Security Analysis and Portfolio Management - Assignment Example

Finance Student’s Name: Instructor: Problem 16, p. 157 1) a) Formula HPR =  State of Economy Probability Ending Price + Dividend HPR (%) Ending Value HPR (%) Boom 0.2500 $144.00 44.00 $0.00 -100.00 Normal 0.5000 $114.00 14.00 0.00 -100.00 Recession 0.2500 $84.00 -16.00 30.00 150.00 b) The cost of a put and one share is $112 ($12 + $110) HPR Normal = ($110 minus $112 plus $4) divide $112 = 1.8% HPR Boom = ($140 minus $112 plus $4) divide $112 = 28.6% HPR Recession = ($110 minus $112 plus $4) divide $112 = 1.8% State of Economy Probability Put + Stock + Dividend Ending Value HPR (%) Boom 0.2500 $144.00 28.60 Normal 0.5000 $114.00 1.80 Recession 0.2500 $114.00 1.80 c) Regardless of what happens to the price of the stock a minimum of 1.8% HPR is guaranteed. With this, you remain protected from price decline. Problem 20, p. 277 Investors are faced with the challenge of obtaining the highest possible returns from their investments. They try to gain maximally while limiting their exposure to risk. An investor will argue that taking very little risk brings low returns while taking a very high risk endangers one’s investments. So he will pursue to strike a balance between returns and risks so as to attain highest returns possible. For one to attain the optimal risky portfolio he may have to combine many factors so as to attain this point of tangency whereby further movement up the curve will bring out higher the amount of risk and less returns and a movement below that point results to insufficient returns, tempting the investor to increase the amount of risk. Every investor has a level of risk-love behavior as long as this will optimize his returns. This means that for one to analyze the optimal risky portfolio there is no consideration for risk aversion since each investor loves returns. To attain the optimal risky portfolio, investor may have to apply several investment tools and considerations. He may have to come with a mix of assets to diversify the portfolio and avoid complete losses. Diversification does not mean avoiding losses (being risk-averse) rather it means having different types of risk classes. This serves as a guarantee for success at least in one of the investments. Another way of attaining optimal risky portfolio is taking advantage of favorable laws of some countries as compared to others. Some states have better tax laws as compared to others and investors will take such advantage to optimize their returns on portfolios and also reduce their exposure to risk. This means that all investors have a common goal of optimizing their returns. They are said to achieve this as long as they believe that they getting the best from their investments. This brings up the idea that every investor is on the optimal point no matter their risk behavior. It also makes us understand that different investors have different concepts of optimal risky portfolio. However, given the same type of assets, the investors will all settle to the one point which has the highest level of returns. They will go to greater heights to establish the history of the stocks and their price fluctuation over time so as to know the stability of the stocks. Some investors argue that stocks which have been performing very well in the past are usually over-valued as many people will rush to invest in them. Another factor to optimizing a portfolio is maintaining the efficient frontier. This is ensuring that all factors like tax efficiency, timing and asset-price correlation are very well monitored. It will include re-balancing of asset-classes to reduce the risk exposure brought about by changing industry factors. All in all, investors try their best to achieve a level of returns which secures them against risk while at the same time getting compensation from their investments. Problem 20, p. 227 1920's 1930's 1940's 1950's 1960's 1970's 1980's 1990's The small company stocks -3.72% 7.28% 20.63% 19.01% 13.72% 8.75% 12.46% 13.84% Large Company Stocks 18.36 -1.25 9.11 19.41 7.84 5.9 17.6 18.2 Long Term government 3.93 4.6 3.59 0.25 1.14 6.63 11.5 8.6 Intermediate Government 3.77 3.91 1.7 1.11 3.41 6.11 12.01 7.74 Treasury Bills 3.56 0.3 0.37 1.87 3.89 6.29 9 5.02 Inflation -1 -2.04 5.36 2.22 2.52 7.36 5.1 2.93 Serial Correlation of Assets   The small company stocks Large Company Stocks Long Term government Intermediate Government Treasury Bills Inflation The small company stocks 1 -0.143678383 0.724982267 0.93985243 0.877075424 0.196534576 Large Company Stocks -0.143678383 1 -0.38559058 -0.45081336 -0.350911877 0.102892182 Long Term government 0.724982267 -0.385590581 1 0.834009 0.696802 0.440117 Intermediate Government 0.93985243 -0.450813367 0.834009 1 0.892572 0.159787 Treasury Bills 0.877075424 -0.350911877 0.696802 0.892572 1 0.434768813 Inflation 0.196534576 0.102892182 0.440117 0.159787 0.434768813 1 The small company and large company stocks are weakly, negatively correlated, as indicated by the correlation statistic. The correlation between large company and small companies is -0.143678383. This value is negative, which implies that an increase in the value large company stock is followed by a reduction in the value of the stock of the small company. Hoverer, the correlation value is too small to be relied upon during the prediction of the performance of the either stocks (Lhabitant, 2004). The small company stock and long-term government are powerfully, positively correlated variables. The correlation between the small company and long-term government is 0.724982267. This value is positive, which implies that long term government favors the strengthening of the value of the small company stock. The correlation statistic is so high, in that, it can be accurately be relied upon when predicting the performance of stock of the small company. The small company and intermediate government are powerfully and positively correlated as the correlation statistic indicates. The correlation between intermediate government and the small company is 0.93985243, which is the highest value of the all variables that were analyzed. This shows that the two variables can be accurately be relied upon during predictions. The probability of an increase in the value of stock of the small company is highly increased by the presence of an intermediate government. The Treasury bill and stock of the small company are powerfully, positively correlated variables. The correlation between the small company and Treasury bill is 0.877075424. This value is positive, which implies that Treasury bill favors the strengthening of the value of the small company stock. The correlation statistic is so high, in that, it can be accurately be relied upon when predicting the value of stock of the small company. The small company and large company stocks are weakly, positively correlated, as indicated by the correlation statistic. The correlation between the small company and inflation is 0.196534576. It suggests that presence of inflation in an economy is likely to favor the strengthening of the stock value of the small company. This suggests that inflation cannot be reliably be used in predicting the performance of the small company stock. Large company stock and long-term government are weakly, positively correlated variables. The correlation between large company and long-term government is -0.38559058. This value is positive, which implies that long term government favors the strengthening of the value of the large company stock. However, the relationship is not that powerful to be relied upon when predicting the performance of stock value of the large company (Kieso et. al, 2012). Large company and intermediate government are weakly and negatively correlated as the correlation statistic indicates. The correlation between intermediate government and the small company is -0.450813367, which indicate that the presence of an intermediate government is likely to hinder the strengthening of the company’s stocks. This shows that the two variables cannot be accurately relied upon during predictions (Bolton & Wang, 2009). The probability of an increase in stock’s value of a large company is highly compromised by the presence of an intermediate government. The Treasury bill and stock of large company are weakly and negatively correlated variables. The correlation between large company and Treasury bill is -0.350911877. This value is negative, which implies that the provision of more treasury bills is likely to compromise the strengthening of the large company stock value. In this respect, the two variable cannot be accurately be relied upon during the prediction of the performance of stocks (Lhabitant, 2004). Large company stocks and inflation are weakly, positively correlated, as indicated by the correlation statistic. The correlation between large company stock and inflation is 0.102892182. It suggests that presence of inflation in an economy is likely to favor the strengthening of the stock value of large company, although not to a larger extent. This suggests that inflation cannot be reliably be used in predicting the performance of the large company stock. Correlation Between the small company stocks and large company stocks The small company stocks Large Company Stocks -3.72% 18.36 7.28% -1.25 20.63% 9.11 19.01% 19.41 13.72% 7.84 8.75% 5.9 12.46% 17.6 13.84% 18.2  Correlation The small company stocks Large Company Stocks The small company stocks 1 0.038936 Large Company Stocks 0.038936 1 The small company and large company stocks are weakly, positively correlated, as indicated by the correlation statistic. The correlation between large company and small companies’ stocks is 0.038936. This value is positive, which implies that an increase in the value large company stock is followed by an increase in the value of the stock of the small company. However, the correlation value is too small to be relied upon during the prediction of the performance of the either stocks. Correlation between Long-term Government and Intermediate Government Long Term government Intermediate Government 3.93 3.77 4.6 3.91 3.59 1.7 0.25 1.11 1.14 3.41 6.63 6.11 11.5 12.01 8.6 7.74  Correlation Long Term government Intermediate Government Long Term government 1 0.941506 Intermediate Government 0.941506 1 Correlation between Treasury bill and inflation Treasury Bills Inflation 3.56 -1 0.3 -2.04 0.37 5.36 1.87 2.22 3.89 2.52 6.29 7.36 9 5.1 5.02 2.93 Treasury Bills Inflation Treasury Bills 1 0.505082 Inflation 0.505082 1 Treasury bills and inflation variable are positively and powerfully correlated. This is indicated by the correlation statistic, which is 0.505082, illustrating a powerful relationship. The value implies that presence of treasury bills in an economy increases the likelihood of inflation. This is because the cost of production will increase resulting to lower profit, which consequent lose of value of the companies’ stocks. Question 29. By citing question 19 where E expected return =18%, D portfolio =28%, RF risk free rate of return =8% and A=4.1 Y=E (Rp)-R (f)/A*SD2p In problem 29 (a): From the equation Y*=E (Rm) - R (f)/A*SD2m But SDm=1-Y (28%) =0.6656*28% = 0.1796 or 17.796% and And E (Rm) =RF+1-y (E (rp)-Rf) =0.08+0.6356(0.1) this makes the final calculation to be =0.1784 or 16.36% From the equation Y*=E (Rm) - R (f)/A*SD2m Question 29 (b) The investor will affect the fee charged. Selection of optimal portfolio requires the analysis of risk-return preferences. The following diagram provides insight on the functioning of the selection process. Therefore, considering the diagram above, optimal portfolios must lie on the curve. This is because portfolios above the curve can not be attained. This is owed to the fact that although the returns would be extremely high, the risk involved would also be extremely high, thus, rendering the process impossible. On the other hand, portfolios below the curve lack in efficiency. Although such portfolios depict extremely low risks, corresponding results are also extremely low. This implies that an investor could achieve increased result by employing the same level of risk. Consequently, these portfolios are deemed to be inefficient. Therefore, optimal portfolios must lie on the curve. Consequently, low points on the curve are associated with low risks and corresponding low returns. On the contrast, higher points on the curve are associated with high risks and corresponding high returns. Thus, movement up the curve results in increased risks for potentially reduced returns. On the other hand, movement down the curve results in low risk and extremely reduced returns. Therefore, low risk and low return investments are pointless because they are equivalent to investing in risk-free investments such as government securities. Therefore, this creates a need for a selection process that encompasses analysis of risk-return preferences. This process is achieved with the aid of complex analysis theories designed to evaluate these preferences. Consequently, following substantial analysis using various methods, optimal-risk portfolios are found to be somewhere in the middle of the curve. Moreover, the degree of volatility varies with different portfolios. This is achieved by altering the points that fall on the efficiency curve. This, in turn, results in maximum returns for a selected risk. CFA Problem 11, p. 315 a). Capital Market Line (CML) refers to a line drawn on the capital asset pricing model so as to demonstrate the return rates for portfolios according to the risk-free return rates, as well as the level of risk for a certain portfolio. Bodie, Kane and Marcus (2003) state that the level of risk is calculated by the standard deviation; hence, the CML illustrates a positive linear correlation between the portfolio and the return SD. Additionally, he claims that the CML shows the addition returns expected by an investor for every change that occurs in the level of risk. Most coherent investors expect to get higher returns in exchange of riskier assets, and this is shown graphically using the capital market line. A portfolio that accurately reflects the CML is referred to as a Markowitz efficient portfolio, which was developed by Henry Markowitz and is currently called the modern portfolio theory (MPT). Many investors believe that to achieve the expected returns they need to increase the risk. According to Bodie et al (2003), this is only possible for investors who have an optimal and well diversified portfolio. However, due to conventional wisdom, most investors do not possess such an optimal portfolio, and this may enable increase expected returns without a concurrent increase in risk tolerance through proper diversification of their portfolios. Thus, for Murray to increase expected return of his portfolio, Joan needs to prepare an optimal portfolio for Murray that is well diversified. Moreover, in order to make a well diversified portfolio, Joan needs to understand the relationship between risk and return. According to Benninga (1999), the Modern Portfolio theory states that there is an almost linear relationship between return and risk. He argues that, for each level of risk, there are various levels of return from each different portfolio; hence, an investor needs to pick the highest return for a certain level of risk. However, this is not possible if a portfolio is not optimal and well diversified and; thus, an investor needs to have an optimal portfolio in order to achieve this. Joan can determine whether Murray’s portfolio is optimal by calculating the standard deviation, which represents risk. For instance, if Murray’s portfolio has a standard deviation of 20%, which represents risk, and a 24% expected return, and another portfolio is made, which has a standard deviation of 22%, and still has an expected return of 24%, Murray’s first portfolio is better than the second one. This is because it is insignificant to choose a portfolio that has a high risk just to achieve the same expected return. Therefore, according to Benninga (1999), the best way to achieve a high expected return is to increase the risk. This refers to having an optimal and well diversified portfolio, which is the main problem that investors face. Making a conventional portfolio will only give the investor an illusion of diversity, which is far from reality. Also, having a few return drivers in a portfolio is likely to cause a dramatic failure in the whole portfolio. Therefore, the best action for Joan to take so as to enable Murray to increase expected returns is to ensure that Murray’s portfolio is optimal and well diversified, which can be done by ensuring that the portfolio is exposed to several return drivers so as to avoid unnecessary risk. b). Security market line (SML) is also referred to as characteristic line. It is a line that shows the relationship between the market risk and the expected return for each security, represented graphically. The positive relationship between the market risk and expected return, which is hypothesized by the capital asset pricing model is said to be linear as measured by the standard deviation. The market risk is usually plotted on the x-axis while the expected return is represented on the y- axis. According to Banks (2005), the SML is essential in that it helps to determine whether a certain security is outperformed in the market or undervalued. For instance, in case a security plots the SML, it shows a high expected return for a particular level of risk compared to the entire market. In short, SML shows all the possible marketable securities that are risky. Market risk is a risk that investors take when they decide to invest in the market. This is because if a specific market they have invested in deteriorations, such as real estates, stocks and bonds among others, the investment value also deteriorates. However, market risk can be reduced through several ways such as diversifying the investors’ money in different markets so as to minimize portfolio exposure to other markets. This is essential in that it will minimize the decline of the investors’ portfolio in case one or two markets decline. Therefore, this is one of the actions that Joan can take in order to help York reduce the risk of his portfolio. In addition, the investors’ portfolio also faces the risk of inflation, which minimizes the buying power of the investors’ money. Inflation may give investors the illusion of earning money, when in the real sense they are losing since the value of their investments is reducing as inflation continues. Thus, Joan can advise York to choose a variety of investments from his home country for his portfolio as opposed to other countries. This means that his investment portfolio will be done in a particular currency like the U.S dollars instead of currency from others countries. This is essential in that there will be a lot of information for markets close to him than far, which is vital for making the right decisions and reduce market risk that may arise. However, this can be risky for the York since his portfolio is open to currency risk such that in case the value of his currency deteriorates, the value of his portfolio may also deteriorate. Nevertheless, Joan can enable York reduce this risk by trying the Forex market. Banks (2005) states that market risks are present in all financial monies, and it is not possible to remove them entirely no matter how the investor’s portfolio is diversified. However, the best way for Joan to help York minimize the risk exposure of his portfolio would be by helping him understand his risk tolerance, and ensuring that his portfolio is well diversified and re-evaluated since every investor has his own level of risk tolerance, which changes depending on different circumstances in life. List of References Banks, E. (2005). Catastrophic Risk: Analysis and Management. Boston: John Wiley & Sons. Benninga, S. (1999). Financial Modeling, Massachusetts: The MIT press. Bodie Z., Kane, A. and Marcus, A. (2003). Essentials of Investment, Fifth edition, USA: McGraw-Hill. Bolton, P., Chen, H., & Wang, N. (2009). A unified theory of Tobin's q, corporate investment, financing, and risk management. Cambridge, Mass.: National Bureau of Economic Research. Jack C.K and Stephen S.A (1979). Portfolio analysis. University of Michigan: Prentice-Hall Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2012). Intermediate accounting (14th ed.). Hoboken, NJ: Wiley. Lhabitant, F. (2004). Hedge Funds: Quantitative Insights.. Chichester: John Wiley and Sons Ltd. Prigent J.L.(2007). Portfolio Optimization and Performance Analysis. Chapman& hall: CRC Stefan F. G.(2000). Passive Portfolio Strategies. Fachhochschule: Diplomarbeit. Read More