Question

Assume that you recently graduated and landed a job as a financial planner with Cicero Services, an investment advisory company. Your first client recently inherited some assets and has asked you to evaluate them. The client has $2 million invested in the stock of Blandy, Inc., a company that produces meat-and-potatoes frozen dinners. Blandy's slogan is "Solid food for shaky times." Unfortunately, Congress and the president are engaged in an acrimonious dispute over the budget and the debt ceiling. The outcome of the dispute, which will not be resolved until the end of the year, will have a big impact on interest rates one year from now. You have also gathered historical returns as follows for the past 10 years for Blandy, Gourmange Corporation (a producer of gourmet specialty foods), and the stock market. The risk-free rate is 4% and the market risk premium is 596. Year Historical Stock Returns Market Blandy Gourmange 30% 2696 4796 -54 -14 15 15 N 7 + - 00 0 10 -23 -3 -32 38 2875 Average return: 8.00% 9.2096 Standard deviation: 20.10% ? 38.6096 Correlation with the 1 ? 0.678 market: Beta: 1 ? 1. Suppose an investor starts with a portfolio consisting of one randomly selected stock. How to measure the risk and return given different scenarios for a particular stock? What are the criteria the investor should consider to choose a single stock to invest? As more and more randomly selected stocks are added to the portfolio, what happens to the portfolio's risk? How does correlation affect your portfolio return and risk? Calculate the estimated correlation between Blandy and Gourmange using the data in the above Table. Does this explain why the portfolio standard deviation was less than Blandy's standard deviation? - 1.3

Answer 1

1. The standard deviation gets smaller as more stocks are combined in the portfolio, while r_p (the portfolio’s return) remains constant. Thus, by adding stocks to your portfolio, which initially started as a 1-stock portfolio, risk has been reduced.

2.

Company Specific (Diversifiable) Risk 35% Total Portfolio Risk, op 209 Market Risk 10 20 30 40 2,000 stocks

3.

Notice that the historical returns for Blandy and Gourmange do not move in perfect lockstep. Historical Stock Returns for Blandy and Gourmange Rate of Return 75% Gourmange 60% 45% 30% 15% -15% -30% Blandy 45% -6096 -75% + 1 2 3 4 5 6 7 8 9 10 Year Loosely speaking, correlation measures the tendency of two variables to move together. Correlation between Blandy and Gourmange p= 0.11 Use the Excel function:-CORREL (Blandy returns, Gourmange_returns)