1 (5 points) John James is a 40-year old executive for North Star Tractor Company with a $2.6 million portfolio. John’s wife recently passed away after a long illness and he has three children, ages 10, 15, and 20. John wants to fund the cost of his son’s college education according to the following schedule:
Son Joe: PV of tuition is $15,000
Son Jerry: PV of tuition is $46,000
Son Jack: PV of tuition is $65,000
John and his three sons love to fish together so John wants to build a lake house in the mountains for the family. He hopes to do this within the next year at a cost of $150,000. He also wants to give each of them $100,000 on their 25th birthdays.
John currently makes an annual salary of $160,000 (and he spends almost all of this each year) but wants to retire in 20 years with an annual income of $200,000 after tax (he expects to travel extensively with any grandchildren he might have by then). This means the portfolio must grow in value until retirement. John’s current portfolio consists of a healthcare sector fund (25%), an international index fund (50%), and shares of stock in North Star Tractor. The portfolio has been averaging 8% during the last several years, but John is nervous about a market decline going forward. John describes himself as being neither conservative nor aggressive.
John wishes to change his portfolio so that it is more diversified.
John is in good health as are his children. He has no retirement fund but excellent medical benefits. He owns his house and does not want to borrow from a bank for any purpose during the rest of his life. Tax rate is 32% and inflation should be 2.6%.
A. Formulate the Risk and Return Objectives for John.
B. Identify the most appropriate portfolio for John.
Portfolio Number 1 2 3 Return Risk
Money Market Fund 8% 8% 50% 4.1% 2.2%
Investment Grade Bonds 45% 74% 25% 6.6% 8.1%
Int’l Equities 47% 18% 25% 10.5% 16.3%
Provide two reasons for your selection and provide one reason for rejecting each of the other portfolios.
2 (5 points) Three assets make up the following portfolio:
Asset Dollars Invested Return Standard Deviation
Bond 1 $90 5.7% 4.9%
Equity 1 $130 9.7% 12.6%
Equity 2 $80 12.8% 17.4%
Use the following correlation Coefficient matrix:
Bond 1 Equity 1 Equity 2
Bond 1 1.00 0.00 0.10
Equity 1 0.00 1.00 0.87
Equity 2 0.10 0.87 1.00
A. Determine the return and standard deviation of the portfolio.
B. Comment on the portfolio’s level of diversification.
C. Describe the change in the portfolio if a 15-year Treasury bond were added to it.