Portfolio Management: Practice Problems

Imagine you are applying to become a trainee in a management consulting company, Solutions Inc., which claims to deliver innovative solutions. They are looking for innovative employees who engage with their work. The selection process will be rigorous. You know you will be asked to submit reports based on questions regarding your knowledge of management accounting practice and strategic management accounting. To provide a context for the reports, you have been provided with a scenario in the form a case study on which the questions are based. To answer the questions you are going to have to do some research in the library. Giving you the questions is a method to test your information

The theme of my portfolio is “The Little Writer That Could.” This, of course, is a parody of “The Little Engine That Could.” I chose this theme because of my history as a writer. Up until this year, I have never been confident in myself as a writer. I have always had to constantly tell myself that I would be okay and that I would get better as time went on. I remained at an adequate writing level until recently. I feel so much more confident in myself as a writer now. The theme of that book was that the little engine overcame his problem and fear of not being able to make it over the hill. I view my inability to write as my hill and I am now on my way to the top of it. The fonts I used to make the title are ones I found on the internet. I tried

Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Sharon will evaluate each of these investments to decide whether they are superior to investments that her company already has in place, which have an expected return of 12% and a standard deviation of 6%. The expected returns and standard deviations of the investments are as follows:

e. Suppose you created a two-stock portfolio by investing $50,000 in Alta Industries and $50,000 in Repo Men. (1) Calculate the expected return, the standard deviation, and the coefficient of variation for this portfolio and fill in the appropriate blanks in the table. (2) How does the risk of this two-stock portfolio compare with the risk of the individual stocks if they were held in isolation?

Two assets, A and B, have the same expected return (10%) and the same level of risk (average). Which of the following

14) An investor has the following utility function: U = E(r) – 0.5Aσ2. Portfolio X has an expected rate of return of 12.5% and a standard deviation of 0.15. Portfolio Y has an

It’s actually a very simple quantitative stock ranking scheme. It uses return on capital and earnings yield as inputs. Return on capital is the metric that shows whether a business is a good one or not. Earnings yield is the metric that shows whether a company is cheap or not. Greenblatt suggests using these measures to identify good but cheap businesses, and buy them. That’s the secret behind the ‘magic formula’. In “The Little Book That Beats The Market,” Greenblatt calculated hypothetical returns for the 1988-2004 period. The magic formula returned an average 30.8% per year, while the market return was 12.3% and the S&P 500 returned an average 12.4%. So this formula beats the market by 18% per year.

The first part of this chapter dealt with stock return and the associated risk dealt with in this type of investment. The random

(15 points) Suppose your client is risk-averse but can invest in only one of the three securities, X, Y, or Z, in an uncertain world characterized as follows. Next year the economy will be in an expansion, normal, or recession state with probabilities 0.40, 0.40, and 0.20, respectively. The returns (%) on the three securities in these states are as follows: Security X {expansion = +14, normal = +10, recession = +7}; Security Y {+11, +9, +8}; Security Z {+13, +8, +7.5}. Which security can you rule out, that is, you will not advise your client to invest in it?

This summary addresses the project selections criteria and high-level process for managing this Tampa, Florida--based company’s proposed Strategic Business Units (SBUs). The most current report indicates this company’s current revenue to be $350 million annually, but the Operations SBU recognizes that more must be done to expand while controlling costs if this company is going to continue to grow. Currently, the company has several projects in the works, but the Operations SBU has recognized the need to establish a solid, company-wide portfolio management process if we are to meet and exceed the company’s vision; to become the cruise ship industry’s worldwide “provider of choice”.

−32 −4 10 38 28 75 24 Average and Standard Deviations for Stand-Alone Investments    Use formulas shown previously (tedious) or use Excel (easy) What is Blandy’s stand-alone risk?

Let us begin our discussion on Portfolio Theory with an example of two investments (assets or securities) – Ace and Bravo. Their return expectations are given in the table below. You will notice that both Ace and Bravo are risky investments because they do not offer a certain return. You can begin by comparing the expected return and risk of Ace and Bravo:

According to investment glossaries, a risk is a future probability of loss inherent in any investment (Investopedia Financial Dictionary, 2016). To this day, the positive correlation between risk and return continues to be the cornerstone of financial theory. The basic capital asset pricing model (CAPM) formula is built on this relationship. CAPM provides the required return based on the level of systematic risk of an investment. The risk associated with an investment is taken to lie along a scale. On the low-risk end of the scale, there are low yielding government bonds and securities. At the middle of the spectrum are medium performing investments – such as high yielding loan notes, and rental property. At the far end of the scale – high-risk – are futures, options, and equity investments. However, the positive relationship between risk and return does not guarantee that taking a greater risk will result in higher returns. Rather, a higher risk may lead to the loss of a greater amount of capital. This paper seeks to examine the risk and return relationship and how investors can determine the optimal trade-off.

This argument is flawed. In order to know performances of both strategies, both the shift direction and shift size should taken into consideration. First, it is not appropriate to conclude that one strategy can outperform another strategy in the category of active portfolios management strategies even though under the condition that there is a steeping of the yield curve. Performances of different strategies are various, different, even though under one same condition, since the detailed information of each strategy is unknown. Theoretically, performances of two strategies depends on the detailed shift situations (trend and size) of the yield curve. Second, the core method of the barbell strategy is focusing on the exceeding situations. To be more specific, the barbell strategy concerns securities with the longest and the shortest maturities. Meanwhile, the main approach of the ladder strategy is to build a portfolio including securities with approximately equivalent maturities. Third, however, under some situations, ladder strategy will outperform the barbell strategy. To be more precise, once the maturities of these two strategies are same, and if the yield curve will experience a negative steepening trend, the discount rate of the ladder strategy will be lower. Consequently, as the denominator of the ladder strategy is smaller than that of the barbell strategy, the ladder strategy will beat the other one. Fourth, on the other hand, if the maturities of these two

Standard deviations are an indicator of market volatility and represent risk. The lower standard deviations, the lower risks of portfolios. Even though the expected market return of active portfolio does not perform well, the risk of active portfolio is minimized. There is no short selling in the active portfolio and the the active portfolio is diversified through balanced investment of these ten stocks. Furthermore, the weights of 10 stocks in the active portfolio are more balanced than the passive portfolio. Therefore, the investors who pursue high expected market return should choose passive portfolio and risk averse investors should choose active portfolio. The investors should consider transaction fees and management fees of active portfolio and investors can insist on choosing active portfolio if they believe they can have higher return that offset these fees.