Aardvark (A) Inc, Bandicoot (B) Inc and the TSX market portfolio

Problem 1 (24 marks):

You are given the following information on Aardvark (A) Inc, Bandicoot (B) Inc and the TSX market portfolio, under 5 different economic conditions. Aardvark Inc has a correlation with the market portfolio of 0.9 and Bandicoot Inc has a correlation with the market portfolio of -0.5. The TSX market portfolio has a standard deviation of 10%. The government of Canada T-bill is yielding a return of 4%.

State of the Economy	Probability	Return on A	Return on B
Boom	0.3	30%	8%
Improving	0.2	20%	8%
No change	0.2	10%	10%
Slowdown	0.2	0%	12%
Recession	0.1	-20%	15%

a) Calculate the expected return for Aardvark Inc. (3 marks)

b) If the expected return for Bandicoot Inc is 9.9%, calculate the standard deviation for Bandicoot. (5 marks)

c) Calculate the correlation between the two stocks. Assume risk for Aardvark is 15.52%. (5 marks)

d) Assume you create a portfolio with $40,000 invested in Aarkvard and $160,000 invested in Bandicoot. Determine the expected return and standard deviation of returns for this portfolio. (8 marks)

e) How well does diversification work in this scenario? How much risk reduction have you achieved from the worst-case outcome? Comment. (3 marks)

Problem 2 (8 marks):

You have $100,000 to invest in a portfolio containing Xantus shares and Yak shares. Your goal is to create a portfolio that has an expected return of 10.6%. Xantus has an expected return of 11.4% and a beta of 1.25. Yak has an expected return of 8.68% and a beta of 0.85,

How much money will you invest in Yak shares? (6 marks)
What is the beta of your portfolio? (2 marks)

Problem 3 (4 marks)

For each stock state whether it is overvalued, undervalued or correctly priced if the risk-free rate of return is 3.2% and the expected return on the market is 11.6%. Also state your investment strategy (buy, sell, or hold).

Stock	Beta	Expected Return
A	1.46	15.79%
B	0.72	8.62%

Problem 4 (10 marks)

A company recently paid a dividend of $1.45. You expect dividends to grow at a rate of 5% for 1 year, then level off to 3.5% per year, forever. The company’s shares have a correlation with the market of 0.8. The standard deviation of the market is 3.4% and the standard deviation of the stock is 2.5%. The return on T-bills is 3% and the market risk premium is 5%.

What would you be willing to pay for this stock today?
If the stock is selling in the market for $80, would you recommend buying or selling it? (2 marks)

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