks, North and South. The followings
are information pertaining to the two stocks:

State of Probability of Rate of return (%) Rate of return (%)

economy occurrence North South
Recession 0.4 6 10
Normal 0.3 14 7
Boom 0.3 18 5

Additional information:
Beta of North 1.35
Beta of South 0.68
Return of the market 15%
Risk free rate of return 3%

Required:

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

(6 marks)

b. Calculate the covariance and correlation between North and South. Comment on the correlation
between the two stocks.
(4 marks)
c. Erin is interested to invest equally in North and South. Calculate the expected return and standard
deviation of the portfolio.
(3 marks)

d. Based on the previous calculation, suggest the best investment option for Erin. Explain your
answer.
(2 marks)

e. Suppose Erin now considers to equally invest in a portfolio consisting of North and a risk-free
asset. Applying the CAPM, advise whether or not she should do so. Explain your answer.
(5 marks)

f. Explain the difference between standard deviation and beta. Discuss why is beta regarded as a
better measure of risk for a large and well diversified portfolio as compared to standard deviation.
(5 marks)
(25 marks)
Question 2 (Test 1 – APR 2019)

Princess Luna, manager of Unicorn Collections Berhad is considering investing the company’s excess
funds in one possible pair of three securities: Rainbow Berhad, Pinkie Berhad and Twilight Berhad. As
a new investor, she needs your advice on selecting the best investment. Her assistant has compiled
the following data relating to the securities:

Securities Rainbow Pinkie Twilight

Expected return 8.2% 14.1% 9.3%
Standard deviation 8.35% 4.38% 5.31%
Share price RM 20 RM 25 RM 24
Beta coefficient 0.8 0.5 1.2

Correlation of the possible pairs of the three securities is as follows:

Rainbow and Pinkie 0.8432

Pinkie and Twilight 0.9217
Rainbow and Twilight 0.8392

Princess Luna plans to invest based on the following proportions:

1. 1,500 shares in Rainbow and 2,800 shares in Pinkie, or

2. 2,200 shares in Pinkie and 1,875 shares in Twilight, or
3. 2,000 shares in Rainbow and 2,500 shares in Twilight.

Required:

a. Calculate the expected return and standard deviation of the proposed portfolios based on the
above proportions.
(10 marks)

b. Based on your answer in (a), advise Princess Luna regarding which portfolio to invest in.
(2 marks)

c. Assume that Princess Luna intended to hold a portfolio that is equally invested in Rainbow and
Fluttershy. Fluttershy is a risk-free security with the expected return of 15%. Calculate the
expected return and standard deviation of this portfolio.
(5 marks)

d. Compare your answer in (b) and (c) above. Decide which portfolio would be a better investment
to Princess Luna.
(2 mark)

e. The expected return of the market is 13% and the risk-free rate is 8%. Using the CAPM, advise
Princess Luna which of the above portfolios in part (a) would she buy or sell.
(6 marks)

f. Explain and differentiate between ‘firm specific risk’ and ‘systematic risk’. How is the required
return of a well-diversified portfolio affected by each type of risk?
(5 marks)
(30 marks)