Reading 66: Portfolio Concepts Los k~Q1-7

stocks, expected, following, developed, businesses

LOS k: Calculate the expected return on a portfolio of two stocks, given the estimated macroeconomic factor model for each stock.

Q1. Carla Vole has developed the following macroeconomic models:

Return of Stock A = 6.5% + (9.6 × productivity) + (5.4 × growth in number of businesses)
Return of Stock B = 18.7% + (2.5 × productivity) + (3.7 × growth in number of businesses)

Assuming a portfolio contains 60% Stock A and 40% Stock B, the portfolio’s sensitivity to productivity is closest to:

A) 4.72.

B) 6.76.

C) 5.34.

Q2. Colonial Capital leans heavily on the capital asset pricing model (CAPM) in its investment-making decisions, but the company’s analysts find it difficult to use. In an effort to make the calculations easier, Colonial has modified the CAPM to use the S& 1500 SuperComposite Index as a benchmark.

Colonial recently hired high-powered money manager Marjorie Kemp away from a rival company in an effort to boost its lagging returns. Kemp understands the appeal of the CAPM but likes to use multiple valuation methods for the purposes of comparison.

In her first act as chief investment officer of Colonial, Kemp sent a memo to all portfolio managers instructing them to start using alternative methods for valuing assets. She opened by touting the benefits of other forms of asset valuation.

“The CAPM requires a lot of unrealistic assumptions. Arbitrage Pricing Theory’s (APT) assumptions are far less restrictive.”
“A major benefit of multifactor models relative to the CAPM is their ability to be effectively tested using real-life data.”
“Under APT, risk is easier to calculate than is the case with the CAPM, for which beta must be estimated based on unobservable returns.”
“Neither multifactor models nor APT require an estimation of the market risk premium.”

Kemp then called a meeting of Colonial’s analysts to discuss asset-valuation strategies. The debate grew quite spirited.

A longtime Colonial analyst named Smathers said the company had experimented with multifactor models years earlier and could not come up with a model that satisfied everyone. He then proposed creating a number of multifactor models for different sectors. The responses were as follows:

Florio said he didn’t like APT because it did not indicate what the risk factors were.
Garcia said he liked APT because it acknowledged that arbitrage opportunities occasionally exist.
Inge said he disliked APT because it did not allow analysts to consider the market portfolio.

After about 30 minutes, Kemp realized nothing productive would occur, so she set everyone to work analyzing a valuation model. She wrote the following equation on a blackboard:

Expected stock return = expected S& 1500 Index return / 2 + capacity utilization / 15 + 1.5 × GDP growth ? 2 × inflation

Which factors, taken in combination, would create the best multifactor model for utility stocks?

A) Projected winter low temperature, interest rate term structure, housing starts, price/earnings factor.

B) Projected change in energy prices, interest rate term structure, estimated GDP growth, projected market return.

C) Projected winter low temperature, projected change in energy prices, projected change in inflation, projected market return.

Q3. Which statement represents Kemp’s weakest argument?

A) “Under APT, risk is easier to calculate than is the case with the CAPM, for which beta must be estimated based on unobservable returns.”

B) “The CAPM requires a lot of unrealistic assumptions. APT’s assumptions are far less restrictive.”

C) “Neither multifactor models nor APT require an estimation of the market risk premium.”

Q4. Kemp’s equation is closest to:

A) arbitrage pricing theory.

B) a macroeconomic multifactor model.

C) a microeconomic multifactor model.

Q5. Which analyst made the most sense?

A) Florio.

B) Garcia.

C) Inge.

Q6. The Adams portfolio contains 35% Khallin Equipment stock and 65% Giant Semiconductor stock. Analyst Joe Karroll estimates that 40% of Khallin’s return variance is determined by cost trends and 60% is determined by purchasing trends. Karroll also estimates that Giant’s return variance is 75% determined by cost trends and 25 percent determined by purchasing trends. Assuming an estimated return of 7% for Khallin and 16% for Giant and a cost factor of –0.07 and a purchasing factor of 0.0325, the Adams portfolio’s expected return is closest to:

A) 12.9%.

B) 9.7%.

C) 8.0%.

Q7. Mary Carruthers has created the following macroeconomic model for stock in Magma Metro Systems and Clampett Pharmaceuticals: