Assignment 1

Due: Jun 10 at 7:59am
Calenda Investment analysis 2019
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Details
Question One
More often than not, investors have been faced with indecision over investing in
either equity securities or fixed income securities. While some have argued that
investing in equity securities entails ownership in a company, others are of the view
that fixed income securities are more beneficial as they guarantee payment of
interest which is more important than ownership.
Evaluate this dichotomy.  
 
Question Two
You are given the following data about available investments:

State of the Economy Probability Return (A) Return (B)

Strong Boom 0.15 -0.60 0.75

Weak Boom 0.20 -0.30 0.50

Average 0.05 -0.10 0.15

Weak Recession 0.40 0.20 -0.10

Strong Recession 0.20 0.80 -0.35

 
Compute and fully interpret the following for these investments:
● Mean (expected) rate of return for each investment.
● Standard deviation for each investment.
● Coefficient of variation for each investment.
● Covariance among the rates of return.                                                
● Correlation coefficient of the rates of return.
                                                                                    
Question Three
You have been asked to look at the following share portfolio:

Share Value of Return last 12 Standard Beta

holding months deviation

A K13,000 12% 46% 1.0

B K15,000 15% 32% 1.5

C K18,000 9% 63% 0.5

 

 
Over the last 12 months the return on the market was 10% and the risk-free rate was
7%.
● Explain the implications of the betas for the individual assets (shares) in relation
to the beta for the market.
● Calculate the market value, beta and return over the last 12 months of the
portfolio.                           
● Estimate the return you would have expected from the portfolio using the
Capital Asset Pricing Model (CAPM). Explain why the expected return is
different from the actual return.                                                                      
● Assuming that the returns on shares A and B have a correlation coefficient of
0.6%, calculate the return and risk of a portfolio consisting only of holdings in A
and B.
● Explain the difference in assumptions underlying portfolio theory and the
CAPM.
                                                                                                 
            END    
The Beta of an individual share represents the sensitivity of the stock's return to the market returns.
The Beta also represents the systematic part of the risk of the asset. The higher the Beta, the more
sensitive it is to the market returns and t

Beta is a measure of a stock's volatility in relation to the overall market. By

definition, the market, such as the S&P 500 Index, has a beta of 1.0, and
individual stocks are ranked according to how much they deviate from the
market.

A stock that swings more than the market over time has a beta above 1.0. If a
stock moves less than the market, the stock's beta is less than 1.0. High-beta
stocks are supposed to be riskier but provide higher return potential; low-beta
stocks pose less risk but also lower returns.

Beta is a component of the capital asset pricing model (CAPM), which is used to

calculate the cost of equity funding. The CAPM formula uses the total average
market return and the beta value of the stock to determine the rate of return that
shareholders might reasonably expect based on perceived investment risk. In
this way, beta can impact a stock's expected rate of return and share valuation.

Portfolio theory is an economic theory of investor behavior. It postulates a framework for selecting optimal
(efficient) portfolios. This framework is closely connected to the efficiency frontier because every investor
chooses a portfolio on the upward sloping part of this curve. The importance of this topic became clearest when it
was used to derive the CAPM (which is a model of asset pricing based on investor behavior described by the
portfolio theory). In its essence, portfolio theory narrows in on one specific aspect of normative investment... short
term diversification. Its results, taken at face value, are not accurate if we consider diversification over long
horizons, asymmetric information/differences in opinion, transactions costs, nontradeability of certain assets, and
other imperfections in financial markets. Regardless, portfolio theory remains an important component of finance
theory for three reasons

For example, a gold exchange-traded fund (ETF), such as the SPDR Gold
Shares (GLD), is tied to the performance of gold bullion. Consequently, a gold
ETF would have a low beta and R-squared relationship with the S&P 500.

One way for a stock investor to think about risk is to split it into two categories.
The first category is called systematic risk, which is the risk of the entire market
declining. The financial crisis in 2008 is an example of a systematic-risk event; no
amount of diversification could have prevented investors from losing value in
their stock portfolios. Systematic risk is also known as un-diversifiable risk.

Unsystematic risk, also known as diversifiable risk, is the uncertainty associated

with an individual stock or industry. For example, the surprise announcement that
the company Lumber Liquidators (LL) had been selling hardwood flooring with
dangerous levels of formaldehyde in 2015 is an example of unsystematic risk. It
was risk that was specific to that company. Unsystematic risk can be partially
mitigated through diversification.
Capital market theory is an extension of the portfolio theory of
Markowitz. The portfolio theory explains how rational investors
should build efficient portfolio based on their risk-return preferences.
Capital Market Asset Pricing Model (CAPM) incorporates a
relationship, explaining how assets should be priced in the capital
market.

Assumptions of Capital Market Theory:

ADVERTISEMENTS:

(1) Investors are expected to make decisions based solely on risk-

return assessments (expected returns and standard deviation
measures).
(2)(2) The purchase and sale transactions can be undertaken in
infinitely divisible units.
(3)(3) Investors can sell short any number of shares without limit.
(4)(4) There is perfect competition and no single investor can
influence prices, with no transactions costs, involved.
(5) (5) Personal income taxation is assumed to be zero.
(6)(6) Investors can borrow/lend, the desired amount at riskless
rates.
(7) The above assumptions, although some of them are unrealistic
provide a basis for an efficient frontier line common to all.
Different expectations lead to different frontier lines. If
borrowing and lending is introduced the efficient frontier line
can be thought of as a straight line. Lending is like investing in a
riskless security say of Rf in the Fig.1.
(8) Assumptions of Markowitz Theory:
The Portfolio Theory of Markowitz is based on the
following assumptions:
(1) Investors are rational and behave in a manner as to maximise
their utility with a given level of income or money.

(2) Investors have free access to fair and correct information on the
returns and risk.
 (3) The markets are efficient and absorb the information quickly
and perfectly.

(4) Investors are risk averse and try to minimise the risk and
maximise return.

(5) Investors base decisions on expected returns and variance or

standard deviation of these returns from the mean.

(6) Investors choose higher returns to lower returns for a given level of
risk.

A portfolio of assets under the above assumptions is considered

efficient if no other asset or portfolio of assets offers a higher expected
return with the same or lower risk or lower risk with the same or
higher expected return. Diversification of securities is one method by
which the above objectives can be secured. The unsystematic and
company related risk can be reduced by diversification into various
securities and assets whose variability is different and offsetting or put
in different words which are negatively correlated or not correlated at
all.