Mini case questions

Assume that you
recently graduated and landed a job as a financial planner with Cicero
Services, an investment advisory company. Your first client recently inherited
some assets and has asked you to evaluate them. The client presently owns a
bond portfolio with $1 million invested in zero coupon Treasury bonds that
mature in 10 years. The client also has $2 million invested in the stock of
Blandy, Inc., a company that produces meat-and potatoes frozen dinners.
Blandy’s slogan is “Solid food for shaky times.”
Unfortunately,
Congress and the President are engaged in an acrimonious dispute over the
budget and the debt ceiling. The outcome of the dispute, which will not be
resolved until the end of the year, will have a big impact on interest rates
one year from now. Your first task is to determine the risk of the client’s
bond portfolio. After consulting with the economists at your firm, you have
specified five possible scenarios for the resolution of the dispute at the end
of the year. For each scenario, you have estimated the probability of the
scenario occurring and the impact on interest rates and bond prices if the
scenario occurs. Given this information, you have calculated the rate of return
on 10-year zero coupon for each scenario. The probabilities and returns are
shown below:

Scenario

Probability of Scenario

Return on a 10 year Zero
Coupon Treasury Bond During the Next Year

Worst Case

0.10

-14%

Poor Case

0.20

4%

Most Likely

0.40

6%

Good Case

0.20

16%

Best Case

0.10

26%

1.00

You have also
gathered historical returns for the past 10 years for Blandy, Gourmange
Corporation (a producer of gourmet specialty foods), and the stock market.

Historical Stock
Returns

Year

Market

Blandy

Gourmange

1

30%

26%

47%

2

7

15

-54

3

18

-14

15

4

-22

-15

7

5

-14

2

-28

6

10

-18

40

7

26

42

17

8

-10

30

-23

9

-3

-32

-4

10

38

28

75

Average return

8.0%

?

9.2%

Standard Deviation

20.1%

?

38.6%

Correlation with market

1.00

?

0.678

Beta

1.00

?

1.30

The risk-free rate
is 4% and the market risk premium is 5%.
Questions
O. Your client decides to invest
$1.4 million in Blandy stock and $0.6 million in Gourmange stock. What are the
weights for this portfolio? What is the portfolio’s beta? What is the required
return for this portfolio?

P. Jordan Jones (JJ) and Casey Carter (CC) are
portfolio managers at your firm. Each manages a well-diversified portfolio.
Your boss has asked for your opinion regarding their performance in the past
year. JJ’s portfolio has a beta of 0.6 and had a return of 8.5%; CC’s portfolio
has a beta of 1.4 and had a return of 9.5%. Which manager had better
performance? Why?

Q. What does market equilibrium
mean? If equilibrium does not exist, how will it be established?

R. What is the Efficient Markets
Hypothesis (EMH) and what are its three forms?
What evidence supports the EMH? What evidence
casts doubt on the EMH?