Evaluation of Stock Market Performance Using Beta and Standard Deviation - Case Study Example

Name: Tutor: Title: Evaluation of Stock Market Performance Using Beta and Standard Deviation Course: Date: Introduction Over the past decades, the benefits of international diversification have been extended to stock portfolios. Investors of international stock markets consider themselves enjoying the substantially higher return with less risk than investment in single market. Risk-averse investors tend to avoid risk and would rather invest in markets with fewer risks and a lower return than in markets with high risks but possibly better returns. Hong Kong, United Kingdom and Japan foreign stock markets are an example of international stock markets that investors can invest in, however, with adequate information on the respective market and their performances. . Benefits of international stock market diversification in return investment Investors who choose to invest in a range of assets practice diversification and through that reduce the investment risks that they are exposed to. Diversification ensures improved returns and performance of assets in the markets. According to Fisher (2012) study, the results of the returns of hypothetical international collection indicated a higher performance compared to the domestic set. He states that, other than performance, Investing in countries with less cross border associations increases returns on investments and reduces the unpredictability with respect to total returns on investments in the long-term. Diversification improves performance through risk adjustment and maintaining permanent weights. Diversification of international stock exchange allows investors to have a variety of assets to choose from and improve the ration of return to volatility. Acquisition of assets in different countries hedges against risk exposure since business cycles and economic growth levels in different countries vary. At this point, risk at the level of returns is reduced by the variation in performance of companies over long term periods. Example of risk hedging through diversification is the 1990s’ incident of Janus and Templeton mutual fund companies. International markets are currently experiencing interdependence which is an added advantage to diversification (Burhan, 2007). Policies that govern International financial dealings are also improving and becoming more independent. For businesses, developing international relations also increases productivity through diversification of technology and other economies of scale. Evaluation of performance for Hong Kong, Japan and UK stock markets Before investing, it is appropriate to analyse the performance of the target markets and volatility of stock mutual fund or index in order to forecast and secure returns. The performance of stock markets can be evaluated using standard deviation and Beta methods of evaluation. Standard deviation estimates risk exposures as a result of changing asset prices and therefore help in determining the most appropriate way of managing investment portfolio. It measures the Volatility of impossible risks Standard Deviation Country Type of index Year Performance UK FTSE 2010 5899.94 2011 5572.28 2012 5897.81 Hong Kong Hong Kong hang seng 2010 23035.45 2011 18434.39 2012 22656.92 Japan Nikkei 2010 10638.60 2011 10228.92 2012 10395.18 UK stock market Mean (UK) = (5899.94 + 5572.28 + 5897.81)/3 = 5790.01 Deviations 2010: 5899.94 - 5790.01= 109.93 2011: 5572.28 - 5790.01= -217.73 2012: 5897.81- 5790.01 = 107.80 (109.94)2 + (-217.73)2 + (107.80)2 = 12086. 80 + 47406.35 + 11620.84 = 71113.99 Deviation = 71113.99/3 = 23704.66 Standard deviation (ơ) = √23704.66 Ơ = 153.96 Hong Kong Stock Market Mean = (23035.45 + 18434.39 + 22656.92)/3 = 21375.59 Deviations 2010: 23035.45 - 21375.59 = 1659.86 2011: 18434.39 - 21375.59 = -2941.2 2012: 22656.92 - 21375.59 = 1281.33 (1659.86)2 + (-2941.2)2 + (1281.33)2 = 2755135.22 + 8650657 + 1641806.57 = 13047598.79 Deviation = 13047598.79/3 = 4349199.60 Standard deviation (ơ) = √4349199.60 Ơ = 2085.47 Mean (Japan) = (10638.60 + 10228.92 + 10395.18)/3 = 10420.90 2010: 10638.60 – 10420.90= 217.7 2011: 10228.92 - 10420.90 = - 191.98 2012: 10395.18 - 10420.90 = -25.72 (217.7)2 + (-191.98)2 + (-25.72)2 = 47393.29 + 36856 + 661.52 = 84910.81 Deviation = 84910.81/3= 8.15 Standard deviation (ơ) = √28303.60 Ơ = 186.24 A bigger standard deviation value indicates that the volatility or unpredictability of future prices is very high. High level of uncertainty makes stock of the market more risk. UK stock market is the less risky market with a standard deviation of 153.96. However, this also involves less return compared to other markets with a higher standard deviation (risks). The Hong Kong Stock market happens to be the most risky market to invest in by both international and domestic investors. It has a standard deviation of 2085.47, indicating the highest degree of unpredictability. Investors committing funds in such a market are completely unsure of price movements of stocks and therefore the committed investments will be risky such that, returns might be according to expectations or fail to recover the cost of capital of the investment (Yekim, 2006). Hong Kong stock market requires risk aggressive persons who are ready to dare huge risks but also focus on high returns if market conditions favour the investment. Japan stock market has a standard deviation of 186.24. Among the three, it is not the least unpredictable or the most volatile. Risks involved in the market are fair and not more or less exaggerated. Investors suitable for the Japan stock market are not afraid of taking risks neither are they aggressive to risks (Chukwuogor, 2008). Phillips (2008) writes that, equities from other opportunities other than US amounts to more than 50% of the market capitalisation in the world. This therefore is an open opportunity for investors from the US to invest in these stock markets rather than in the domestic markets. Calculating Beta Benchmark country is the USA Correlations of UK, Hong Kong and Japan equity markets with US equity markets (volatility of the regional and country indices.) Countries Covariance Returns in 2010 Returns on 2011 Returns 2012 UK 0.6 5899.94 5572.28 5897.81 Hong Kong 0.4 23035.45 18434.39 22656.92 Japan 0.3 10638.60 10228.92 10395.18 US 14892.62 13800.84 14892.97 ra is the rate of return for US portfolio while rb is the rate of return of each of the three countries. Cov(ra,rb) is the covariance between rates of return of US and each of the three countries. Average (US) = (14892.62 + 13800.84 + 14892.97)/3 = 14528.81 US, UK Beta Average (UK) = (5899.94 + 5572.28 + 5897.81)/3 = 5790.01 Variance: rb = √14528.81 = 120.54 ra = √5790.01 = 76.09 Covariance = (76.09 - 120.54 ) = -44.45 βa= -44.45/120.54 = -0.368 = -0.37 US, Hong Kong Beta Average (US) = (14892.62 + 13800.84 + 14892.97)/3 = 14528.81 Average (Hong Kong) = (23035.45 + 18434.39 + 22656.92)/3 = 21375.59 Variance: rb = √14528.81 = 120.54 ra = √21375.59 = 146.20 Covariance = (146.20 – 120.54) = 25.66 βa = 25.66/120.54 = 0.213 = 0.21 US, Japan Beta Average (US) = (14892.62 + 13800.84 + 14892.97)/3 = 14528.81 Average (Japan) = (10638.60 + 10228.92 + 10395.18)/3 = 10420.90 Variance: rb = √14528.81 = 120.54 ra = √10420.90 = 102.08 Covariance = (102.08 – 120.54) = -18.46 βa = -18.46/120.54 = -0.153 = -0.15 Beta measures the price volatility of stock in a given market with respect to other markets. Since it measures how returns on assets are sensitive to market returns, it is the correlated relative unpredictability. The UK market has a beta of -0.37 which is less than zero. Stocks in the market have a high volatility in price compared to stocks of other markets. The price of stocks in UK market moves in a different direction than the prices of US stock market. It also means that price of these stocks against the direction of the index. Investing in UK market will involve high risks which risk-averse investors might shy away from since they always avoid risks. However, it is the also the best for risk averse people who invest in different countries since they will study the variation and invest in countries with favorable prices of assets at that time. It is possibly ventured into by the risk aggressive investors and investors who are neither aggressive nor afraid of risks. An example of stocks with such beta is gold (Bala & Premaratne, 2001). Hong Kong market has a beta of 0.21 which is less than one but greater than zero. This means that, the variation of price for stocks in Hong Kong market is a bit less than price movements in US stock market but however, the same direction as the stock prices. The prices also experience less fluctuation of the daily operations. This is better for the risk-averse investors since it is less risky, however it has less returns. The purpose for diversification is also less achieved in this case. The Japan market is also another stock market with a higher volatility since it has a negative beta of -0.15 which is less than zero. This means that the prices of stocks in Japan market moves in an opposite direction as that of the US Stock market. Although there is high risk, the returns are very high in the market. Country/ Index 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 UK (FTSE) 4000. 52 5198. 94 5400. 90 5989. 78 6399. 86 6200 4256. 20 6289. 64 5899. 94 5572. 28 Hong Kong (Hong Kong Hang seng) 9445. 26 12456. 70 14194. 90 14876. 43 19964. 72 27626. 92 15127. 51 21902. 11 23035. 45 18434. 39 Japan (Nikkei) 8578. 95 10676. 64 11488. 76 16111. 43 17225. 83 15307. 78 8859. 56 10107. 87 10228. 92 10395. 18 UK market Mean = 4000.52 + 5198.94 + 5400.9 + 5989.78 + 6399.86 +6200 + 4256.20 + 6289.64+5899.94 +5572.28 = 60780.34/ 10 = 6078.03 Deviations Mean= 6078.03 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Deviation 4000.52- 6078.03= -2077.51 5198.94-6078.03= -879.09 5400.9-6078.03= -677.13 5989.78 - 6078.03= -88.25 6399.86 - 6078.03= 321.83 6200 - 6078.03= 121.97 4256.20 - 6078.03= -1821.83 6289.64 - 6078.03 = 211.61 5899.94 - 6078.03= -178.09 5572.28 - 6078.03= -505.75 (-2077.51)2 + (-879.09)2 + (-677.13)2 + (-88.25)2 + (321.83)2 + (121.97)2 + (-1821.83)2 + (211.61)2 + (-178.09)2 + (-505.75)2 = 6883.08/10 Standard deviation (ơ) = √688.31 = 26.24 Hong Kong Market Mean (Hong Kong) = 9445.26 + 12456.70 +14194.90 + 14876.43 +19964.72 + 27626.92 + 15127.51 + 21902.11 + 23035.45 + 18434.39 = 177064.39/10 = 17706.44 Mean = 17706.44 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Deviation 9445.26 -17706.44 = -8261.18 12456.70 - 17706.44 = -5249.74 14194.90 -17706.44 = - 3511.54 14876.43 -17706.44 = -2830.01 19964.72 -17706.44 = 2258.28 27626.92 - 17706.44 = 9920.48 15127.51- 17706.44= -2578.93 21902.11-17706.44 = 4195.67 23035.45 -17706.44= 5329.01 18434.39 -17706.44= 727.95 (-8261.18)2+ (-5249.74)2+ (-3511.54)2+ (-2830.01)2+(2258.28)2 (9920.48)2+ (-2578.93)2 + (4195.67)2+ (5329.01)2+ (727.95)2= 44862.79 Deviation =44862.79/10 = 4486.28 Standard deviation (ơ) = √4486.28 = 66.98 Japan stock market Mean (Japan) = 8578.95 + 10676.64 + 11488.76 + 16111.43 + 17225.83 + 15307.78 + 8859.56 + 10107 + 10228.92 + 10395.18 = 118980.05/10 = 11898.01 Deviations Mean = 11898.01 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Deviation 8578.95 -11898.01= -3319.06 10676.64-11898.01= -1221.37 11488.76-11898.01= -409.25 16111.43-11898.01= 4213.42 17225.83-11898.01= 5327.82 15307.78-11898.01= 3409.77 8859.56-11898.01= -3038.45 10107.87-11898.01= -1790.14 10228.92-11898.01= -1669.09 10395.18-11898.01= -1502.83 (3319.06)2 + (1221.37)2+ (409.25)2+ (4213.42)2 + (5327.82)2+ (3409.77)2+ (3038.45)2+ (1790.14)2+ (1669.09)2+ (1502.83)2= 25901.22/10 = 2590.12 Standard deviation (ơ) = √2590.12 = 50.89 Benefits of international equity investing on the three stock markets (Hong Kong- Japan- UK) International equity investing offers a variety of investing opportunities as compared to domestic portfolio where opportunities are limited. Investing in any of the three international markets gives the investor a chance to access to over twenty one thousand investment opportunities around the world. For example, the Hong Kong stock market only has more than seventeen large stocks at the top of the market, not considering other stocks which are not among the top. Petro China, Industrial and Commercial Bank of China and China mobile are the leading stocks by market capitalisation. This also provides an opportunity for direct trading to the foreign markets across the world. Investing in international equities also ensures that risk as are reduced through international diversification. The different business cycles in foreign markets and different growth patterns of the economy make it possible to plan and hedge the risks. For example the recent tremor in Japan that leads to deterioration of the stock market. In such cases, investors’ loss on capital returns is hedged by the profit earnings in other countries. Countries might also experience recession at different times. An investor in either Japan or any the two countries and America is able to calculate the exposures and find ways of maximising on the other part that is not facing recession. American investors are able to maintain a balance in his portfolio through easy access of industries, markets and sectors in Japan, UK or Hong Kong which might not be extensively accessible in US (Stock & Watson 2003). However, other than the benefits, investment in the international equity markets requires that an investor considers the risks involved in the Hong Kong, Japan and UK equity market such as effects on investments as a result of currency fluctuations. Changes in UK sterling pound, Hong Kong Dollar or Japanese Yen can either increase or reduce investors’ income. The differences in the three markets’ times of opening might cause inconveniences and affect returns on investment such as closing or opening of markets at unexpected times. Financial strategy for UK market The American investor will develop a financial plan for UK market since it is the most appropriate market for the investor as indicated by the standard deviation and beta. Since the American investor is a risk-averse person, he would prefer investments with less risks even if returns are low. UK market has the lowest standard deviation indicating less variance in returns. According to the value of beta in the market, prices of assets in America and that of UK will move in different directions, while they will vary at a wider range. This gives the investor a higher chance to hedge against risk of losing all his investment in domestic country by investing in UK when the prices are better their and not favourable in home country. Financial strategy The investor will acquire funds through borrowing in the foreign country. This is called money market hedging technique. Since the investor is creating an asset in the foreign country, he will also create a liability in the same country to hedge for any possible risks. This includes, borrowing in the foreign currency and since he is investing in the same country, invest in same currency. The best asset to invest in is bonds. The size of investment is $35294.12 US dollars worth of assets. The market is not risky and therefore, returns on investment will not be so much. The expected rate of return is 6% of the total investment. The length of investment is five years for the investor, after which further decisions will be made. In analysis of risks, the investor will consider the degree of uncertainty and price variation between the two countries. Risks in the UK market are less. This is due to a lower standard deviation value. The negative beta result shows a higher rate of variation in prices of the two markets. This therefore gives the investor a better chance to compare and choose the favourable prices at that moment. Analysis for Hong Kong Proposed investments and actual investment should focus on not more than$4 Hong Kong dollars per share. This is because, stocks at the Hong Kong market and famous companies are allowed to trade at even lower prices as long as it above $0.50 Hong Kong dollars. Shares priced below this amount are considered as penny stock. The financial, strategy in Hong Kong market also includes considering investment in terms of the lot side other than the price. After getting a quote, the market provides individual board lot size which a broker will show together with the price of stock. However, odd lot markets are also available for those stocks purchased and do not match the multiples. Consider the 24 ticks close in price rule on current prices since it is less strict compared to the 10 ticks rule on current price provided by HSBC and is stricter. Hong Kong market brokers impose strict rules on prices which limits the orders made by investors. The influence of brokers also includes supporting specific types of orders like the market if touched orders. The perchance therefore includes use of well known brokers to purchase stocks and have clear advise before issuing of the order. Consider investing in companies like Petro China, industrial and commercial bank of china or any other among the top ten companies trading in the Hong Kong market. The financial strategy in the Japan stock market includes consideration of the price movements. The Japanese stock market has over time experienced fluctuations in the price on its stocks. This is due to a lot of influence because foreign currency fluctuations of the countries trading in the market ( Morck & Yeung (2001). Which stock market The best stock for a risk-averse investor is one which involves less risk, however, has less returns compared to other markets with higher risks. Markets showing a lower value of standard deviation have less risk as the prices are expected not to vary so much as compared to those with higher standard deviation. The unpredictability is less. Among UK, Hong Kong and Japan markets, UK market appears to be the best alternative basing on the standard deviation evaluation since it has less unpredictability. However, this changes in the covariance. Conclusion Investment in international markets may involve a wider range of risk exposures. The uncertainty of investment outcome is what compounds to the risk of the venture. For this reason, investors need to study the characteristics of the markets they venture in order to forecast the risks and possible returns on investment. Standard deviation and beta methods of evaluating investments provide an easier way to determine the viability of the investment. References Morck, R & Yeung, B (2001). Japanese Economic Success and the Curious Characteristics of Japanese stock prices. Institute of economic research Bloom berg, Business week (2012). Nikkei 225 Japan. Business week .com. Chukwuogor, C (2008). Stock markets Returns and Volatilities: Global comparison. Eurojournals publishing. Business week, (2012). Seng Index (INDEXHANGSENG:HSI). Business nweek. Philips, B.C, (2008). Considerations for International Equity. CFA institute. Tokat Yesim (2006). International Equity investing: investing in Emerging Markets. Valley Forge, Journal of wealth management. 6(2):68-80 Stock, J.H & Watson, M.W (2003). Understanding changes in international business cycle dynamics. Cambridge,MASS: NBERWorking paper No. 9859 (July) Burhan F. Yavas, (2007). Benefits of International Portfolio Diversification. GBR journal. < http://gbr.pepperdine.edu/2010/08/benefits-of-international-portfolio-diversification> Bala. L & Premaratne, G (2001). Stock market volatility: Examining North America, Europe mand Asia. Universty of Singapore press. Fisher, Gregg. S (2012). Why Global diversification still makes sense. Forbes. http://www.forbes.com/sites/greggfisher/2012/01/17/why-global-diversification-still-makes-sense/> Read More