Question

Brandon is an analyst at a wealth management firm. One of his clients holds a $10,000 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	Investment Allocation	Beta	Standard Deviation
Atteric Inc. (AI)	35%	0.750	53.00%
Arthur Trust Inc. (AT)	20%	1.500	57.00%
Li Corp. (LC)	15%	1.100	60.00%
Transfer Fuels Co. (TF)	30%	0.500	64.00%

Brandon calculated the portfolio’s beta as 0.878 and the portfolio’s expected return as 12.5850%.

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 Transfer Fuels Co. The risk-free rate is 6%, and the market risk premium is 7.50%.

According to Brandon’s recommendation, assuming that the market is in equilibrium, how much will the portfolio’s required return change? (Note: Do not round your intermediate calculations.)

0.5148 percentage points

0.7590 percentage points

0.8184 percentage points

0.6600 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 13.43% from the portfolio with the new weights. Does he think that the required return as compared to expected returns is undervalued, overvalued, or fairly valued?

Fairly valued

Undervalued

Overvalued

Suppose instead of replacing Atteric Inc.’s stock with Transfer Fuels Co.’s stock, Brandon considers replacing Atteric Inc.’s stock with the equal dollar allocation to shares of Company X’s stock that has a higher beta than Atteric Inc. If everything else remains constant, the portfolio’s beta would (increase or decrease?)

Answer 1

New portfolio beta =Weighted average beta

= 1.5*20% + 1.1*15%+0.5*65%

= 0.79

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

= 6% + 0.79*7.50%

= 11.925%

Hence, change in required return = 12.5850% - 11.925%

= 0.66 percentage points

i.e. 0.6600 percentage points

He expects return to be 13.43% but CAPM return is 11.925%

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