Applied Portfolio Management - Assignment Example

Applied Portfolio management xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date submitted xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Applied Portfolio Management Question 1 (a) A covered call in portfolio management is a common strategy that involves an investor writing a call-option contract and at the same, owns an equivalent quantity of shares of underlying stock. Covered call is used when an investor feels that the market value of underlying stock will fluctuate and therefore desires to generate some additional income from the underlying stock shares. Covered call reduces the risk incurred from stock ownership as it protects against decline in the market price of underlying stock. Put overwriting is the ownership of shares of stock and at the same time writing put options appropriately against these specific shares. It allows portfolio managers to get additional income without having to write calls so as they fear opportunity losses in the bull market. It reduces the probability of incurring large losses whenever investment in shares is made. Portfolio insurance is another investment strategy that includes combining financial instruments such as debts, derivatives and equities in a manner that protects portfolio value from degradation. It hedges portfolio stocks against market risk and market downturns, preventing investment losses from being occurred. All these options aim at maximizing the returns from investments and reducing any potential losses to a minimum. (b) Index Put options in portfolio management are written as a rise in underlying stock value is anticipated. When the portfolio market advances by 5%, invested make the greatest gain from their portfolio. Market up 5% (index =657.31) Options expire out of the money Interest received = 1,864 Total = $9, 264 Market unchanged (index = 626.01) Options expire in the money: Options loss is ($626.01-$650.00)*200 = -$4,798 Option premium received = 7,400 Interest received = 1,864 Total = $4,466 Market down 5%( index = 594.71) Options expire in the money: Options loss is ($594.71-$650.00)*200 = -$11,058 Options premium received = 7,400 Interest received =$ 1 864 Total = $1,794 (c)The Black-Scholes Formula is extensively used by participants of the option market to determine the price/premium for portfolio options. The price of a put option, for example, is derived from the Black-Scholes Formula shown below: P = N(-d2) Ke-r(T-t) – N(-d1) S N (.) represents cumulative distribution function of the standard normal distribution T − t represents time to maturity S represents spot price of the underlying asset K represents strike price r represents risk free rate (annual rate, expressed in terms of continuous compounding) σ represents volatility of returns of the underlying asset N (d1) and N (d2) represent the probabilities of the option in context expiring in-the-money. N (d1) and N (d2) represent the probabilities of the option in context expiring in-the-money. For example: d1 = [ln(S/K) + (r - ∂ + 0.5σ2)T]/[σ√(T)] = [ln(5500/5430) + (0.02 - 0 + 0.5*0.212)1]/[0.21√(1)] = d1 = 0.2612331347 Now we find d2 = d1 - σ√(T) = 0.2612331347 - 0.21 = d2 = 0.0512331347 In MS Excel, using the input "=NormSDist(-0.2612331347)", we find that N(-d1) = 0.39695642 In MS Excel, using the input "=NormSDist(-0.0512331347)", we find that N(-d2) = 0.479569806 Now we use the Black-Scholes formula: P(S, K, σ, r, T, ∂) = Ke-rTN(-d2) - Se-∂TN(-d1) = 5430e-0.020.479569806- 5500*0.39695642 = P(S, K, σ, r, T, ∂) = $369.2398137 (d) A scenario analysis is calculating an estimate of the expected value as well as any change in value of a specific portfolio in a given scenario that occurs in a current period or just recently and is broken out by asset and currency. A standard deviation for future monthly or yearly returns is first determined. The portfolio value is then estimated with regard to a two or three standard deviation below and above the average amount of return. Hedges are used to manage any risk that portfolio may be exposed to, ensuring that the portfolio value does not rise above or fall below the standard deviations. Above, he hedge performs well as the estimated portfolio value lies within the acceptable range of standard deviation. Question two Active versus passive investment management Passive management is a monetary approach whereby the investor invests with the idea of minimizing capital and reduces the impact of incorrect anticipation of the future. Active management is a financial approach whereby the manager invests and makes choices according to his research and knowledge of the existing market. Active investors have a perspective that they are able to accurately identify enough high-performing investments which help them achieve more than average results whereas passive investors believe that this is impossible instead they try to imitate their respective investable universes. Active managers are more advantageous than passive managers especially when the market changes. Portfolio rebalancing Portfolio rebalancing is risk control process that the investors use to decide whether and when to restore the target asset allocations when the portfolio drifts from their goals and preferences, that is, bringing back the portfolio’s target allocation to its original state. The two main strategies used for rebalancing are automatic and manual. In automatic strategy the investors rebalance their portfolio at the same time of the year annually. The inflated withdrawal returns are removed and the target allocation is rebalanced. When the stocks have high returns in the market and the bonds have less returns the investors sells stocks to buy bonds. In manual strategy the investors rebalance their portfolio any time of the year according to the market changes. The investors rebalance to shift to well-performing allocation. They buy additional equity during severe equity downdraft. Rebalancing approaches Buy and hold, constant-mix and constant proportion are the commonly used approaches to rebalance the equity portion of a portfolio. In buy and hold approach the investor invests and does nothing on the target allocations. In this case the product of the difference between the initial allocation and the value of stock market equals to one. The rate of increase of returns is proportional to the initial target allocation and the portfolio value never goes below the initial investment in cash. The investors are risk tolerant regardless of the market condition. In constant-mix approach the portfolio is rebalanced as the market changes. In this case the stock is a constant proportion of returns. The stocks are bought when they fall in value and are sold when their value rises to increase the market returns. In the constant proportion approach the stock value is equal to the product of the difference between the assets allocated and the market value and the product is referred to as the multiplier. When the multiplier exceeds one it is referred to as constant-proportion portfolio insurance. The portfolio should not fall below the multiplier selected by the investor. In this case the stocks are sold as their value falls and bought when their value rises to rebalance the portfolio. Tactic asset allocation Tactical asset allocation is an approach that an investor uses to shift the portfolio in response to the changes in the market. It exploits inefficiencies and disequilibrium of assets in the market during the short-term period. It is a typical shifting from stocks to bonds. The managers receive compensation for their excess returns since the tactical asset allocation gives the tracking error. They are exposed to maximize their excess of returns. The investors take short-term bets and shift from the strategic weights. Question three Setting Portfolio Objectives In a business there is need to set objectives which lead to accomplishment of the intended mission. One has to put into consideration both the demand of the client and success of the company. There are four core portfolio objectives and include capital appreciation, principal of stability, income growth and income. Before setting the objectives one should evaluate the presented situation. This is because there are difficulties in setting these objectives which include indecision which mainly occur when dealing with a client in a business set up. This mainly occurs when a client is unable to make a decision. Actually, it said that it is hard to accomplish ones objectives until it is well decided what one wants to accomplish. Subjectivity is another obstacle in the process of objective-setting. This is from that fact that investing is a science and an art. Instead of clear distinction of black and white, there are inescapability grey shades that will involve judgments which are subjective. In traditional Portfolio Objectives the terminology that advisors use may differ but the major identified include: Principal stability which is the most used portfolio objective and also conservative and will eventually create a significant return. Actually the emphasis is on maintaining the value which is said to be original of the specific fund. In income objective there’s no particular proscription against any decline in the principal value. If it is the selected objective, apposite investment include common stock, government bonds etc. Income growth involves managing of fund subject to time of the money value. This differs from income objective whose mandate is to generate more current income within a specified parameter which is risky. Primary objective is the main objective in accomplishment of an investment. Little may be achieved until this is accomplished. It is also advisable to put into consideration a secondary objective which indicates the next in significance after having the specific primary objective. For example, a person may consider that the current income to be the major objective. In order to accomplish this, investment may be made in debt which are long-term, market securities or common stock which are divided producing. A client may then be uncertain and may enquire of any chance of losing the money and therefore the principal of stability would be the secondary objective. A client may also enquire whether the income would stand the inflation. This will lead to the secondary objective of income growth. Inconsistent objectives are an additional factor considered in objectives establishment. This may arise due to incompatibility of primary and secondary objectives. An example is the primary objective being principal of stability while the secondary being capital appreciation. Simply put in this way, one wants no losses but appreciate capital gain. Infrequent objectives rise when objectives may seem to be incompatible but it is possible to make a specific portfolio that would be successful. Portfolio dedication refers to the harmonization of returns from a portfolio investment which has known liabilities in the future. This is related to portfolio objectives in those institutions for example insurance companies use portfolio dedications to make decisions. There is need to set objectives before making these decisions in the companies.66 Question four a.) Roles of capital markets As part of understanding three main functions of a capital market, it is important to understand a capital market. A capital market is defined as a financial asserts market that usually has a long or indefinite maturity. The main three functions of a capital market are; to raise long term fund for corporation, government, banks and businesses that usually involves the provision of a platform for security trading. Further, the market is used in provision of rupee loans, consultancy services, underwriting and foreign exchange loans. b.) Three forms of the Efficient Markets Hypothesis (EMH). EMH states that at any particular time, all security prices are usually reflected within all available information. The three forms of EMH are “weak” form that state that all past market prices are wholly reflected in the security prices. The “semi strong” form which asserts that all public information is wholly reflected within all securities. Finally, we have the “strong” form that all information is wholly reflected within the securities prices. c.) Function of capital markets in Part (a)that is addressed by the EMH The function of long term fund for corporate, government, businesses and banks is widely addressed by the EMH hypothesis. This is because this function mainly entails the sale of securities and shares as a way of raising funds for the named institutions. d.) Random walk It is evident that EMH literature mainly revolves around random walk hypothesis. Once in a while stock perceive to extend as a run where stock prices can either go up or down. This display is compatible with a random walk. For instance the following series defines a time series of stock prices changes where U is and increases whereas D is decrease; UUU DD U DDD UU DD U D UU DD U DD UUU DD UU D UU D. Here we have 18 runs. Let {Y1, Y2...} be the sequences of stock prices either annually or monthly. Using calculation of logarithmic it follows that Yt =In (It)-In (It-1) Assuming that the stock prices series is discrete it follows that f(X, Y) = f (xt, xt+1) Resulting to: P(x, y) = F(x, y)/F1(x) This probability gives an indication that time series of the defined security prices thus a clear indication of a run test. e.) Anomalies that challenge the EMH It is quite evidence that research indicate that there are several stock market anomalies that are constantly challenging EMH. Market anomalies are defined as market patterns that usually lead to abnormal returns that pose challenges to EMH especially the semi-strong EMH which states that major analysis does not have any value for any individual investor. The paradox within stock markets is that an investor may tend to think that a market is efficient while it is clear that at this particular time, the market is not efficient since it lacks an individual who can analyze securities. It is notable that efficient markets highly depends on the various market participants that usually believe that a market is inefficient and trade security as a way of outperforming the market. Question five Styles in Equity Portfolio Management The main goal of styling in portfolio is to develop measures which are accurate of vital differences in various investment portfolios. High-quality information in style is important in order to comprehend the way a portfolio is managed, to check whether it might provide benefits which are diversified in a portfolio which is multimanager and to come up with benchmarks which are appropriate and styles groups which will allow comparison with portfolio. Styles used in portfolio management include Return-Based Styling (RBS). It is well known for its effective low cost and the relative simplified data collection. It is a statistical approximation of portfolio average of allocation of assets at t the return interval, leads to its limitation. Characteristics-Based Styling refers to that style that comes up with style information obtained from elementary portfolio characteristics. Its timeliness is much clearer than RBS. Its advantage is that it is able to calculate the finest number of different styles dimensions which will differentiate equity portfolios. Its disadvantages are that it is costly and use limited portfolio characteristics. The other major style is the Factor-Based Styling (FBS) and is based under statistical process of Factor Analysis. Broad styles are useful in long-term when making decisions in allocation of style manager. Style tilts do have a potential at fund level as it may add value if they done in a way that decrease its worth in trading cost. Quality of the different styles does matter in portfolio management and is subject to judgment before being applied. Categories of stocks Ordinary shares They are said to be standard shares which lack specific restrictions. They have the gains though is the most risky. These shareholders are paid last during liquidification. Preference shares They shareholders have preferential treatment during distribution of dividends annually. They obtained fixed dividends therefore no increment if any profit is received. However, have rights a head of shareholders who are ordinary incase of trouble. Cumulative shares In this type of shares the dividends are forwarded to the next year if not paid in the previous year. This are paid despite the income of the business. Redeemable shares They come with an agreement that the company may buy the shares at a time in future. It may either be a fixed time or any date as agreed upon by the business. Question six Real Assets in Portfolio Management Portfolio management refers to a systemic way of maintaining investments efficiently. There is therefore a need to run the investment efficiently in order to obtain sufficient and promising returns. Several factors are said to contribute to the development and existence of the management. The main objectives of portfolio management may include minimization of risks, capital safeguard and appreciation of capital. Real assets are said to characterize by tangible form which is related to illiquidity. They are mainly referred to as hard assets which are said to have intrinsic value. They are contrasted to assets e.g. equities and bonds which are financial assets and commodities which are soft, that is perishable stuffs and also consumable. Examples of this include infrastructure, timber and real estate. Real assets may deliver different and essential benefits including protection from inflation, diversification of portfolio and the total returns are high. The cash-flow is high though the occurrence of risks is also high. This is mainly seen in case of inflation. Actually many investors are now focusing on real assets. This is as result of promising benefits. They have established that real assets play a role in specific portfolios through tactical, opportunistic and strategic policies of investment. The real assets are known to be impacted by both macro and micro developments, climate developments and sovereign policy. In institutions which invest, Timberland, for example, the maintenance of assets has increased its income. In 2009, the company diversified the assets so that it could fill the Florida Retirement Systems. Due to the high turnover the company has increased output and has efficiently diversified its operation. This has been effective in most countries. As a result of this they have gained benefits from portfolio diversification and real assets which have lower volatility. Investors have continued to view gold as one of the most the safest investment. Gold is considered to be inflation hedge which is good traditionally. Its price tends to increase with inflation as most investors tend to run to its safety during market crisis. These benefits as a real asset are however, accompanied by limitations which include underperformance periods. These periods are then followed by gains periods which are shorter. Nevertheless, focusing on safety, it is an appropriate part of portfolio management. However, one has to put in mind that gold doesn’t provide income and therefore not conducive for investors whose interest is to generate cash from portfolios. Real estate recently has provided investments which are attractive. Owning specific real estate is said to provide a great store value and also play a role as a hedge against price rises. This advantage is important as it makes real estate to a major player in portfolio management. However, the real estates are known to be relatively time-consuming and are prone to obstacles which are not seen in other investments. In addition to this it also requires a significant investment which does not favor smaller and potential investors who are interested in building portfolio which is diversified. The fact of it being less liquid compared to other assets makes it more difficult and hard for willing investors to get cash when need arises. References Joseph, Benning. (2008). Trading strategies for capital markets. New York: McGraw-Hill Stephen, Addam Zeff. (2007). financial reporting and global capital markets: a history of the International accounting standards committee 1973-2000. Oxford: Oxford University Press Vasudevan, Sundararajan. (2003). The future of domestic capital markets in developing countries. Washington, D.C.: Brookings Institution Press / Read More