PS2 AK - Problem Set 2 Answer Key Econ 233 BKM 9: CFA 12...

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Problem Set 2 Answer Key Econ 233 BKM 9: CFA 12 (31 in 7 th edition) 12. a. Expected Return Alpha Stock X 5% + 0.8(14% - 5%) = 12.2% 14.0% - 12.2% = 1.8% Stock Y 5% + 1.5(14% - 5%) = 18.5% 17.0% - 18.5% = - 1.5% b. i. Kay should recommend Stock X because of its positive alpha, compared to Stock Y, which has a negative alpha. In graphical terms, the expected return/risk profile for Stock X plots above the security market line (SML), while the profile for Stock Y plots below the SML. Also, depending on the individual risk preferences of Kay’s clients, the lower beta for Stock X may have a beneficial effect on overall portfolio risk. ii. Kay should recommend Stock Y because it has higher forecasted return and lower standard deviation than Stock X. The respective Sharpe ratios for Stocks X and Y and the market index are: Stock X: (14% - 5%)/36% = 0.25 Stock Y: (17% - 5%)/25% = 0.48 Market index: (14% - 5%)/15% = 0.60 The market index has an even more attractive Sharpe ratio than either of the individual stocks, but, given the choice between Stock X and Stock Y, Stock Y is the superior alternative. When a stock is held as a single stock portfolio, standard deviation is the relevant risk measure.
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This note was uploaded on 10/06/2010 for the course ECON FINANCE taught by Professor Kaipommerenke during the Spring '09 term at University of California, Santa Cruz.

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PS2 AK - Problem Set 2 Answer Key Econ 233 BKM 9: CFA 12...

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