The correlation between the two investments, offers somewhat of a reduction if risk.
- In case the portfolio was 75% Gold Hill the expected return would decrease because the 8.8% return component would have more weight. If the portfolio contained 75% of TECO the expected return would increase since TECO’s expected return would have more weight in this case. Nevertheless, such reduction in diversification would make risk increase. The complete table “Risk and returns of portfolios” provides the different changes.
- The portfolio between TECO – S&P 500 has an expected return of 14.3% and a standard deviation of 14.1%. In this portfolio the correlation is greater than the one in the other portfolio because the risk-reducing effect is much lower than the one in the portfolio TECO – Gold Hill. (See all the possible combinations on TABLE 2).
- The portfolio’s risk would decrease if more stocks were. The correlation between stocks is also relevant.
- I think investors consider the risk as a whole rather than by each. Nevertheless, if a big part of a portfolio is made up of a risky stock, it would make the portfolio more risky as a whole.
- Total risk is made by Diversifiable (company-specific) risk and market (non-diversifiable) risk. Unique events to a particular firm cause the diversifiable risk while factors that affect all companies cause the market risk. The difference between diversifiable and market risk is that diversifiable risk can be reduced by diversifying whereas market risk can not be eliminated.
- No, because the market compensates risk diversification if you don’t diversify is your fault and you should be willing to accept the risk.
- (ATTACHMENT 1,2,3,5)
S&P 500 – T-Bonds
Equation = S&P 500 = 0.08 + 3.08395284618099E-17
The slope coefficient is 3.08395284618099E-17.
R2 = 1.
S&P 500 – TECO
Equation = S&P 500 = 0.027 + 0.7 TECO
The slope coefficient is 0.7.
R2 = 0.996114926
S&P 500 – Gold Hill
Equation = S&P = 0.152 – 0.386666667 Gold Hill
The slope coefficient is – 0.386666667.
R2 = 0.71090448
These regression lines are called Value Line. The slope is beta; this measures the sensitivity of a stock in relation to the market fluctuations. Finally, the difference between the expected return and the predicted return is the distance between the plots in the graph and the regression curve.
- (ATTACHMENT 4)
- Required rate of return on the market = 15 %
- Risk-free rate of return = 8%
- Market Risk Premium = the difference between required rate of return and risk free rate of return = 7%
- Risk premium for TECO = 7% x 0.6 = 4.2%
- Required rate of return on TECO = 8% + 4.2% = 12.2%
- Security Market Line (SML)
= 8% + (15% - 8%)0.6
= 8% + 4.2%
= 12.2%
The slope of the Security Market Line, 7% in this case, indicates the degree of risk aversion in the economy, which defines whether the investors will be willing to bear the risk of adquiring TECO stock.
- If inflation expectations went up by 3% above the estimated, TECO’s required rate of return would also have to go up by 3%, therefore the required rate of return for teco would move from 12.2 to 15.2%. An explanation similar to what applies to this case can be found on the power point for the chapter. What happens is that the SML shifts and that causes explains the increment.
If investors’ risk aversion increased so that the market risk premium rose from 7% to 8%, TECO’s required rate of return would increase
= 8% + (8%)0.6
= 8% + 4.8%
= 12.8%
If TECO’s beta rose from 0.6 to 1, TECO’s required rate of return would increase
= 8% + (15% - 8%)1
= 8% + 7%
= 15%
- According to the EMH stocks are always in equilibrium. Investors can never beat the market. Additionally, according to the EMH concept, the expected return of a stock would be the required return of such stock. The concept does not consider plant property and equipment. EMH does affect corporate decisions since according to this concept, stocks are fairly valued because its price it’s a reflection of public information. Jack Taylor may consider acquiring personnel with knowledge on EMH because this hypothesis seems to work.