Solved Financial Portfolio Management Assignment: Plot The Security Market Line Using The Data In Stocks Vs. Bonds: The Long-Term Performance Data (Download Now)

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3 min readApr 1, 2021

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Solution Pages: 10

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Questions Covered in the Solution

1. Make a well-written summary of Part 1 and Part 2 learning objectives mentioned in Part 1 and Part 2 readings inside the Part 1 and Part 2 assignment guidelines

Part1: Learning Objectives:

• Review of financial market theory and practice using the contributions of Harry Markowitz and William Sharpe
• Review of interest rate determination
• Review of derivatives basics
• Review of innovations in the financial markets

Part2: Learning Objectives:

Develop perspective about market cycles for fixed income and equity securities
• Know long-term historical rates of return
• Know method for calculating rates of return
• Know the relative size of the fixed income and equity markets, their asset value and their trading volume

2. Plot the Security Market Line using the data in Stocks vs. Bonds: The Long-Term Performance Data, by identifying multi-year up and down market cycles for fixed income and equity returns, with a different SML for each cycle. Consider fixed income ‘low — beta’ and equity ‘high beta’.

3. Explain how rates of return and their standard deviations are calculated

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Sample of Solution

  1. Summary of learning objectives:

Although, human nature is perfused with cupidity and rapacity to acquire self-interests but the markets are so structured that their invisible hand doesn’t let any participant to always win. Participants of the market have their own preferences and risk appetites for which they demand relative compensation of returns. Moreover, active participants of the market define its efficiency of incorporating relative information in valuing the stocks. Being a participant of the market and just investing in index stocks, the investors are only exposed to the intrinsic market risk which systematic in nature and affects all the securities trading in the market. Apart from the systematic risk, the investors are also exposed to a firm specific risk which is unsystematic in nature and can be mitigated through a diversified portfolio. Moreover, the returns expected by the investors from each stock is directly related to its risk exposure. Hence, for a more risky stock which has more vibrant and unexpected return patterns, the investors would demand greater returns. Theory of practice which infers the differing preferences of the investors justifies the existence of risk leverage in the markets. Investors who prefer to take risks would value risky stocks, though demand greater returns but they would be willing to accept additional risks. While the risk-averse investors would compromise on returns and refrain from accepting additional risks. Such integrated risk preferences shape the markets and the annualized returns through their expectations.

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  1. Plot the Security Market Line using the data in Stocks vs. Bonds: The Long–‐Term Performance Data, by identifying multi — year up and down market cycles for fixed income and equity returns, with a different SML for each cycle. Consider fixed income ‘low — beta’ and equity ‘high beta.’

Security Market line, in essence, defines the required rate of return for the stocks based on the market risk premium and Beta values. Market Risk Premium is effectively the excess rate which participants of the market must realize above the risk-free rate of return. While the risk-free rate is the realized return on the Treasury securities. Whereas, fixed income is considered low-beta while equity income is considered as high-beta in formulating the Security Market Line. For each market cycle, separate SML has been shaped based on the equation

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