Question

Question1

1. Describe and illustrate the expected relationship between risk and expected return based on security market line (SML)             (7mark)
2. Hwang DBS Bhd has identified three potential stocks to buy in FBM KLCU but will only pick two to be added in the portfolio. The following information has been collected:  

   	AirAsia	Daya Material	Muhibbah Engineering
   Expected return	12%	25%	18%
   Standard deviation of return	2.2	5.9	3.4

Covariances of returns between companies
AirAsia and Daya Material	8.2
AirAsia and Muhibbah Engineering	2.5
Daya Material and Muhibbah Engineering	17.6

(i)Estimate the correlation coefficients between each of the three possible portfolio combinations and explain the implications of these coefficients for portfolio risk.    (9mark)

(ii)Calculate the expected rate of return and standard deviation for each of the three possible 2-stock portfolios, and indicate which portfolio has the most efficient risk-return profile.                 (14mark)

Answer 1

a) The security market line is used in CAPM, a model that describes risk-return relationships for E(R) Undervalued Stocks Security Market Line M Overvalued Stocks Systematic risk securities. The concept of beta is central to the capital asset pricing model and the security market line. The beta of a security is a measure of its systematic risk that cannot be eliminated by diversification. A beta value higher than one represents a risk level greater than the market average, while a beta value lower than one represents a level of risk below the market average. The formula for plotting the security market line according to CAPM is as follows: Required Return = Risk Free Rate of Return + Beta Market Return-Risk Free Rate of Return)

i. Let A be AirAsia, B be Daya Material, C be Muhibbah Engineering CORR(RA,R3) = 7 - COV(RARB) (SD(RA) SD(RB)) 1 = 0.632 (2.2x5.9) COV(RB, R) 17.6 CORR(R3,Rc) = (sD(R)SD(R)) (5.9 x 3 CORR(RĄ,Rc) = (SD(RA)SD(R)) (2.2 x 3.4) COV(RAR) 2.5 = 0.3342 If two pairs of assets offer the same return at the same risk, choosing the pair that is less correlated decreases the overall risk of the portfolio. Portfolio weights-WĄ, W E(Rp) = w1R1 + w2Rq + ... + wnRn For first possible portfolio (A,B) E(Rp) = WA X E(RA) + W5 x E(RB) E(Rp) = 0.50 x 0.12 + 0.50 x 0.25 E(Rp) = 0.185 Risk can be calculated with the help of portfolio variance Portfolio Variance = w *SD (Ra) + w?, *SD (R.) + 2*(WA)*(w.) *Cov(RAR) =0.52 x 2.22 +0.52 x 5.92 + 2 x 0.5 x 0.5 x 8.2 = 40.37 SD of the portfolio1 = 40.37 = 6.35374 0.185 . Expected Returns Sharpe Ratio= Risks 6,35377 = 0.03

For second possible portfolio (B,C) E(Rp) =W3 X E(R3) + W X E(R) E(Rp) = 0.50 x 0.25 +0.50 x 0.18 E(Rp) = 0.215 Risk can be calculated with the help of portfolio variance Portfolio Variance = w*, *SD (Re)+w2 *SD (R) + 2*(wo)*(wc) *Cov(RB, Rc) =0.52 x 5.92 +0.52 x 3.42 + 2 x 0.5 x 0.5 x 17.6 = 20.3925 SD of the portfolio2 = 20.3925 = 4.5158 0.215 Expected Returns Sharpe Ratio = Risks 4.5158 = 0.0476 For third possible portfolio (A,C) E(Rp) = WA X E(RA) +Wc * E(R) E(Rp) = 0.50 x 0.12 +0.50 x 0.18 E(Rp) = 0.15 Risk can be calculated with the help of portfolio variance Portfolio Variance = w *SD (R.) + w *SD (Rc) + 2*(w.)*(w)* Cov(RAR) =0.52 x 2.22 +0.52 x 3.42 +2 x 0.5 x 0.5 x 2.5 = 5.35 SD of the portfolio3 = 5.35 = 2.313 Expected Returns Sharpe Ratio=- 0.15 Risks =2312 = 0.065 The Sharpe ratio is maximum for portfolio 3, so the portfolio of AirAsia and Muhibbah Engineering has the most efficient risk return profile.