Question

8.7. A stockbroker, Richard Smith, has just received a call from his most important client, Ann Hardy. Ann has $50,000 to invest and wants to use it to purchase two stocks. Stock 1 is a solid blue-chip security with a respectable growth potential and little risk involved. Stock 2 is much more speculative. It is being touted in two investment newsletters as having outstanding growth potential, but also is considered very risky. Ann would like a large return on her investment, but also has considerable aversion to risk. Therefore, she has instructed Richard to analyze what mix of investments in the two stocks would be appropriate for her. She also informs him that her plan is to hold the stock being purchased now for three years before selling it. After doing some research on the historical performances of the two stocks and on the current prospects for the companies involved, Richard is able to make the following estimates. If the entire $50,000 were to be invested in Stock I now, the profit when sold in three years would have an expected value of $12.500 and a standard deviation of $5,000. If the entire $50.000 were to be invested in Stock 2 now, the profit when sold in three years would have an expected value of $20,000 and a standard deviation of $30,000. The two stocks behave independently in different sec- tors of the market so Richard's calculation from historical data is that the covariance of the profits from the two stocks is 0. Richard now is ready to use a spreadsheet model to determine how to allocate the $50,000 to the two stocks so as to minimize Ann's risk while providing an expected profit that is at least as large as her minimum acceptable value. He asks Ann to decide what her minimum acceptable value is. a. Without yet assigning a specific numerical value to the minimum acceptable expected profit, formulate a quadratic programming model in algebraic form for this problem. b. Display this model on a spreadsheet. c. Solve this model for four cases: Minimum accept- able expected profit = $13,000, $15,000, $17,000. and $19.000 d. Ann was a statistics major in college and so under- stands well that the expected return and risk in this model represent estimates of the mean and standard deviation of the probability distribution of the profit from the corresponding portfolio. Ann uses the notation and o for the mean and standard devia- tion. She recalls that, for typical probability dis- tributions, the probability is fairly high (about 0.8 or 0.9) that the return will exceed g - 6, and the probability is extremely high (often close to 0.999) that the profit will exceed - 36. Calculate - and - 30 for the four portfolios obtained in part c. Which portfolio will give Ann the highest w among those that also give - 0?

Answer 1

Part-1) Assume Si = percentage of portfolio to invest in stock 1 and S2 = percentage of portfolio to invest in stock 2. Now, Minimize Risk = ($5,00051)2 + ($30,000S2) subject to $12,500S1 + $20,000S2 > Minimum Expected Profit where S1 + S2 < 100% and S1,2 0,2 0. Part 2 & 3) Minimum acceptable expected profit = $13,000 А. Тв Тc DE Stock 1 Stock 2 Expected Profit (on $50,000 $12,500 $20,000 2 Risk (Stand. Dev. for $50,000 $5,000 $30,000 6 Total Portfolio (% of $50,000 Stock 1 93.3% $46,667 Stock 2 6.7% $3,333 100% <=1 100% 19 10 | 11 | 12 | 13 | Minimum Expected Profit $13.000 Expected Profit Portfolio $13,000 14 Risk (Variance) $25,777,778 15 16 Risk (Stand. Dev.) $5,077 B TD Minimum acceptable expected profit = $15,0000 A Stock 1 Expected Profit (on $50,000) $12,500 F с Stock 2 $20,000 Risk (Stand. Dev. for $50,000 $5,0000 $30,000 Stock 1 66.7% $33,333 Portfolio (% of $50,000 Stock 2 · 33.3% $16,667 Total 100% <= 100% Minimum Expected Profit $15,0000 Portfolio $15,000 Expected Profit 12 13 14 Risk (Variance ($111,111,111 15 16 Risk (Stand. Dev.) $10,541

Minimum acceptable expected profit = $17,000 А В Stock 1 Expected Profit (on $50.000 $12.500 DE Stock 2 $20,000 Risk (Stand. Dev. for $50,000) $5,000 $30.000 Stock 1 20.0% $20,000 Portfolio (% of $50,000) Stock 2 60.0% $30,000 Total 100% Minimum Expected Profit $17,000 Expected Profit Portfolio $17,000 >= Risk (Variance) $328,000,000 Risk (Stand. Dev.) $18,111 16 Minimum acceptable expected profit = $19,000 A Stock 1 2 Expected Profit (on $50,000) $12,500 D E C Stock 2 $20,000 Risk (Stand. Dev. for $50,000) $5.000 $30.000 Stock 1 13.3% $6,667 Portfolio (% of $50,000) Stock 2 86.7% $43,333 Total 100% <= 100% Minimum Expected Profit $19.000 Expected Profit Portfolio $19,000 14 Risk (Variance 3676,444,444 15 16 Risk (Stand. Dev.) $26,009 PART-4) $13,000 $15,000 $17,000 $19.000 ou- ou-30 $5,077 $792352231 $10,541 $4,459 -$16,623 $18,111 -$1,111 -$37,333 $26,009 -$7,009 -$59,027 From the above calculations we can conclude that the portfolio with a minimum expected profit of $15,000 provides the highest ! a month those that also provide u - 0 20.