Question

Andrew 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 0.600 0.23% 35% 20% 1.500 0.27% Atteric Inc. (AI) Arthur Trust Inc. (AT) Li Corp. (LC) Baque Co. (BC) 15% 1.300 0.30% 30% 0.500 0.34% Andrew calculated the portfolio's beta as 0.855 and the portfolio's expected return as 12.41%. Andrew 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 Baque Co. The risk-free rate is 6.00%, and the market risk premium is 7.50%. According to Andrew's recommendation, assuming that the market is in equilibrium, the portfolio's required return will change by 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, Andrew expects a return of 12.14% from the portfolio with the new weights. Does he think that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued?
drop down 1 options: 0.26%, 0.20%, 0.32%, or 0.30%

drop down 2 options: decrease or increase

drop down 3 options: increase or decrease

Answer 1

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Answer:

We know from CAPM model (Re) = Rf+ Beta * Market Risk premium

Given Rf= 6% and Market risk premium = 7.5%,

Return of Atteric = 6+0.6*7.5 = 10.5%

Return of Arthur = 6+1.5*7.5 = 17.25%

Reuturn of Lobster = 6 + 1.3*7.5 = 15.75%

Return of Baque = 6+0.5*7.5 = 9.75%

After all shares of atteric are replaced by Baque, weight of Baque = 30+35 =65%=0.65

=> New return of portfolio = 0.2 * 17.25 + 0.15*15.75 + 0.65 * 9.75 = 12.15%

Change = 12.41 - 12.15 = 0.26%

The stock expert expects 12.14% which is equal to the calculated return of 12,15%, we can say that the stocks are Fairly valued.

If the Atteric is replaced with company X stock, then total portfolio beta would be higher and the required return from the portflio would be higher