The Alex Sharpe Case allows students to:
1. Understand and quantify risks associated with individual stocks and portfolios.
2. Calculate beta using linear regression.
3. Understand the relationship between risk/return and the Capital Asset Pricing Model (CAPM).
Please write a paper (single-spaced within paragraphs, double-spaced between paragraphs, 12 PT Times New Roman Font, 1 inch margins) answering the following questions:
1. Alex Sharpe sat in her home office and evaluated the investment strategy for her children’s educational savings. Currently, money is invested in a Vanguard 500 Index fund, a no-load mutual fund constructed to track the performance of the S&P 500. In order to achieve higher returns, Alex had been considering a more active strategy. She has narrowed down her search to two stocks: Hasbro and R.J. Reynolds. She wants to insure that the expected return on the new portfolio would provide adequate compensation for taking on any new risky assets.
CLIENT PROFILE: Who is Alex Sharpe and what are her objectives.
QUESTION 1: Estimate and compare the returns and variability (i.e., annual standard deviation over the past five years) of Reynolds and Hasbro with that of the S&P 500 Index. Which stock appears to be riskier?
QUESTION 2: Suppose Sharpe’s position had been 99% of equity funds invested in the S&P500 and either 1% in Reynolds or 1% in Hasbro. Estimate the resulting portfolio position. How does each stock affect the variability of the equity investment? How does this relate to your answer in Question 2 above?
QUESTION 3: Perform a regression of each stock’s monthly returns on the Index returns to compute a beta for each stock. How does this relate to your answer in Question 2 above?
QUESTION 4: How might the expected return of each stock relate to its riskiness?
QUESTION 5: In what stock(s) (if any) should Sharpe invest?