International Financial Markets - Example

International financial markets Table of Contents Table of Contents 2 Section 3 Company Background and comparative analysis 3 Mean return and standard deviation of stocks 5 Covariance and correlation of stocks 5 Section 2 6 Different combination for portfolio A’s risk and return 6 Risk and return of minimum variance portfolio 7 Portfolio return and standard deviation 8 9 Sharpe Ratio of Portfolio A 9 Section 3 10 Weighting of risk free asset in Portfolio B 10 Capital market line of Portfolio B 11 Market benchmark analysis 12 References 13 Appendix 15 Section 1 Company Background and comparative analysis Five companies namely Land securities group plc, BT group plc, Marks and Spencer group plc, Mondi Plc and Bunzl plc are considered for creating a portfolio. Though portfolio will be considered with two stocks out of the total five probable stocks, still these five companies have shown high growth and future growth prospects. Growth is the key determinant that led to the selection of the above companies for creating a portfolio giving an annual return of 20%. Each of the company belongs to different industry class, thus leading to a varied choice of portfolio selection. BT group plc – It is a UK based multinational company that offers telecom services to more than 160 countries across the globe. Its clientele comprises corporate and governments around the world. It mainly provides broadband, communication and digital TV services to more than 17 million clients in UK. It has reported £18.29 billion for the FY 2014 and £4.48 billion for the 3rd quarter of FY 2015. It holds 29% market share in the UK broadband industry (BT plc, 2015). Land securities group plc – It is a UK based real estate investment company. Its property portfolio is worth £11.76 pounds. It provides property services to public and private sectors, mainly retail parks, shopping malls, food stores, etc. It reported a £716 million as revenue for FY 2014 compared to its peers like British Land Company, Corio, Hammerson and Intu properties (Land securities, 2015). Marks and Spencer group plc – It is a UK based retail company and caters to home products, clothing and food segments. It operates through 798 stores in UK and 455 stores across Europe. It reported £10.33 billion and net income of £503.5 million (Marks and Spencer, 2015). Mondi plc – It is a UK based packaging company that offers packaging services to Europe, Russia, South Africa and US. It mainly has four segments of operation i.e. fibre packaging, packaging paper, uncoated fine paper and consumer packaging. It reported £4.7 billion and £345.73 million as its revenue and net income for FY 2014 (Mondi, 2015). Bunzl plc – It is a company based in UK that caters to supply of non food products like food packaging, catering items, food processors, tableware cleaning products, etc across 27 countries. It provides outsourcing services to Australia, Europe and US. Its revenue and net income for the FY 2014 stood at £6.16 billion and £210.70 million respectively (Bunzl, 2015) Table 1: Comparative analysis of key financial metrics The above table represents the comparative analysis of the key financial metrics of the five companies. The financial metrics that are used are EPS (earnings per share), price to earnings (P/E), annual dividend and dividend yield. These four metrics are key indicators that led to the selection of the five companies. All the five companies exhibit good financial health. It EPS and dividend yield is pretty good. EPS implies how much return is generated for every £100 invested in the company whereas P/E refers to the willingness to pay for the company’s stock to earn a pound. Mean return and standard deviation of stocks Mean return of stocks of the five companies is significant of the average growth rate. It shows how the stocks have grown over the 2 year period from March 1, 2013 to February 27, 2015. Standard deviations of the stocks imply the change or the degree of change of stock return from its average. Mean return is calculated by finding the daily growth rate of the stocks and normalising it to annual rate, whereas SD is calculated by degree of change in the stock return. The mean return of stocks for Bunzl, Marks & Spencer, Mondi, Land and BT plc are 31.82%, 31.70%, 40.60%, 35.14% and 44.81% respectively. All the above stocks show high growth rate in stock prices, but Mondi and B plc have witnessed highest returns for the period (Yahoo Finance, 2015a) Standard deviation of the above companies is 1.02% , 1.51%, 1.61%, 1.09% and 1.36% respectively, which is significant of the stock price volatility (Appendix 1) (Yahoo Finance, 2015b). Land and Bunzl show low price volatility amongst the other companies. Covariance and correlation of stocks Covariance and correlation of the stocks imply the degree of relatedness between the stocks i.e. how does one stock’s price react to the increase or decrease in the price of the other stock. It is calculated by considering the stock return over the period of 2 years. Stock symbol BNZL MKS MNDI LAND BT BNZL -4.3% -2.1% 6.0% 0.9% MKS -4.3% 3.8% 2.2% -2.0% MNDI (Yahoo Finance, 2015e) -2.1% 3.8% 8.3% -4.0% LAND 6.0% 2.2% 8.3% 2.1% BT 0.9% -2.0% -4.0% 2.1% Table 2: Calculation of correlation of stocks Individual stock return of the above companies is matched with the return of other stocks to find the correlation between them. From the above table it is seen that all the stocks are positively correlated, but the stocks which have low degree of correlation will be considered for creating a portfolio. Marks and Spencer and British Telecom have lowest correlation of 29.606%, which implies that if the return from one rises, the return from the other stock will also rise but at a low pace. This will result in minimising the risk if these two stocks are considered for the portfolio (Yahoo Finance, 2015c). Section 2 Marks and Spencer and BT plc are the two stocks that are suitable for the portfolio A. Though Mondi plc has high expected return, its risk factor or beta is higher than the other two. This shows that it will be subject to high volatility. To maximise return from the portfolio i.e. in this case annual return of 20%, stocks which have high expected return, low beta and low correlation should be considered. If stocks with strong positive correlation are taken, then a rise in return from one would also result in the increased return of the other and similarly if one falls the other stock return will also fall. Different combination for portfolio A’s risk and return Different weights are assigned to each of the selected stock to find the portfolio risk and return for each combination of the weights. Weights have been assigned on increasing and decreasing sequence of the selected stocks i.e. MKS and BT. Portfolio variance, standard deviation and adjusted expected return are calculated for each and every weight combination. The average return, SD and beta of individual stocks are considered for calculating the portfolio return and risk. The expected return is the adjusted return i.e. it considers the market risk (beta). Risk and return of minimum variance portfolio Minimum variance portfolio is the mix of risk weight that gives maximum return with lowest level of variance or standard deviation. Minimum variance of the portfolio is observed when the risk weight for the two companies i.e. Marks and Spencer and British Telecom is 45% and 55% respectively (Yahoo Finance, 2015d). With the given level of risk weight the portfolio variance stands at 0.000102 and the standard deviation at 0.010119157. From all the above risk weights for the desired portfolio mix, the above weight combination results in low variance and standard deviation. At the given level of expected annual return of 20%, the portfolio performs beyond the expectation with low level of variance. Low variance level is considered for constructing a portfolio as it signifies low volatility of market price of stock, resulting in positive and stable returns (Kevin, 2008). Figure 1: Efficient frontier of portfolio A The above figure is significant of the efficient frontier of portfolio A. Efficient frontier is the blue curve that denotes expected portfolio returns of the different combinations of the two stocks. The point where the risk outcome is less the curve bends upwards. The horizontal line is the market line and any portfolio beneath and above the line represents sub optimal returns with the given level of risk. Risk is low when portfolio is below the line and high when above. The bent in the curve shows the optimal portfolio i.e. in this case it shows a return of 39.308% with a minimum risk outcome of 0.0101. Portfolio return and standard deviation In this case the client’s annual return requirement is 20%. Owing to the annual return requirement the weight combination that gives the highest return that meets the annual requirement of the client i.e. 20% or exceeds it will be considered for constructing portfolio A. It is calculated by assigning ascending and descending weights to the stocks of Marks and Spencer and British Telecom i.e. 100-0, 95-5, 90-10,..........10-90,5-95,0-100. The individual risk weights are used to calculate the portfolio variance, standard deviation and expected return. Individual company stock return and beta are taken into account for calculating portfolio return and standard deviation. The portfolio return stands at 39.308% with minimum deviation of 0.010119157. Though maximum return is observed when the weight ratio is 100 for BT and 0 for MKS which is 45.437%, the standard deviation is more than the optimum level i.e. 0.013630227. Thus, optimum portfolio return is observed when the expected return meets the required annual return with minimum level of variance and standard deviation (Appendix 2). Figure 2: Optimum portfolio return Sharpe Ratio of Portfolio A Individual Sharpe ratio is calculated by dividing the adjusted return of individual stock return by standard deviation of that stock. The individual Sharpe ratio is then used to find the portfolio Sharpe. The optimum weight where the portfolio gives maximum return with minimum deviation is adjusted with the individual Sharpe ratio of the portfolio stocks. The final result is the Sharpe ratio of the portfolio. Sharpe ratio is significant of the excess return over the risk free rate of return per unit of market risk. In other words it explains how much does one unit of risk or volatility fetches additional return (Khan and Jain, 2007). Greater value of the ratio is indicative of higher risk premiums or adjusted return. In this case individual Sharpe ratio of MKS and BT are 0.05750 and 0.09133, whereas the portfolio Sharpe is 0.07611. Table 3: Portfolio Sharpe Ratio Section 3 Weighting of risk free asset in Portfolio B In this case the required annual return for portfolio B is 20% after considering the minimum portfolio risk i.e. the client is risk averse. It means that portfolio which has a return more than 20% will be accepted where the risk is less. In portfolio B the optimum return is 25% and the minimum risk level is 1.84. The objective here is to minimise the risk of portfolio A by introducing a risk free asset with interest rate of 4% to reduce the overall risk of portfolio B. Standard deviation is taken as the risk measure of the portfolio. Figure 3: Optimum return for portfolio B The above figure represents the optimum return for portfolio B, where the expected return is 25% and the risk outcome is 1.84. 85% of the total weight is allocated to the risk free asset and the remaining 15% is allocated to the risky asset i.e. stocks of Marks and Spencer and British Telecom. The 15% risk weight is further allocated on the basis of risk weight allocation of portfolio A i.e. 45% to MKS and 55% to BT. Moreover allocating 80% to risk free asset is justified as it gives an expected return which is more than the desired annual return as also the risk of the portfolio is also lower (Appendix 3). Capital market line of Portfolio B From figure 3 the expected return and risk of portfolio can be determined. The expected return of portfolio is calculated by multiplying the risk free weight with the risk free rate and adding it to the adjusted return after multiplying it with the risk weight. For calculation purpose the standard deviation is annualised i.e. 5.51 and 4.98 for MKS and BT respectively. The expected return of the portfolio is 25% and the risk is 1.84. It shows how after introducing the risk free asset the overall portfolio risk has come down (Khan and Jain, 2007). Risk of portfolio A was 3.69 and after introducing the risk free asset risk of portfolio B came down to 1.84. Figure 4: Capital Market line of portfolio B The above figure observes the capital market line which is the upward sloping line that ends at the y intercept. The intercept on the y axis implies the expected return when the portfolio consists of only the risk free asset and is equal to 4% with risk outcome of 0. It cuts the efficient frontier of portfolio B where the return exceeds the required return level of 20% at 25%, where the portfolio risk is optimum i.e. 1.84. Any point higher on the efficient frontier implies higher return with high risk outcome. Market benchmark analysis Figure 5: Market benchmark analysis The above figure shows the performance of portfolio A compared to its market benchmark i.e. FTSE 100 and S&P 500. Market beta is always 1 and if portfolio beta is less than the market risk then it is considered to be less volatile. In this case portfolio risk is lower than the market risk i.e. 0.9176 (Yahoo Finance, 2015f). Similarly it has outperformed the market indices of FTSE 100 and S&P 500. It shows a return of 39% compared to FTSE 100’s return of 7.10% and 25% of S&P 500 (Yahoo Finance, 2015g). In all likelihood portfolios A will beat the market benchmark (Reilly and Brown, 2011). References BT plc, 2015. About BT Group. [online] Available at: < http://www.btplc.com/> [Accessed on 08 April 2015]. Bunzl, 2015. Bunzl about . [online] Available at: < http://www.bunzl.com/ > [Accessed on 08 April 2015]. Kevin, S., 2008. Security analysis and portfolio management. New Delhi: PHI Learning Pvt. Ltd. Khan, and Jain, 2007. Financial Management. New Delhi: Tata McGraw-Hill Education. Land securities, 2015. Land securities – about us. [online] Available at: http://www.landsecurities.com/ > [Accessed on 08 April 2015]. Marks and Spencer, 2015. MKS - Style and living. [online]. Available at: < http://www.marksandspencer.com/ >. [Accessed on 08 April 2015]. Mondi, 2015. Mondi – home. [online]. Available at: >http://www.mondigroup.com/> [Accessed on 08 April 2015]. Reilly, F. and Brown, K., 2011. Investment Analysis and Portfolio Management. Ohio: Cengage Learning. Yahoo Finance, 2015a. BT Group plc. [online] Available at: < https://in.finance.yahoo.com/q?s=BT-A.L> [Accessed on 08 April 2015]. Yahoo Finance, 2015b. Land Securities Group PLC. [online] Available at: < https://uk.finance.yahoo.com/q?s=LAND.L > [Accessed on 08 April 2015]. Yahoo Finance, 2015c. Bunzl plc. [online] Available at: < http://finance.yahoo.com/q?s=BNZL.L > [Accessed on 08 April 2015]. Yahoo Finance, 2015d. Marks & Spencer Group plc. [online] Available at: < https://in.finance.yahoo.com/q?s=MKS.L: > [Accessed on 08 April 2015]. Yahoo Finance, 2015e. Mondi plc. [online] Available at: < http://finance.yahoo.com/q?s=MNDI.L> [Accessed on 08 April 2015]. Yahoo Finance, 2015f. S&P 500. [online] Available at: < http://finance.yahoo.com/echarts?s=%5Egspc+interactive> [Accessed on 08 April 2015]. Yahoo Finance, 2015g. FTSE 100. [online] Available at: https://in.finance.yahoo.com/q?s=%5EFTSE > [Accessed on 08 April 2015]. Appendix Appendix 1 Date BNZL MKS MNDI LAND BT FTSE 100 S &P 500 Average daily return 0% 0% 0% 0% 0% 0% 0% Average annual return 32% 32% 41% 35% 45% 7% 25% Standard Deviation 0.01017 0.0151 0.01615 0.01092 0.01363 0.00747 0.00721 Covariance 0.0045% 0.0053% 0.0080% 0.0048% 0.0050% Correlation 0.58943 0.47052 0.66412 0.58868 0.48792 Beta 0.80213 0.95123 1.43548 0.86008 0.89014 1 1 Risk free return 4% 4% 4% 4% 4% Sharpe Ratio 0.08573 0.0575 0.06984 0.08941 0.09133 Expected increase in return 6.5% 6.9% 8.5% 6.7% 6.8% Appendix 2 Portfolio A MKS BT Average Return 31.82% 45.44% Mean return 38.63% Standard Deviation 5.51 4.98 Beta 0.95 0.89 Portfolio Risk 0.92 Weights Variance Std Dev Expd Return 100% 0% 30.393683 5.513046651 31.816% 95% 5% 27.492177 5.243298258 32.497% 90% 10% 24.866393 4.986621408 33.178% 85% 15% 22.516333 4.745137794 33.859% 80% 20% 20.441995 4.521282505 34.540% 75% 25% 18.643381 4.317798221 35.221% 70% 30% 17.120491 4.137691463 35.902% 65% 35% 15.873323 3.984133908 36.583% 60% 40% 14.901879 3.860295136 37.264% 55% 45% 14.206157 3.76910563 37.945% 50% 50% 13.786159 3.712971742 38.626% 45% 55% 13.641884 3.693492147 39.308% 40% 60% 13.773333 3.711244065 39.989% 35% 65% 14.180504 3.765700992 40.670% 30% 70% 14.863399 3.855307847 41.351% 25% 75% 15.822016 3.977689834 42.032% 20% 80% 17.056357 4.129934311 42.713% 15% 85% 18.566422 4.308877069 43.394% 10% 90% 20.352209 4.511342258 44.075% 5% 95% 22.413720 4.734312993 44.756% 0% 100% 24.750953 4.97503299 45.437% Appendix 3 Portfolio B MKS (Weight) 45% BT (Weight) 55% SD 3.693492147 Return 39% Adjusted return 1.440461937 Risk free rate 4% Expected return 20% Risk free asset weight Risk free weight Portfolio A weight Adjusted return of Portfolio A Risk free return Variance Standard deviation Expected Return 100% 0% 1.440461937 0.04 0 0.00 4% 95.00% 5% 1.440461937 0.04 1.3746 1.17 11% 90.00% 10% 1.440461937 0.04 2.4866 1.58 18% 85.00% 15% 1.440461937 0.04 3.3774 1.84 25% 80.00% 20% 1.440461937 0.04 4.0884 2.02 32% 75.00% 25% 1.440461937 0.04 4.6608 2.16 39% 70.00% 30% 1.440461937 0.04 5.1361 2.27 46% 65.00% 35% 1.440461937 0.04 5.5557 2.36 53% 60.00% 40% 1.440461937 0.04 5.9608 2.44 60% 55.00% 45% 1.440461937 0.04 6.3928 2.53 67% 50.00% 50% 1.440461937 0.04 6.8931 2.63 74% 45.00% 55% 1.440461937 0.04 7.5030 2.74 81% 40.00% 60% 1.440461937 0.04 8.2640 2.87 88% 35.00% 65% 1.440461937 0.04 9.2173 3.04 95% 30.00% 70% 1.440461937 0.04 10.4044 3.23 102% 25.00% 75% 1.440461937 0.04 11.8665 3.44 109% 20.00% 80% 1.440461937 0.04 13.6451 3.69 116% 15.00% 85% 1.440461937 0.04 15.7815 3.97 123% 10.00% 90% 1.440461937 0.04 18.3170 4.28 130% 5.00% 95% 1.440461937 0.04 21.2930 4.61 137% 0.00% 100% 1.440461937 0.04 24.7510 4.98 144% Read More