Module 3 Assignment: Financial Risk and Required Return

Module 3 Assignment: Financial Risk and Required Return

Case 12: Mid-Atlantic Specialty, Inc.
Directions: Fully answer each question regarding Case 12: Mid-Atlantic Specialty, Inc.
Hint: Please note that you should use formulae given in Chapter 10 (page 377) to compute Variance in Row 38 rather than using Excel command for computing variance. To see if you are on the right track, remember that if your computed value in Cell D38 is not equal to 0.013725, you are making a mistake somewhere.

Here is my attempt at answering the questions for Case 12:

1. Comparing stand-alone risk/expected return of the four investments and S&P 500:

– 1-Year T-Bill has an expected return of 7% with no risk.

– Healthcare Fund has an expected return of 14% with a standard deviation of risk of 9.4%.

– Inverse ETF has an expected return of 7% with a standard deviation of risk of 11.0%.

– Biotech Fund has an expected return of 15% with a standard deviation of risk of 22.6%.

– S&P 500 has an expected return of 15% with a standard deviation of risk of 18.9%.

So the Biotech Fund has the highest expected return but also highest risk. The T-Bill has the lowest risk but also lowest expected return. The Healthcare Fund, Inverse ETF, and S&P 500 fall in between.

2.

a. Portfolio of 50% Healthcare Fund and 50% Inverse ETF:

Expected return = 0.5*14% + 0.5*7% = 10.5%

Variance = (0.5)^2*9.4^2 + (0.5)^2*11.0^2 + 2*0.5*0.5*9.4*11.0*0 = 6.05

Standard deviation = √6.05 = 2.46 = 2.5%

b. Portfolio of 50% Healthcare Fund and 50% Biotech Fund:

Expected return = 0.5*14% + 0.5*15% = 14.5%

Variance = (0.5)^2*9.4^2 + (0.5)^2*22.6^2 + 2*0.5*0.5*9.4*22.6*0 = 16.01

Standard deviation = √16.01 = 4.0%

The risk differs because the assets in the portfolios have different standard deviations. The Inverse ETF and Healthcare Fund have lower correlation, hence when combined, lead to a diversification benefit and lower risk. The Healthcare and Biotech Fund likely have higher correlation, so combining them does not lower risk as much.

3.

a.

b. As an individual investor with a diversified portfolio, I would buy the Healthcare Fund. It has moderately high expected returns for a reasonable amount of risk. The other options either have too much risk (Biotech Fund) or too low returns (T-Bill, Inverse ETF) to be attractive.

4.

a. No, the return on the 1-year T-Bill is not risk free because there is a chance the economy could perform poorly and returns could be lower than 7%.

b. No, if you hold a single stock you assume firm-specific risk which would not be compensated for through diversification. So you would take on additional risk without additional expected return.

5. Three key learning points:

– Combining assets with low correlation can lower portfolio risk through diversification.

– Expected return should be evaluated relative to risk – higher returns typically involve higher risk.

– Even “low-risk” assets like T-Bills have some risk of returns deviating from expectations.