Investment Analysis and Portfolio Management - University Assignment

This assignment solution delves into the core concepts of investment analysis and portfolio management. It begins by calculating expected returns based on probabilistic outcomes and determining the expected selling price of a stock. The solution then proceeds to compute the standard deviation of returns, assessing the risk associated with the stock and its coefficient of variation. Furthermore, the assignment addresses the impact of interest rate changes on the Security Market Line (SML) and distinguishes between systematic and unsystematic risk, emphasizing the importance of diversification. The solution references key financial management texts, including works by Brealey and Myers, Brigham and Houston, and Damodaran, providing a comprehensive analysis of the subject matter.

Investment Analysis & Portfolio Management
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Investment Analysis & Portfolio Management
A. In order to compute the expected returns, the expected selling price needs to be determined
based on probabilistic outcomes highlighted.
Expected selling price = 0.6*11 + (1-0.6)*12 = K11.4
Dividend income during holding period = K2
Buying price of the stock = K10
Hence, expected holding period returns = [(11.4+2-10)/10]*100 = 34 %
B. In order to compute the standard deviation of returns for the stock, the returns in case of
both the possible prices need to be computed.
Returns (Selling price = K11) = [(11+2-10)/10]*100 = 30%
Returns (Selling price = K12) = [(12+2-10)/10]*100 = 40%
Expected returns = 30*0.6 + 40*0.4 = 34%
The standard deviation of the stock can be estimated using the following table (Damodaran,
2010).
From the above, it is apparent that the standard deviation of the given stock is 24%
C. Coefficient of Variation = Standard Deviation/Mean = 24/34 = 0.706
It is apparent that the coefficient of variation is moderate to high as standard deviation stands
at 70.6% of the mean value. This implies that the given stock would be termed as moderate
to high risk considering the fluctuations in stock price (Brealey and Myers, 2007).

Investment Analysis & Portfolio Management
D. The treasury bill rate would act as the risk free rate which would act as the intercept of the
SML while the slope would be determined by the excel return per unit risk. The required
SML is indicated below (Brigham and Houston, 2014).
0 5 10 15 20 25 30 35
0
5
10
15
20
25
30
35
40
45
Security Market Line
Risk (%)
Returns (%)
The cross on the line tends to denote the given stock.
E. If an increase in the interest rate is announced then, there would an incentive for the
investors to switch to other investments and hence there would an increase in the equity
premium which would lead to higher return expectations from the investors for the same
returns as before. As a result, the SML would become steeper as indicated below
(Damodaran, 2010).
0 5 10 15 20 25 30 35
0
5
10
15
20
25
30
35
40
45
Security Market Line
Risk (%)
Returns (%)
The red line tends to indicate the new SML owing to increase in the interest rate.

Investment Analysis & Portfolio Management
F. Systematic risk or non-diversifiable risk refers to the risk associated with stock market
which cannot be done away with even if the portfolio is well diversified as it is risk
associated with the market. This is captured by the beta of the stock. On the other hand,
unsystematic risk or diversifiable risk refers to the risk associated with a particularly
industry or company and thus can be mitigated by ensuring the portfolio is well
diversified. Thus, systematic risk is unavoidable for any investor while unsystematic risk
can be avoided through the use of diversified investment portfolio (Brealey and Myers,
2007).
References

Investment Analysis & Portfolio Management
Brealey, R., and Myers, S., (2007) Principles of Corporate Finance. 9th edn. New York City:
McGraw –Hill.
Brigham, E. F. and Houston, J. F., (2014) Fundamentals of Financial Management. 14th edn.
Boston: Cengage Learning.
Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York:
Wiley, John & Sons.