Question

6. Portfolio beta and weights Aa Aa E Rafael is an analyst at a wealth management firm. One of his clients holds a $5,000 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: Stock Atteric Inc. (AI) Arthur Trust Inc. (AT) Corp. (LC) Baque Co. (BC) Investment Allocation 35% 20% 15% 30% Beta 0.750 1.400 1.200 0.400 Standard Deviation 38.00% 42.00% 45.00% 49.00% Rafael calculated the portfolio's beta as 0.843 and the portfolio's expected return as 8.64%. Rafael 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 Rafael's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change? O O O O 0.68 percentage points 0.84 percentage points 0.78 percentage points 0.53 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, Rafael expects a return of 9.46% 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? Undervalued

Answer 1

New portfolio beta =Weighted average beta

= 1.4*20% + 1.2*15%+0.4*65%

= 0.72

New portfolio return = risk free rate + beta*market risk premium

= 4% + 0.72*5.50%

= 7.96%

Hence, change in required return = 8.64% - 7.96%

= 0.68 percentage points

i.e. 0.68 percentage points

He expects return to be 9.46% but CAPM return is 7.96%

Hence, he thinks that revised portfolio is undervalued

Portfolio beta would INCREASE

Since portfolio beta is equal to weighted average beta. With inclusion of higher beta stock, portfolio beta would increase