Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater

QUESTION

a. John Wilson is a portfolio manager at Austin & Associates. For all of his clients, Wilson manages portfolios that lie on the Markowitz efficient frontier. Wilson asks Mary Regan, CFA, a managing director at Austin, to review the portfolios of two of his clients, the Eagle Manufacturing Company and the Rainbow Life Insurance Co. The expected returns of the two portfolios are substantially different. Regan determines that the Rainbow portfolio is virtually identical to the market portfolio and concludes that the Rainbow portfolio must be superior to the Eagle portfolio. Do you agree or disagree with Regans conclusion that the Rainbow portfolio is superior to the Eagle portfolio? Justify your response with reference to the capital market line.
b. Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater nonsystematic risk than Eagles portfolio. Define nonsystematic risk and explain why you agree or disagree with Wilsons remark.
Solution: a) I agree withRegans conclusion that the Rainbow portfolio is superior to the Eagle portfolio. Capital market line (CML) is used to determine about efficiency of portfolio. CML is made up of various combination of risk free asset and risky asset. CML is considered to be superior of efficient frontier because it takes into account inclusion of risk free asset also in the portfolio. CAPm model represent that market portfolio is essential the efficient frontier. Since here Rainbow portfolio is identical to market portfolio therefore this will be the best and superior portfolio. b) Non systematic risk is company specific risk and it eliminates from diversification of the portfolio. Non systematic risk is in addition to systematic risk of any company. Systematic and non

c risk for any company becomes total risk and measured by standard deviation. I agree with Wilson remarks. Although CML represent only systematic risk and nonsystematic risk is eliminated through diversification but return used in constructing the CML remains the total return. Therefore it is possible to construct the portfolio with securities with high non systematic risk and lower systematic risk and then eliminating non systematic risk through proper diversification and thereby achieve the higher return and efficient portfolio.

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