Statistical Tools for Financial - Research Paper Example

Statistical tool for Financial Research al affiliation The implications of a rolling portfolio incase of IPOs are the subject of this work. After assessing the risk return values, we have focused our attention on the role of portfolio executives as well as on the necessity adopt a frequent revision policy in particular market conditions. OVERVIEW The experience of many firms that got into financial trouble, improper accounting practice and derivatives analysis in the post-Enron world of 2002 is an evident example of poor corporate governance that allowed Portfolio Managers1 to benefit at the expenses of minority shareholders, making necessary to use an Initial Public Offering2. However IPOs problems affect not simply corporations but also start-up companies facing plenty of obstacles, including the cost of Compliance with Sarbanes Oxley. Modern corporate finance however unanimously points to a formidable hurdle: Portfolio executives. Considering that the timing of an IPO will be driven by company growth and market conditions, we have based our assumptions for an efficient portfolio strategy on improving capital markets with IPOs hoping to maximise their wealth. With a rapid growth of issuers' activity on the cable markets, expected to continue in the next few years, we have used Time Warner Cable unit for this case study. If Section 1 illustrates and develops the implications of a newly created portfolio detailing executive level strategic financial decisions for the following year, Section 2 is more focused on the concept of decision planning as well as on its effects in case of poor corporate governance decisions. We have based the risk-return characteristics of our rolling portfolio investment strategy on stocks bought and held for up to one year. Although the average long-run portfolio return is low and in line with market reactions to security offer announcements, this IPO stocks appear as long-shots, securing a buy-and-hold returns of 1,000 percent. In line with average NASDAQ market capitalization our IPO firm exhibits relatively high stock turnover and low leverage, contributing to lower systematic risk exposures. To analyse the implications of these strategic decisions, we have based our assessment on globally acknowledged peer-reviewed research and theory. Our conclusions are finally presented in Section 3. 1. Newly created portfolio strategy and executive-level strategic financial decision making The acknowledgement that flipping is useful in helping to create liquidity may convince an executive team that focusing resources almost exclusively on a few late-stage assets is a wise move. Measuring value and risk at portfolio level can contribute to appropriately capture the portfolio strategic risk and induce executives dissatisfied with the current status quo to analyse if they intend to leave corporate strategic risk management and diversification completely to shareholders and markets or how an independent growth path can be possible in their high-risk business. To analyse these issues it is important to develop a structured approach that helps senior executives better understand the impact of portfolio decisions on risk and value of the corporate or therapy area level portfolios. Therefore we have based our approach on assessing a strategy of purchasing and holding successive IPO stocks receives an expected return commensurable with risk. Usually this can be achieved by creating different market scenarios reflecting uncertainty around the product profile and resulting in a Risk and Value plot at the portfolio level. In consideration of the above, we have assessed this portfolio by using the Markowitz two assets portfolio model. Clearly when managing a very active investment portfolio against a well-defined benchmark, the goal of the manager should be to generate a return that exceeds that of the benchmark while minimizing the portfolio's return volatility relative to the benchmark. Assuming a portfolio of assets equally invested (50%), the return on a two-assets portfolio can be expressed as: Eq. 1 where and represent the weight of each assets within the portfolio, whereas the variance of the two-assets portfolio is identified by the following equation: Eq. 2 where CV indicates the covariance or the correlation . The larger difference between Non Convertible Preferred Stock3 and Common Stock4 in 2008 and 2009 generates a portfolio expected returns amounting to 67.84% in December 2008 and to 44.85% in December 2009. In particular the closer difference between the CS closing prices (21.09% in Dec. 2008 and 21.34% in Nov. 2009) and the average mean price (21.22%) indicates a higher variance (3.125) pointing however to a slightly low Standard Deviation5 and volatility. The CS' overall value of the SD equal to 0.0017% seems to indicate low volatility of the dataset underlining a certain reliability, a condition traditionally preferred by investors, whereas NCPS' overall value of the SD, equal to 0.32% underlines a slightly higher (if compared to CS) volatile tendency as well as larger daily ranges. Other interesting statistical data are the variance and the covariance. According to the two-factor model applied, the variance of any security, measuring the asset's own risk, is 3.12 (CS) and 0.10 (NCPS), determining a covariance equal to -0.03%. This negative value can be motivated with the association of good outcomes (a plus deviation) for one asset with bad outcomes (a minus deviation) of the other, determining positive and negative deviations at dissimilar times. For many purposes it is useful to standardize the covariance and divide the covariance between the two assets by the product of the SD of each asset. This operation, which has the same properties of the covariance produces the Covariance Correlation6 which may range from -1 to +1. In the case under consideration the statistical Covariance Correlation of -1% indicates not simply the lack of disparity between the overall values of the SDs of the 2 equities but points also towards good and bad returns of the two assets occurring at opposite times, though when this situation occurs, a portfolio can always be constructed with 0 risk. In addition to this, since our portfolio combines 2 stocks with 50% invested in each, it has exactly the same return as does either stock by itself, since the returns are identical. Therefore the risk of the portfolio, as measured by the SD, is identical to the SD of either stock by itself. As a consequence of this, a perfect negative correlation will indicate also that when one security's return is high the other is low. However the wide range of different potential combination of CS and NCPS shares giving different levels of risk and return are only evident on the efficient frontier. In consideration of the current recession experienced by capital markets as well as of NCPS slightly higher volatility we suggest our executive team to keep under constant observation markets in order to avoid risky assets sales into illiquid markets in conditions of liquidity pressures. Further details related to this aspect will be presented in Section 2. 2. Effects of executive level financial decisions, revision and common practice In consideration of the strategy briefly outlined in our overview, security value will certainly increase and are expected to generate ROIs7 greater than the firm's cost of capital in growing market conditions. This principle translates in three important rules for the management based on avoiding investments in business likely to earn economic returns below the cost of capital, on reinvesting in businesses likely to earn economic returns above the cost of capital or on making strategic plans that can realistically achieve favourable future fade rates. The final of these three rules however deserves some more discussion, considering that PMs, well-versed in companies' life-cycle histories, use this empirically based knowledge to evaluate management's strategies. Although common practice suggests an yearly revision of executive financial decisions, the existence of particular market conditions has induced us to focus the remaining part of this paragraph on them. Volatile capital markets, in particular request a continuous attention in order to avoid the danger for dealers subject to liquidity pressures to sell assets into already illiquid markets. In fact improper trading techniques might result in a fire sale scenario, in which a cascade of failures and liquidations sharply depresses asset prices, with adverse financial and economic implications. In such market conditions underwriters sometimes provide informal price support in the after-market by buying shares at a price close to the IPO price in an attempt to discourage flipping when initial returns are negative. On the other hand, when the after-market price rises dramatically and volume is high, flipping is beneficial to the underwriter by increasing market-maker profits. This topic introduces an other relevant aspect often analysed by academics: returns to IPO. Brav and Gompers (1997) and Brav, Geczy and Gompers (2000) for instance found that underperformance is concentrated primarily in small firms with low book-to-market ratios fully confirming Fama and French (1993) opinion assessed in their three factor model and debiting eventual IPO anomalies to pricing small firms with low book-to-market ratios. Eckbo, Masulis and Norli (2000) focus their attention on the reduction in leverage occurring when new equity is issued reducing subsequent equity risk exposure and thus contributing to the apparent unusual behaviour of returns following seasoned equity offerings8. In contrast with Fama (1998) measuring normal returns, Schultz (2003) used simulations to study the behaviour of abnormal return measures after events that are triggered by prior stock price performance. His results conclude that many of the popular measures of long-run abnormal returns will falsely reveal subsequent poor performance if a firm chooses to issue stock after its price has risen in the recent past, even if the stock price is fully rational. Amihud and Mendelson (1986) have argued that firm size proxies for the illiquidity of the stock and that higher transaction costs for small firms raise the required gross return so that net expected returns are equalized, given the risk of the stock. In their empirical work, they found that the cross-sectional dispersion in average returns across portfolios of NYSE stocks sorted on bid-ask spreads is similar to the dispersion in average returns across portfolios sorted on risk estimates. From this perspective, size is not a risk factor, but rather a proxy for differential transactions costs. Thus, actions that increase the liquidity of a firm's stock might reduce required returns and increase the stock price if such actions were costless. Decisions on whether the firm should undertake policies that increase liquidity depend on whether the benefits exceed the costs. There has been much recent work on the linkages between market microstructure, asset pricing, and corporate finance. An other important ratio often analysed and generating relevant market effects is Book-to-market ratio 9. Fama and French interpret the book-to-market ratio as an indicator of "value" versus "growth" stocks, as reflecting "distress risk". The apparent disappearance of the size effect if true would be problematic for the liquidity effect unless small-capitalization stocks have relatively low transactions costs in recent years. These firms are more likely to suffer financial distress costs in future periods if further bad news hits. If Daniel and Titman (1997) are correct that firms with lower book-to-market ratios have lower expected returns, holding risk constant, then corporate financial policies designed to lower BTM would improve firm value by lowering the cost of capital. In the corporate finance literature, the BTM ratio has been interpreted as a measure of the type of investment opportunities that are available to the firm. For example, Smith and Watts (1992) have interpreted high BTM firms as those with "assets-in-place" and low BTM firms as those with relatively more "growth options". From this perspective, the fact that accounting book values make no attempt to measure the value of growth options drives the cross-sectional dispersion in BTM ratios. Interpreted in this way, the BTM ratio is exogenous and reflects the investment opportunity set facing the firm. It would not make sense, for example, to advise firms to sell assets in place and invest in growth options just to lower the ratio and, from the perspective of Daniel and Titman, to lower the cost of capital. 3. CONCLUSIONS After market returns for 2009 IPOs averaged about 24% for the first nine months, pretty much in line with the average annual performance going back to the last crash as well as with the necessity of efficient market hypothesis. Initial public offerings or IPOs are considered risky trading opportunities with investors often advised to stay away from them until the price stabilizes and the growth potential of the company is revealed. Fluctuating markets conditions and the existence of non-market forces controlling selling prices, illiquidity conditions and poor executive management seem to confirm that the best strategies to profit from IPO shares is the 'buy early and sell early' strategy for short-term traders, and 'establishing target prices for enter and exit' for long-term traders. Word Count : 2,097 Words allowed: 1,400-2,100 REFERENCES Arnold Glen. Corporate Financial Management. 2nd edition. New Jersey (U.S.A.): FT Prentice Hall, 2002. 235. Barber B., Lyon J., 1997. Detecting long-horizon abnormal stock returns: the empirical power and specification of test statistics. Journal of Financial Economics 43, 341-372. Brav A., Geczy C., Gompers P., 2000. Is the abnormal return following equity issuances anomalous Journal of Financial Economics 56, 209-249. Brav A., Gompers P., 1997. 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