FPX5014 Applied Managerial Finance

1. 1. Assets C and H are perfectly negatively correlated. This means that as Asset C’s returns increased by 3% from January to February and decreased by 5% from February to March, then:
2. A. The returns of Asset H exhibited no discernible pattern with those of Asset C.

B The returns of Asset H decreased by 3% from January to February and increased by 5% from February to March.

1. The returns of Asset H exhibited the same pattern.
2. D. The returns of Asset H decreased by 5% from January to February and increased by 3% from February to March.

Solution:

1. The returns of Asset H decreased by 3% from January to February and increased by 5% from February to March.

Explanation – Negative correlation can be defined as a relationship between any two variables that move in the opposite direction. In case of a perfect negative correlation, if one variable increases the other decreases by the same amount. 

2. In general, it is reasonable to expect that holding a portfolio consisting of both international and domestic assets, rather than domestic stocks alone, will provide greater risk-reduction benefits due to which of the following factors?

A The differing economic, regulatory, and political systems expose domestic and international securities to different, and potentially offsetting, sources and amounts of market risks. While the domestic and foreign companies share common sources of diversifiable risk, the differences in market risk can still cause their patterns of returns to differ sufficiently to offer small risk-reduction benefits.

B The differing economic, regulatory, and political systems expose domestic and international securities to different, and potentially offsetting, sources and amounts of diversifiable and market risks. This can cause the securities to generate independent or offsetting patterns of returns.

Solution: A The differing economic, regulatory, and political systems expose domestic and international securities to different, and potentially offsetting, sources and amounts of market risks. While the domestic and foreign companies share common sources of diversifiable risk, the differences in market risk can still cause their patterns of returns to differ sufficiently to offer small risk-reduction benefits.

Explanation – There are two types of risk diversifiable risk and non diversifiable risk. Diversifiable risk is those risk that are not priced by the market whereas undiversifiable risk are priced by the market. Since, in the given scenario an investor invests in both domestic as well as international markets there is a scope of risk reduction.

3. Two securities, A and B, are expected to be worth $100.00 in one year. Because A is riskier than B, the current price of A should be A) Equal to B) Higher than C) lower than   D)the current price of B.
4. lower than the current price of B.

Explanation – A security is priced by calculating the present value at an appropriate discount rate. The discount rate consists of the real interest rate as well as risk premium. Since, A is riskier than B the discount rate will be higher for it, resulting in lower current value of A.

James owns a two-stock portfolio that invests in Blue Llama Mining Company (BLM) and Hungry Whale Electronics (HWE). Three-quarters of James’s portfolio value consists of BLM’s shares, and the balance consists of HWE’s shares.

Each stock’s expected return for the next year will depend on forecasted market conditions. The expected returns from the stocks in different market conditions are detailed in the following table:

Market Condition	Probability of Occurrence	Blue Llama Mining	Hungry Whale Electronics
Strong	0.25	50%	70%
Normal	0.45	30%	40%
Weak	0.30	-40%	-50%

Calculate expected returns for the individual stocks in James’s portfolio as well as the expected rate of return of the entire portfolio over the three possible market conditions next year.

The expected rate of return on Blue Llama Mining’s stock over the next year is  .A) 14% B)18.90 C) 11.90% D)16.80%

Solution : A) 14%

Explanation : Expected return for blue Llama Mining = 0.25* 50% + 0.45* 30% + 0.3 * (-40%) =14%.

The expected rate of return on Hungry Whale Electronics’s stock over the next year is A) 13.33%, B)20.50%, C) 25.42%,D) 23.17%    .

Solution: B) 20.50%

Explanation – Expected return for Hungry Whale Electronics = 0.25* 70% + 0.45* 40% + 0.30 * (-50%) = 20.50%.

The expected rate of return on James’s portfolio over the next year is A)13.29% B)15.63%, C)  18.76% D)21.10% 

Solution : B) 15.63%

Explanation : Expected return of return for Jame’s portfolio = 0.75 * 14 + 0.25* 20.50 = 15.63%.

This 0.75 is taken because James includes (3/4) of the portfolio to Blue llama mining and the rest 25% to Hungry whale electronics.

Returns earned over a given time period are called realized returns. Historical data on realized returns is often used to estimate future results. Analysts across companies use realized stock returns to estimate the risk of a stock.

Consider the case of Blue Llama Mining Inc. (BLM):

Five years of realized returns for BLM are given in the following table. Remember:

1.	While BLM was started 40 years ago, its common stock has been publicly traded for the past 25 years.
2.	The returns on its equity are calculated as arithmetic returns.
3.	The historical returns for BLM for 2012 to 2015 are:
		2012	2013	2014	2015	2016
Stock return		20.00%	13.60%	24.00%	33.60%	10.40%

Given the preceding data, the average realized return on BLM’s stock is A) 62.99% B)20.32% C) 50.80% D) 40.64%

The answer is B) 20.32%

Explanation: The average realized return is calculated on the basis of arithmetic mean. The arithmetic mean of the past returns can be calculates as (62.99+20.32+50.80+40.64)/4 =20.32%.

Question - The preceding data series represents A) the population, B) a sample, C) the universe of BLM’s historical returns.

Answer: B) sample

Explanation: The data that has been provided to us Is just the sample data because the population data must have included the returns from the date the company came into existence.

Question - The standard deviation of BLM’s historical returns is  .a. 7.03% B) 9.13% c) 8.17%) D) 12.33%

Answer : B) 9.13%.

Explanation :

Year	Return	Mean Return	(Return - Mean Return)
2012	20	20.32	0.1024
2013	13.6	20.32	45.1584
2014	24	20.32	13.5424
2015	33.6	20.32	176.3584
2016	10.4	20.32	98.4064
			333.568

Standard deviation = Square root of (333.568/4) = 9.13%

Question - If investors expect the average realized return from 2012 to 2016 on BLM’s stock to continue into the future, its coefficient of variation (CV) will be a. 0.83% b) 0.38% c) 0.45% d) 0.52%

Answer : C) 0.45%

Explanation: The formula for coefficient of variation is (Standard deviation /mean).

Therefore, (9.13/20.32) = 0.45%

Question –

Emma holds a $5,000 portfolio that consists of four stocks. Her investment in each stock, as well as each stock’s beta, is listed in the following table:

Stock	Investment	Beta	Standard Deviation
Andalusian Limited (AL)	$1,750	0.90	9.00%
Zaxatti Enterprises (ZE)	$1,000	1.90	12.00%
Water and Power Co. (WPC)	$750	1.20	18.00%
Makissi Corp. (MC)	$1,500	0.30	28.50%

Suppose all stocks in Emma’s portfolio were equally weighted. Which of these stocks would contribute the least market risk to the portfolio?

1. A) .Andalusian Limited
2. B) Makissi Corp.

C)Water and Power Co.

D)Zaxatti Enterprises

Answer - B) Makissi Corp.

Explanation – Beta help in determining the market risk of a portfolio. The higher the Beta, the greater is the market risk. In this case, the Beta for Makissi Corp is the least which hos that it contributes least market risk to the portfolio.

Question –

Suppose all stocks in the portfolio were equally weighted. Which of these stocks would have the least amount of standalone risk?

A)Zaxatti Enterprises

B)Andalusian Limited

C)Makissi Corp.

D)Water and Power Co.

 Answer: B)Andalusian Limited

Explanation : The standalone risk of a stock can be determined using its standard deviation. The standard deviation of Andalusian Limited is the least in the given portfolio.

Question –

If the risk-free rate is 7% and the market risk premium is 9%, what is Emma’s portfolio’s beta and required return? Fill in the following table:

	Beta	Required Return
Emma’s portfolio	A)0.965 B)0.820  C) 0.647 D) 1.448	A)19.449% B)12.234% C) 22.440% D)12.685%

Answer :  Beta C) 0.647 D)12.685%

Explanation: Required return = Risk free rate + Market risk premium * Beta

Required return = 7 + 9 * 0.647 = 12.8%  which is closest to 12.685%.

Question

Julie, an analyst at Fantastique General (FG), models the stock of the company. Suppose that the risk-free rate rRF = 5%, the required market return rMrM = 10%, the risk premium for small stocks rSMB = 3.2%, and the risk premium for value stocks rHMLrHML = 4.8%. Suppose also that Julie ran the regression for Fantastique General’s stock and estimated the following regression coefficients: aFG= 0.00, bFGbFG = 1.2, cFG = -20.4, and dFGdFG = -1.3. If Julie uses a Fama-French three-factor model, then which of the following values correctly reflects the stock’s required return?

A -60.52%

B -50.48%

C -72.52%

D -65.52%

Solution : A -60.52%

Explanation:

Fama and French Model
Particulars	Return	Beta
Risk Free rate	5		5
Market risk premium	5	1.2	6
Small minus big	3.2	-20.4	-65.28
High minus Low	4.8	-1.3	-6.24

Required return = 5 + 5 *1.2 + 3.2 * (-20.4) + 4.8 * (-1.3) = -60.52%.

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