Case Analysis Beta Management Company

Submitted by: Biwesh Neupane, Dev Raj Dhungana Mingma Sherpa (Lama), Shrawan Regmi Introduction Analysis Using excel, we calculated following mean and standard deviation for the two stocks and the index. The calculations are shown in Appendix I. Stock Monthly Mean Monthly Standard Deviation (STD) Vanguard Index 500 Trust 1.1025% 4.61% California REIT -2.265% 9.23% Brown Group -0.671% 8.17%

The two individual stocks have almost double the variability than the Vanguard Index 500 Trust. This means that the stocks are riskier than the Vanguard Index 500 Trust in terms of the variability or deviation from the mean. However, individual standard deviation is not a proper measure of risk. Since, we are creating a portfolio consisting of Vanguard Index 500 Trust and one of the two individual stocks we need to calculate the portfolio variance which is a better measure of risk. We know that,
2 2 2 2 2 p = w12 12 + w2 2 + 2 w1 w2 Cov(r1 , r2 ) = w12 12 + w2 2 + 2 w1 w2 1 2 12

Where, = variance

2
= standard deviation

W = Weight for stock in the portfolio Cov (r1,r2) = covariance between the return of the two stocks in portfolio 1|Page

= coefficient of correlation among the stock

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Therefore, Stock Covariance Monthly Standard Deviation (STD) Coefficient of correlation 4.61% Vanguard Index 500 Trust California REIT 0.0003 9.23% 0.0735 Brown Group 0.0024 8.17% 0.6562

Now, we know that Ms. Wolfe is considering investing $200,000 in either California REIT or Brown Group making her equity exposure to $20 million out of her total investment of $25 million. For simplicity, we can safely assume that about 1% of her equity exposure will be invested California REIT or Brown Group and rest in Vanguard Index 500 Trust. a) Calculation of portfolio variance (99% Vanguard, 1% California REIT) = 0.992 x 0.04612 + 0.012 x 0.09232 + 2 x 0.99 x 0.01 x 0.0003 = 0.002081 Portfolio standard Deviation = 0.002081 = 4.57% b) Calculation of portfolio variance (99% vanguard, 1% Brown group) = 0.992 x 0.04612 + 0.012 x 0.08172 + 2 x 0.99 x 0.01 x 0.0024 = 0.0021221 Portfolio standard Deviation = 0.0021221 = 4.61% Looking at these figures, we can see that the portfolio variance for Brown group is greater than that for California REIT. Thus, Brown group stocks have more variability to the portfolio than the California REIT. Thus, Brown Group stock is more risky. However, it contradicts with the previous answer when only looking at individual standard deviation we found that California REIT is more risky. This is because covariance or correlation among the stocks is more important to determine the riskiness of portfolio than the individual stocks. Since, Brown is more positively correlated to Vanguard than the California REIT it increases the overall portfolio risk. In other words, since Covariance between the Brown's stock and Vanguard is almost 8 times than between California REIT and Vanguard, the portfolio that includes Brown is riskier. Now, let us base our analysis on Capital Assets Pricing Method (CAPM). We know that, E(Ri) = Rf +[E(Rm)-Rf)] 3|Page

Where, E(Ri) = Expected return on capital assets Rf = Risk free rate of return E(Rm) = Expected Return on market = is the sensitivity of the expected excess asset returns to the expected excess market returns

Now, the calculation of beta () a) Beta of California REIT = Cov (Rm, Ri)/var(Rm) = 0.0003/0.04612 = 0.1411 b) Beta of Brown = Cov (Rm, Ri)/var(Rm) = 0.0024/0.04612 = 1.13 We know that lower the beta, less sensitive the stock would be to market movements. Hence, higher the beta, riskier is the stock. This is consistent with our second analysis that Brown Group's stock is more risky since its beta is higher than that of California REIT's. In terms of the expected return on capital assets, we can see that the Brown Group's stock should have higher expected return than California REIT's. One of the major issues in determining the expected return on capital assets is to use the right risk free rates. Different authors have different view regarding the use of risk free rate. Some researchers use short term treasury bills rate as a risk free rate where as some researchers use long term treasury bills rate. In our case, we have used 10 year Treasury bond rate as the measure of the risk free rate. 1 The coupon rate for 10 year US Treasury Bill is 2% (Shown in Appendix II). Likewise we should use effective annual rate for market return. Effective expected annual rate of return E(Rm) = (1+0.010125)12 -1 =14.06% a) Expected return for California REIT = 2% + 0.1411(14.06%-2%) = 3.7016% b) Expected return for Brown Group = 2% + 1.13 (14.06% - 2%) = 15.628% Thus, we can see that the expected return for Brown Group is higher than that of California REIT, this is primarily because the beta for Brown Group is higher. When
1 Brigham, Eugene F., Houston, Joel F., "Fundamentals of Financial Management", 7th Edition, Cengage Learning

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an investor wants to invest in Brown Group they will demand extra premium for the extra risk they take. Hence, the expected return for Brown is higher. This follows the basic principle of risk and return, which is higher the risk higher the return. Now, it depends on the risk bearing capacity of investors to decide which stock to invest in. A risk averse investor, as a universal assumption, would choose to reduce its risk through portfolio diversification. In this case, it is better for Ms. Wolfe to invest in California REIT, since it lowers the risk of the overall portfolio.

Conclusion The case is a very good example of the use of portfolio to diversify and reduce risk. When we consider the individual stocks, Brown and California REIT and market index individually, the standard deviation of each is around 8.17%, 9.23% and 4.6%, representing California REIT as risky stock. But when we add small amount of individual stock to the market index, we find that the portfolio variance declines. However, the portfolio riskiness declines when we add California REIT to the portfolio. The riskiness of a stock is best measured by its covariance with the market, rather than its own variance. As can be seen in the analysis, the covariance between the new asset and the portfolio, rather than the variance of the assets, matters more to the total risk of the final portfolio. In other words, individual risk can be diversified away in a portfolio. But the market risk has to be held by the investors and they expect some risk premium for taking the market risk. Hence, the expected return for risky assets is greater than that of less risky assets. To conclude, while deciding on the stock to add on portfolio, individual stock variance matter less. Hence, investor or broker should look at the portfolio variance. In this case as well, it is better for Ms. Wolfe to invest in California REIT than in Brown Group's stock.

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Appendix I

Month

VanIndex

California REIT

Brown

1989

1990

Jan Feb March April May June July August September October November December Jan Feb March April May June July August September October November December Mean

7.32 -2.47 2.26 5.18 4.04 -0.59 9.01 1.86 -0.4 -2.34 2.04 2.38 -6.72 1.27 2.61 -2.5 9.69 -0.69 -0.32 -9.03 -4.89 -0.41 6.44 2.72 1.1025 4.6063436 88

Standard Deviation Covariance between Vanguard and Individual stocks Correlation Beta

-28.26 -3.03 8.75 -1.47 -1.49 -9.09 10.67 -9.38 10.34 -14.38 -14.81 -4.35 -5.45 5 9.52 -0.87 0 4.55 3.48 0 -13.04 0 1.5 -2.56 2.26541666 7 9.23073598 2 2.99628854 2 0.07353166 0.14116252

9.16 0.73 -0.29 2.21 -1.08 -0.65 2.22 0 1.88 -7.55 -12.84 -1.7 -15.21 7.61 1.11 -0.51 12.71 3.32 3.17 -14.72 -1.91 -12.5 17.26 -8.53 -0.67125 8.1667711 21 23.655903 13 0.6561697 66 1.1293001 63

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Appendix II

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