Investor Smith is determining whether to invest in the Pacific Pools Corp. (“PPC”) or Swimming-R-Us, Corp. (“SRU”). Smith believes that putting all of eggs in one basket is a sound strategy. Thus, he intends to only invest in either PPC or SRU. Investor Baker is evaluating the same two companies, PPC and SRU. Although Baker believes that investing in many companies at similar time is a sound strategy, and is thus determining whether either PPC or SRU must be added to her portfolio.
Throughout their investigation, both Smith and Baker have found out that the returns on pool manufacture’s stocks are sensitive to weather. Both have determined that if the weather in the US is sunny in the coming year, the stock of PPC must raise by 50%. If the weather in the US is normal, then the stock of PPC must raise by 10% and if the weather in the US is rainy, then the stock of PPC must decrease by 20%. The National Weather Service has indicated that there is a 30% chance for sunny weather, 50% chance for normal weather and a 20% of rainy weather in the coming year.
In addition factors that Smith and Baker have determined about such stocks are that the standard deviation for PPC is 24.98% and the beta for PPC is 1.5. For SRU, the standard deviation is 5%, the expected return (r) is 9% and the beta is .95. In addition, Smith and Baker have determined that the risk-free rate is 5% and the return on the market is expected to be 11%.
Baker currently has a portfolio of three stocks; 30% of her portfolio is made up of Coke that has an expected return (r) of 10% and a beta of .80; 40% of her portfolio is made up of Intel that has an expected return of (r) of 13%, and a beta of 1.5; and, 30% is made up of General Electric, that has an expected return (r) of 11% and a beta of 1.0.
problem 1: Determine the risk, expected return (r) and required return (r_{s}) of Baker’s portfolio. Do this supposing that she has not yet added either PPC or SRU to the portfolio. Is Baker being sufficiently compensated for the risk that she is taking with her portfolio?
problem 2: Determine the required rate of return (r_{s}) for each of stocks in Baker’s portfolio. Which stock must she substitute with either PPC or SRU?