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INTEGRATED CASE: MERRIL FINCH INC.

A Paper of Accounting and Finance Class


by Group 2:

Annisa Deni Istina


Kardo Eliezer
Wirawan Adi

Pra-MBA Master of Management


Faculty of Economy and Business
Universitas Gadjah Mada
2019
A. Question:
1. Why is the T-bill’s return independent of the state of the economy? Do T-bills promise
a completely risk-free return? Explain.
T-bills does not depend on the state of the economy because the government have to
redeem regardless of the economic condition when the T-bills are matured. T-bills are
considered risk-free because the 5.5% return will be realized in all economic states.
However, the 5.5% rate of return on T-bills consists of the real risk-free return and the
inflation premium, so it is more likely that the real return of the T-bills is less than 5.5%.

2. Why are High Tech’s returns expected to move with the economy, whereas Collection’s
are expected to move counter to the economy?
Based on the given data, we can see that High Tech’s returns move accordingly with ups
and downs of the state of the economy. In other words, we can say that High Tech’s
returns are positively correlated with the economic state. If the economy is in recession,
people tend to allocate their money to fulfil their basic needs rather than spend on
sophisticated electronic appliances, so that High Tech is more likely to experience
negative return.
Meanwhile it is the other way around with Collection. This company’s returns have
negative correlation with the state of the economy. In economic boom, Collections gives
negative return while the firm will experience its highest return in recession times. In a
recession, many companies will face difficulty to pay their matured debt. In this situation,
Collections, which business is collecting past-due debts, earns its highest profit.

B. Calculate the expected rate of return on each alternative, and fill in the blanks on the row
for r in the previous table.
Expected rate of return for each alternatives
High Tech = (0.1)(-27%)+(0.2)(-7%)+(0.4)(15%)+(0.2)(30%)+(0.1)(45%)
= 12.4%
Collections = 1%
US Rubber = 9.8%
Market = 10.5%
2-stock portfolio = 6.7%
C. You should recognize that basing a decision solely on expected returns is appropriate only
for risk-neutral individuals. Because your client, like most people, is risk-averse the riskiness
of each alternative is an important aspect of decision. One possible measure of risk is the
standard deviation of returns.
1. Calculate this value for each alternative and fill in the blank on the row for on the table.
Squared standard deviation for High Tech

= (-27%-12.4%)2(0.1)+(-7%-12.4%)2(0.2)+(15%-12.4%)2(0.4)+(30%-12.4%)2
(0.2)+(45%-12.4%)2(0.1)

= 0.0401

High Tech = √0.0401 = 20.04%

Collections = 13.2%

US Rubber = 18.8%

Market = 15.2%

2-stock portfolio = 3.4%

2. What type of risk is measured by the standard deviation?


The standard deviation is a measure of a stand-alone risk. We can use the standard
deviation to quantify the tightness of the probability distribution. The smaller the
standard deviation, the tighter the probability distribution and, accordingly, the lower the
risk.
3. Draw a graph that shows roughly the shape of probability distributions for High Tech,
US Rubber and T-bills.
2.5
T-Bill

Axis Title 1.5

High Tech
1

0.5
US Rubber
0
-60% -40% -20% 0% 20% 40% 60% 80%
Axis Title

D. Supposed you suddenly remembered that the coefficient of variation (CV) is generally
regarded as being a better measure of stand-alone risk than the standard deviation when
the alternatives being considered have widely differing expected returns. Calculate the
missing CVs, and fill in the blanks on the row for CV in the table. Does the CV produce the
same risk rankings as the standard deviation? Explain.
High Tech’s CV = /r-hat = 20.04%/12.4% = 1.62
CV shows the risk per unit of return, and it provides a more meaningful risk measure when
the expected returns on two alternatives are not the same.
When we use , the ranks of risk for High Tech, US Rubber and Collections are 20%, 18.8%
and 13.2% respectively. After we measured the risk per unit of return, we can see that
Collections is the most risky stock. CV provides better measure of a security’s stand-alone risk
because with CV we can consider wether the return in a stock worth the risk, compared to
other stocks.

E. Supposed you created a two-stock portfolio by investing $50,000 in High Tech and $50,000
in Collections.
1. Calculate the expected return, the standard deviation and the coefficient of variation
(CV) for this portfolio, and fill the appropriate blanks in the table.
Expected Rate of Return = (0%)(0.1)+(3%)(0.2)+(7.5%)(0.4)+(9.5%)(0.2)_(12%)(0.1)
= 6.7%
Standard deviation for the portfolio
= ((0%-6.7%)2(0.1)+(3%-6.7%)2(0.2)+(7.5%-6.7%)2(0.4)+(9.5%-6.7%)2 (0.2)+(12%-
6.7%)2(0.1))1/2
= 3.4%

CV = 3.4%/6.7% = 0.5
2. How does the riskiness of this two-stock portfolio compare with the riskiness of the
individual stocks if they were held in isolation?
High Tech gives high return in good economics while Collections is the opposite. These
two stocks are negatively correlated so if we invest the money on both stocks, we can
diversify the risk. Thus, the risk of investing in both stocks as a portfolio is lower than if
we held one of them in isolation.

F. Suppose an investor starts with a portfolio consisting of one randomly selected stock.
1. What would happen to the riskiness and to the expected return of the portfolio as more
randomly selected stocks were added to the portfolio?
Adding more stocks to a portfolio will decline its diversifiable risk. By diversifying, bad
events for one firm will be offset by good events on another. If we chose stocks with low
correlations with one another and with low stand-alone risk, the portfolio’s risk would
decline faster than if random stocks were added. The reverse would hold if we added
stocks with high correlations and high s.
2. What is the implication for investors? Draw a graph of the two portfolios to illustrate
your answer.
The investor should hold a well-diversified portfolio rather than individual stock so that
they can eliminate the diversifiable risk of the stocks.

Portfolio of stocks

One stock

0 10.5 %
0
As we can see from the graph that by combining two or more stocks into a diversified
portfolio, risk has been reduced while the portfolio’s return remains the same (10.5%).

G. Question:
1. Should the effects of a portfolio impact the way investors think about the riskiness of
individual stocks?
A two-or-more-stock portfolio security able to reduce diversifiable risk or single-stock
portfolio’s risk to almost zero point. This affect investors’ tendency toward securities.
Naturally, a rational investor more prefer a well-diversified portfolio rather than a single
stock. A stand-alone stock has stand-alone risk as measured by its σ or coefficient of
variation (CV). It would be riskier for investor to hold a single-stock portfolio. This stock
may be appealing to a small individual investor since it has a high return potential.
However, investing to single stock also could result in losing all the investor’s money.
Nevertheless, diversifiable risk of single stock can be eliminated by combining it with
another stock into a well-diversified portfolio. This last-mentioned portfolio is more
favourable to risk-averse investor.
2. If you decided to hold a one-stock portfolio (and consequently were exposed to more
risk than diversified investors), could you expect to be more compensated for all your
risk; that is, could you earn a risk premium on the part of your risk that you could have
eliminated by diversifying?
Investors who hold a single-stock portfolio would be exposed to high degree of risk.
However, that high-degree risk would not be compensated with enough return. If the
return is sufficiently enough to compensate the high risk, rational investors, which are
usually more-wealthy investors, would consider buying that portfolio and add them to
their well-diversified portfolio. In result, price will go up and return will go down.
Therefore, it is almost impossible to find stocks in the market with returns high enough to
compensate the stock’s diversifiable risk.

H. Given the expected rates of return and the beta coefficients of the alternative supplied by
Merrill Finch’s computer program:
1. What is beta coefficient, and how are betas used in risk analysis?
Beta coefficient is the slope of the regression line showing the relationship between a
given stock and the general stock market. Beta coefficient works as a metric that shows
extent to which a given stock’s return s move up and down with the stock market. In short,
beta measures market risk.
2. Do the expected returns appear to be related to each alternative’s market risk?
Yes. Market risk of each alternative single-stock portfolio affects the expected returns of
the diversified portfolio. The higher the alternative’s rate of return the higher its beta.
3. Is it possible to choose among the alternatives on the basis of the information
developed thus far? Use the data given at the start in the problem to construct a graph
that shows how the T-bill’s, High Tech’s, and the market’s beta coefficient are
calculated. Then discuss betas measure and how they are used in risk analysis.
To this point, it is still not enough information to choose among the various alternatives.
We require to know the required rates of return on the alternatives and compare them
with their expected returns.
Graph:

Return on
Stock (%) High Tech
(slope = beta = 1.32)
Market
(slope = beta = 1.0)

T-Bills
(slope = beta = 0)

Return on
the Market

I. The yield curve is currently flat; that is, long-term Treasury bonds also have a 5.5% yield.
Consequently, Merrill Finch assumes that the risk-free rate is 5.5%.
1. Write out the security market line (SML) equation; use it to calculate the required rate
of return on each alternative; and graph the relationship between the expected and
required rates of return.
SML Equation  ri = rRF + (rM – rRF)bi
rRF = 5.5%
rM = 10.5%
Thus, the required return for each alternatives are as follows:
T-Bill : 5.5% + (10.5%-5.5%)0 = 5.5%
High Tech : 5.5% + (10.5%-5.5%)1.32 = 12.10%
Collections : 5.5% + (10.5%-5.5%)(-0.87) = 1.15%
U.S. Rubber : 5.5% + (10.5%-5.5%)0.88 = 9.90%
Market : 5.5% + (10.5%-5.5%)1 = 10.50%

14.00%
High Tech
REquired Return and Expected Return

12.00%
U.S. Rubber
10.00%

8.00%

6.00%

4.00%

Collections 2.00%

0.00%
-1.00 -0.50 0.00 0.50 1.00 1.50
Beta

2. How do the expected rates of return compare with the required rates of return?
Beta r-i r-hat
T-Bills 0 5.5 5.50%
High Tech 1.32 12.05 12.4%
Collections -0.87 1.15 1.0%
U.S. Rubber 0.88 9.9 9.8%
Market
Portfolio 1.00 10.5 10.5%
From the table above, we can compare required return (r-i) with expected return (r-hat).
If r-i is less than r-hat, the portfolio is undervalued. Investors will more likely to buy it. If
the r-i is higher than r-hat, that portfolio is overvalued, and investors will probably to sell
it or ignore it. From the table, we can conclude that High Tech stocks is undervalued, while
both Collections and U.S. Rubber are overvalued.
3. Does the fact that Collections has an expected return that is less than the T-Bill rate
make any sense? Explain.
Collections’ stock has negative beta that indicates negative market risk. A well-diversified
portfolio may include this stock as an insurance when the economy goes to unfavoured
state. In this state of economy, Collections’ stock will probably have the best performance.
Thus, the return of Collections’ stock investment may offset the loss of others normal
stocks. In this case, the condition of expected return of Collections’ less then T-Bills is
acceptable. A negative-beta stick like Collections’ stock is conceptually similar to an
insurance policy.
4. What would be the market risk and the required return of 50-50 portfolio of High Tech
and Collections? Of High Tech and U.S. Rubber?
50-50 portfolio of High Tech and Collection:
Beta of portfolio would be the weighted average of betas of both stocks in the portfolio.
Therefore, for 50-50 composition, the beta would be:
bp = 0.5(1.32)+0.5(-0.87) = 0.225
and the required return would be:
Rp = rRF + (rM – rRF)bp  Rp = 5.5% + (10.5%-5.5%)(0.225)
= 6.63%

50-50 portfolio of High Tech and U.S. Rubber


bp = 0.5(1.32)+0.5(0.88) = 1.10
and the required return would be:
Rp = rRF + (rM – rRF)bp  Rp = 5.5% + (10.5%-5.5%)(1.10)
= 11.00%
J. Question:
1. Suppose investors raised their inflation expectations by 3 percentage points over
current estimates as reflected in the 5.5% risk-free rate. What effect would higher
inflation have on the SML and on the returns required in high- and low-risk securities?
The increase of inflation expectations will be followed with the same increase of required
return as long as the risk aversion of the investors remain the same (beta is same). The
increase of expected inflation by 3 per cent, will shift the entire SML upward by 3 per cent
parallelly to the base case SML. Now, rRF would be 8.5%, rM would be 13.5% and all
securities’ required returns rise by 3 per cent. Meanwhile, the market risk premium stay
the same at 5 per cent.
2. Suppose instead that investors’ risk aversion increased enough to cause the market risk
premium to increase by 3 percentage points. (Inflation remains constant.) What effect
would this have on the SML and on return of high- and low-risk securities?
The increase of investors’ risk aversion will rotate SML upward about the Y-intecept (rRF).
Risk free return remains at 5.5% while marker return increases to 13.5% resulting in
increase of marker risk premium to 8%. Therefore, the required rate of return will rise
sharply on high-risk (high beta) stocks, but not much on low-beta securities.

Required return
30%

25% Increased Risk Aversion

20%

15%
Increased inflation
Original scenario
10%
3%
5%

0% 0.5 1 1.5 2 2.5


Beta