Question

2. Please answer the following two questions with regard to Austin & Associates. a. John Wilson is a portfolio manager at Austin & Associates. For all of his clients, Wilson manages portfolios that lie on the Markowitz efficient frontier. Wilson asks Mary Regan, CFA, a managing director at Austin, to review the portfolios of two of his clients, the Eagle Manufacturing Company and the Rainbow Life Insurance Co. The expected returns of the two portfolios are substantially different. Regan determines that the Rainbow portfolio is virtually identical to the market portfolio and concludes that the Rainbow portfolio must be superior to the Eagle portfolio. Do you agree or disagree with Regan's conclusion that the Rainbow portfolio is superior to the Eagle portfolio? Justify your response with reference to the capital market line. b. Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater nonsystematic risk than Eagle's portfolio. Define nonsystematic risk and explain why you agree or disagree with Wilson's remark.

Answer 1

A) Yes, I agree that the rainbow portfolio is superior to the eagle portfolio because it is lying on the capital market line with efficient frontier which represents a combination of risky assets. Capital market line is a graphical representation of optimal risk and return of a portfolio. Capital market line combines risky assets with the risk-free assets while efficient frontier represents combination of risky assets so if a portfolio is lying on capital market line along with the efficient frontier, it is better. B) I do not agree with the remark of higher expected return because of higher non- systematic risk in the portfolio because in a diversified portfolio there is no non-systematic risk. The Investor is compensated only for the systematic risk of the portfolio. Non- systematic risk is also known as the security specific risk which can be reduced by diversifying the portfolio. Two main sources of non-systematic risks are: Business specific risk: The business specific risk can be because of many factors like there is a shift in management happening of any company, company is losing market share, some of the product of the company is facing issue with regulator and had to be recalled back from the market. These things can affect the stock performance of the individual security. Financial risk: Financial risk here with reference to specific company means that the company is either too much leveraged or not leveraged at all. The cost of capital is not at the leverage level where it should be the lowest cost of overall capital. Too much leverage can create high risk of bankruptcy and too little can reduce the overall return on capital.