SUDHAKAR D.

DESHMUKH AND RUSSELL WALKER

RiskReturn Relationship (B)

Juan Salvador is interested in quantifying the return and risk relationship offered by
a portfolio of three stocks. He has $100,000 to invest and is considering a one-year
outlook. The stocks include a gold mining company (AUCO), a regional bank (BANC) and
a power utility (ELEC). AUCO has a average annual return of 15% and a volatility,
expressed in standard deviation of 20%. The regional bank, BANC has an average return of
12% and a volatility of 15%. The power utility, which is typical for a highly regulated
industry shows a lower return and lower volatility at 8% return and 10% volatility. The
gold mining company, AUCO, sees greatest profitability during times of economic distress.
This results in AUCO being negatively correlated with BANC and ELEC. The banking
industry and power utility industry move more or less in conjunction with the economy,
suggesting that BANC and ELEC are positively correlated. Specifically, the correlation
coefficient between stocks AUCO and BANC is -0.4, that between AUCO and ELEC is -
0.5, and between BANC and ELEC is 0.6. Juan is also considering saving in an FDIC
insured bank account that yields a 5% risk-free return.

Juan would like to determine the composition of portfolios with minimum volatility
(risk) that are expected to yield returns of 5%, 6%,.15%. Juan can then plot the risk-
return tradeoff curve, from which he can compare portfolios, thereby selecting the one that
meet his risk-return appetite.

Juan is considering two overall investment scenarios. In the first, he is willing to

sell short any of the stocks and borrow at the risk-free rate of 5%. Alternatively, he would
like to do the analysis with no stock short selling or borrowing.

Follow-on Questions

a. From the analysis, identify the risk-return combinations that meet your personal
investment strategies? Why?
b. If you were to recommend an additional class of asset to include in the portfolio,
what would it be? Why? How would it improve the risk-return composition for your
preference? Explain.

2009 by the Kellogg School of Management, Northwestern University. This case was prepared by Professors Sudhakar D.
Deshmukh and Russell Walker. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as
endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission
to reproduce materials, call 847-491-5400 or e-mail cases@kellogg.northwestern.edu. No part of this publication may be reproduced,
stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Kellogg School of Management.