Question

Your group manages an investment fund. Your job is to advise clients on what portfolio best suits their needs, given their characteristics. You have three different customer types I. A young Deakin Commerce graduate (Stephanie) with a long and successful career 11, A middle-aged couple (Harold and Meredith) who are high income earners. They plan ahead of her to retire in 10 years' time. III. An older member of the work force (Akhter) who is hoping to retire in the next 18 months. There are 3 different portfolio packages that you offer your clients PORTFOLIO ALPHA: 70% shares: 20% property; 10% cash PORTFOLIO BETA: 50% bonds; 30% shares; 20% property PORTFOLIO GAMMA: 50% cash: 30% bonds; 20% property Your task is to answer the following questions by referring to your textbook, other finance books, the media, the internet etc.: 1. By using the information in TABLE 1: (a) Calculate the historical returns for each of the above portfolios for the years between 2003 and 2017. Present the answers/numbers in the table. (b) Calculate the expected (average) return, denoted by E(R), and risk (standard deviation), denoted by o, for each of the four asset classes as well as those three portfolios. Present your answers in Table 1 The completed table SHOULD be submitted with your assignment. Students are encouraged to em Microsoft Excel for these workings (5 marks) Explain what is meant by expected return and risk in finance. You need to address the relationship between these two concepts in your explanation. Use your answers from 2. Question 1 (for both assets and portfolios) above to illustrate this relationship 5 marks 3. Discuss the meaning of diversification in finance and how it impacts the risk and the return. You need to address the concept of correlation and how the correlation coefficient impacts on the risk of a portfolio in your discussion. Refer to your answers from Question 1 to illustrate diversification (5 marks)

Answer 1

1. Solution attached .

2. Expected Return: The rate of return expected on an asset or a portfolio. The expected rate of return on a single asset is equal to the sumof each possible rate of return multiplied by the respective probability of earning on each return.

Risk: The uncertainty associated with any investment. That is, risk is the possibility that the actual return on an investmentwill be different from its expected return.

Relationship between expected return and risk: The risk-return relationship. Generally, the higher the potential return of an investment, the higher the risk. A more correct statement may be that there is a positive correlation between the amount of risk and the potential for return. Generally, a lower risk investment has a lower potential for profit. A higher risk investment has a higher potential for profit but also a potential for a greater loss

3. Diversification: Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1 and 1.

A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

4. Systematic risk is the risk caused by macroeconomic factors within an economy and are beyond the control of investors or companies. This risk causes a fluctuation in the returns earned from risky investments. It is calculated using Beta. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market.

In the given case, Beta of assets A is 0.5 and Assets B is 2. Higher the beta more volatile is the asset. Hence, Assets B is riskier.

Impact of increase/decrease by 10% in market return :

E(r) = R_{f + $\beta$}(R_{m -} R_f )

Solution image attached.

5. A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest.

Yes risk aversion is related to different stages of investing life cycle. In the early and mis ages investors generally are risk averse . In the mid stage investors are ready to take risk.

6. The most suitable portfolio option i