Questions 9-10 (30 points total)
Samantha Monat (MSB MBA ’04) was the portfolio manager of the SMB opportunities fund.
Samantha
had developed a proprietary valuation model which served the fund well over the last five years.
Over the
summer, she had trained one of her interns to use the model and had asked them to examine a few different
stocks with it.
Because it was proprietary, she provided the intern the data for the model without letting
them know what the actual stocks were.
Stock A was a leading grocery store chain which had been
profitable each year for the last six, while Stock B was an aerospace firm.
Unfortunately, the Harvard trained intern turned out to be a complete disaster.
While the intern had done
the work, they hadn’t compiled a cohesive report and merely provided a few sparsely labeled graphs.
Moreover, it appeared that the intern really liked drawing lines as each graph included at least one.
Each
graph also showed the equation of every line that was plotted.
Exhibit 1
showed the returns of Stock A
graphed against the returns on the S&P 500, which SMB used as its measure of the “Market portfolio”.
Exhibit 2
showed a similar graph for Stock B.
Exhibit 3
plotted the expected return and expected standard deviation for each of the two stocks based on
the predictions of the model.
According to the model, Stock A had an expected return of 8% with an
expected standard deviation of 18%.
The model projected an expected return for Stock B of 10% with a
standard deviation of 15%.
Exhibit 3
was also the only graph which included multiple lines.
Finally,
Exhibit 4
showed the expected returns for the market and the risk-
free rate as predicted by the fund’s
model

13
Exhibit 1:
Regression of returns of Stock A against the S&P 500
Exhibit 2:
Regression of returns of Stock B against the S&P 500

14
Exhibit 3:
Plot of expected returns and expected standard deviations for Stocks A, B, and the risk-
free asset.
Exhibit 4:
Plot of expected returns and expected betas for the Market and the risk-free asset.

15
9.
Suppose that
SMB currently holds no assets except cash in their portfolio
and that SMB will be
able to invest in a risk-
free asset. Whatever isn’t put into the risk
-free asset will be invested in
EITHER
Stock A
OR
Stock B.
While we know this is not an ideal investment strategy, assume
those are her only choices.
Based on its assessment from its model, in which stock should SMB
invest
?
Briefly, WHY
?
(15 points)
While the above explanation is sufficient, here is a longer explanation of WHY that is the answer.
If SMB is only investing in a combination of only one stock and the risk-free asset, then it means that
any possible portfolio it can hold will lie on a straight line between those two points.
Exhibit 3 shows
the two stocks and the lines connecting them to the risk-free asset.
Recall that when the graph is
expected return (y-axis) vs. standard deviation (x-axis), the slope of the line is called the Sharpe ratio.