Question

Brandon 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	Investment Allocation	Beta	Standard Deviation
Atteric Inc. (AI)	35%	0.900	38.00%
Arthur Trust Inc. (AT)	20%	1.500	42.00%
Li Corp. (LC)	15%	1.300	45.00%
Transfer Fuels Co. (TF)	30%	0.400	49.00%

Brandon calculated the portfolio’s beta as 0.930 and the portfolio’s required return as 9.1150%.

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 4%, and the market risk premium is 5.50%.

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.)

0.7508 percentage points

1.1069 percentage points

1.1935 percentage points

0.9625 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 9.65% 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?

Undervalued

Overvalued

Fairly valued

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 risk would (increase, decrease)

Answer 1

New portfolio beta =Weighted average beta

= 1.5*20% + 1.3*15%+0.4*65%

= 0.755

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

= 4% + 0.755*5.50%

= 8.1525%

Hence, change in required return = 9.1150% - 8.1525%

= 0.9625 percentage points

i.e. 0.9625 percentage points

He expects return to be 9.65% but CAPM return is 8.1525%

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