Alex Sharpe's Portfolio Solution Essay

904 Words Nov 2nd, 2014 4 Pages
Alex Sharpe’s Portfolio

1. Returns and Risk
Estimate and compare the returns and variability (i.e. annual standard deviation over the past five years) of Reynolds and Hasbro with that of the S&P 500 Index. Which stock appears to be riskiest?

S&P 500 Annualized Expected Return: 6.8920% S&P 500 SD (Annualized): 12.477%
Reynolds Annualized Expected Return: 22.4980% Reynolds SD (Annualized): 32.446%
Hasbro Annualized Expected Return: 14.2060% Hasbro SD (Annualized): 28.114%

Reynolds appears to be the riskiest stock since it has the highest standard deviation. The fact that Reynolds also has the highest annualized expected return supports this calculation since risk and return should be directly correlated.

2.
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The regression that we performed in excel for both stocks yielded a beta of .73576 for Reynolds, and a beta of 1.4198 for Hasbro. In question 2 we learned that although Reynolds stock was riskier independently, adding it to the portfolio made it more diversified compared to adding Hasbro, due to the fact that it was less correlated to the market portfolio. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Therefore, since the beta of Reynolds is lower than Hasbro, our beta calculations align with the fact that Reynolds stock makes the overall portfolio less risky. This finding is also intuitive when considering the nature of the companies; Reynolds is a Tobacco company meaning that is should be less sensitive to changes in market conditions than a toy company like Hasbro.

4. Capital Asset Pricing Model (CAPM)
How might the expected return of each stock relate to its riskiness?

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

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