A manager for a small investment organization has been making use of index funds for restricted marketing time. Expansion has encouraged her to now transit into picking stocks. She is contemplating two small but very different listed stocks, but is worried about the risk that will be inherent via these investments in her portfolio. Provides an introduction to CAPM.Stidents will have an insight into total risk, non-diversifiable or portfolio risk, and (CAPM) beta, and compute the differences present in the stocks individually, and portfolio variance with and without stocks, to assess how a very risky (but low-beta) equity option infact lowers the risk, and compute stock-betas.
Investment Return Data
Month Vanguard 500 Index California REIT Brown Group Portfolio A* Portfolio B*
Mean, Standard Deviation
Applying CAPM, Riskfree Rate, Market Risk Premium, Monthly Expected Return
What is Wolfe’s current investment strategy? What kind of adjustment is she considering?
Calculate the variability (standard deviation) of the stock returns of California REIT (CREIT) and Brown Group (BG) during the past two years. How variable are they compared with Vanguard Index 500 Trust? Which stock appears to be riskiest?
Suppose Beta’s position had been 99% of equity funds invested in the index fund, and 1% in the individual stock. Calculate the variability of this portfolio using each stock. How does each stock affect the variability of the equity investment, and which stock is riskiest? Explain how this makes sense in view of your answer to Question 2 above.
Perform a regression of each stock’s monthly returns on the Index returns to compute the “beta” for each stock. This regression is called the Market Model in the literature. How does this relate to the situation described in Question 3 above?
How might the expected return for each stock relate to its riskiness?
What do you think about the move to a more active stock-picking strategy?
Try to derive the Capital Asset Pricing Model (CAPM) equation for the two stocks. Try to work out this question by assuming that Beta’s position had been 99% of equity funds invested in the index fund, and 1% in a riskless money market account. Imagine that you can switch from the money market account to CREIT, BG, or the index fund. Think about the condition for Sarah to be indifferent between switching to CREIT (or BG) and switching to the index.