Question

Brandon is an analyst at a wealth management firm. One of his clients holds a $7,500 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table Investment Allocation 35% 20% 15% 30% Standard Deviation 38.00% 42.00% 45.00% 49.00% Stock Atteric Inc. (AI) Arthur Trust Inc. (AT) Lobster Supply Corp. (LSC) Baque Co. (BC) Beta 0.600 1.500 1.200 0.300 Brandon calculated the portfolio's beta as 0.780 and the portfolio's expected return as 8.29% Brandon thinks it will be a good idea to reallocate the funds in his client's portfolio. He recommends replacing Atteric Inc.'s shares with the same amount in additional shares of Baque Co. The risk-free rate is 4%, and the market risk premium is 5.50% According to Brandon's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change? O 0.45 percentage points O 0.67 percentage points O 0.72 percentage points O 0.58 percentage points Analysts' estimates on expected returns from equity investments are based on several factors. These estimations also often include subjective and judgmental factors, because different analysts interpret data in different ways Suppose, based on the earnings consensus of stock analysts, Brandon expects a return of 6.21% from the portfolio with the new weights. Does he think that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued? O Fairly valued Overvalued O Undervalued

Answer 1

Answer 1:

Correct answer is:

0.58 percentage points

Explanation:

On reallocation Attric Inc.'s shares (35% allocation in portfolio) are replaced by same of amount in additional shares of Baque Co. As such allocation of Baque co' shares in portfolio will increase to (30% + 35% =) 65%

Portfolio beta (before reallocation) = 0.78 (given; also calculated as below)

Portfolio beta (after reallocation) = 0.675 as calculated as below:

With this reallocation:

Required portfolio return = Risk free return + Portfolio beta * Market risk premium

= 4% + 0.675 * 5.5%

= 7.7125%

Change in required return = 8.29% - 7.7125% = 0.5775% or 0.58%

As such option D is correct and other options A, B and C are incorrect.

Answer 2:

Correct answer is:

Overvalued

Explanation:

Brandon's expected rate of return from portfolio with new weights = 6.21%

Brandon's Required return from portfolio with new weights as calculated above = 7.7125%

Since expected return is lower than the required return, portfolio is overvalued.

As such option B is correct and other options A and C are incorrect.

Answer 3:

Brandon considers replacing Attric Inc's shares with equal dollar allocation to shares of Company X's stock that has a higher beta than Attric Inc. If everything else remains constant, portfolio risk would increase.

Explanation:

When reallocation is done by replacing stock of lower beta with stock (by equal dollar investment) of higher beta, it will result in increase in portfolio beta and hence increase in portfolio risk.