Faculty of Economics and Business. Department of Business.
FINANCE I (102329) – Group 3 – 2012-13. Study Guide. Dr. Maria-Antonia Tarrazon & Dr. Joan Montllor
EXERCISE 4: THE HEIRS OF ZECHARIAH SEVENBAGS (ZACARIES SETBOSSES): SOLUTION
1) Efficient and inefficient financial positions
Investing in individual stocks is not efficient in a capital market where lending and borrowing are possible. Therefore, the three brothers have inherited inefficient
investments from their father.
On the contrary, investing 100% of the budget in the risk-free asset (here Royal bonds) is an efficient capital allocation. This means that Rebekah has received an
efficient inheritance (although it does not satisfy her utility function).
Any efficient investment has to be a combination on the Capital Market Line, whether 1) 100% invested in the RFA, 2) a lending combination (part in the RFA and part in
M), 3) 100% invested in M or 4) more than 100% invested in M (borrowing):
CML:
ppp 0,7143·σ0,1·σ
0,07
0,100,15
0,10)E(R
2) Which is the investment that really satisfies the wishes of each of Zechariah Sevenbags’ children?
Investor
Inheritance received
Efficient
inheritance?
Preferences
Efficient investment on CML
Efficient distribution of the
budget (500.000 denarius)
Eliah
500.000 denarius
invested in stocks of
firm A
NO
“happy because he had stock A, the one with the lowest
specific risk”. And any combination on the CML has no
specific risk, since neither the RFA nor M have specific risk:
(P)=0 < (A)= 0,025
p = A = 0,043
E(Rp)Eliah=0,1307 > E(RA)
(P)Eliah=0 < (A)
38,60% in Royal bonds
(193.000 denarius)
61,40% in M
307.000 denarius
Jeremiah
500.000 denarius
invested in stocks of
firm B
NO
“satisfied with stock B, with a standard deviation of
0,1124”. A combination on the CML with this p will
present an E(Rp) > E(RB)= 0,175.
p = B = 0,1124
E(Rp)Jer=0,18029 > E(RB)
160,57% invested in M
with 60,57% of borrowing
802.850 denarius in M
302.850 denarius borrowed
Malachi
500.000 denarius
invested in stocks of
firm C
NO
“was laughing because he had stock C with the highest
expected rate of return”. A combination on the CML with
this E(Rp) will assume
p < C=0,2419.
E(Rp)= E(RC) = 0,25
pMalachi= 0,21< C
300% invested in M
with 200% of borrowing
1.500.000 denarius in M
1.000.000 denarius borrowed
Rebekah
500.000 denarius
invested in Royal
bonds (=RFA)
YES, but she is
not happy
with it.
“Rebekah was crying because she considered herself
capable of assuming such a high risk as Malachi and felt
herself underestimated by her father.” So she has to
disinvest her 500.000 denarius in Royal bonds and borrow
money to invest in M assuming p= C =0,2419.
p = C = 0,2419
E(Rp)Reb=0,2728 > E(RC)
She sells 500.000 denarius
invested in Royal bonds and
invests 345,57% in M
with 245,57% of borrowing
1.727.850 denarius in M
1.227.850 denarius borrowed