QUESTION
Curtin Business School
Department of Finance and Banking
FINANCE (Portfolio Management)
Semester 1, 2012 – Assignment
Industry Risk/Return Analysis
Instructions
1. This is a group assignment. Each group will consist of three students and each group will submit one joint report.
2. In doing this assignment, you are encouraged to refer to the lecture notes, texts, the reading material in Blackboard and any other material that may assist you in understanding what you are doing in this assignment. Group members are expected to actively discuss and work among themselves but not refer to the work of any other groups. Any collusion of this form will be treated very seriously and penalised.
3. Please ensure that each member in a group makes an equal contribution to the assignment, as far as possible. Free riders should be reported to me and may be penalised.
4. You are expected to make this assignment an opportunity to develop you spreadsheet computational skills. Make use of Excel or any other computer spreadsheet of your choice to do your calculations and graphs.
5. Assignments must be typed and neatly presented in a professional report format. The results or summaries of your calculation and your comments must be shown in the body of the report. Make sure the methods and formulas used for your computations are clearly shown. Details of data and calculations can be shown as appendices to the report. Make your report look professional and reader friendly. The length of the report should not exceed 10 pages (Excluding the appendix). Use 12 point font size and standard margins.
6. Ensure that you give adequate cross references to the sources from which you have gathered information in compiling your report.
7. The criteria used in assessing your marks on this assignment will include:
Computational accuracy,
Relevance and accuracy of the interpretation of results,
Demonstration of your understanding of underlying financial concepts and theory,
Neatness and style of presentation.
8. Assignments are due back in class during the week beginning 14 May. Late assignments will attract a penalty of 10% per day.
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You are an investor in the Australian stock market. You wish to examine the behaviour and performance of stocks in different industry groups in the recent past. From this examination you would like to have answers to questions such as: Do stock returns of different industry groups behave similarly or differently? How do their risk return characteristics and their behaviour compare to the overall stock market performance? Is it possible to relate their performances to relevant economic and/or market related events that took place during this period?
You are hoping that this investigation will enable you to relate industry stock performance to economic, political and market related events that may have taken place during the period, and provide some useful information and insights for formulating investment strategies for the future.
To carry out this analysis you are given data for the Australian Stock Exchange ‘Total Market Index’ and index returns for ten industry groups of the ASX for the year March 2011 to February 2012. The data is on Blackboard in the Excel spread sheet ‘Data for Assignment.xlsx’. The spread sheet shows the weekly values of the Total Stock Market and the following ten industry groups: Oil & Gas, Resources, Industrials, Consumer Goods, Health Care, Media, Travel & Leisure, Utilities, Financials and Real Estate
For your analysis, select any three industry groups of your choice from the ten groups available to you.
Carry out the following analyses.
Part 1 (40 marks)
Calculate the following using the data provided:
(a) The discrete rate of return in each week for each of the three industry indexes and for the ASX total market index, and the arithmetic mean return and the geometric mean return of the respective indexes for the period. (10 marks)
(c) The variance and standard deviation of returns for the total market index and each industry index, and the covariances of returns between each pair of industry indexes, the covariance between each industry index and the total market index, and the corresponding correlation coefficients. Show your results with graphs/charts as appropriate. (15 marks)
(d) Comment on your results in (a) to (c) for the total market index and each industry index, comparing the risk return characteristics and performance of each of your indexes. Relate your comments to finance principles and theories you have learnt in this course, and to possible economic and/or market related events that that may have taken place during this period that could have influenced their performances. (15 marks)
Part 2 (40 marks)
(a) Extract for each week, the yield of the 90 day Bank Accepted Bill (BAB) rate or the 3-month Treasury Note rate from the Reserve Bank of Australia (RBA) website: (http://www.rba.gov.au/statistics/tables/index.html#interest_rates) over the same period of March 2011 to February 2012. (Remember that reported yields are usually annualised figures.) Convert the yields to weekly numbers. Use this as a proxy for the risk free rate. (5 marks)
(b) Estimate the ‘Industry Characteristic Line’ for each of your industry indexes relative to the total market index, based on the ‘Market Model’, based on excess returns (discrete returns less the risk free return), and using regression analysis. Show your results graphically. From your results, compute the Beta and the Jensen’s Alpha of each industry index. (20 marks)
(c) Calculate the total risk (the return variance) of each industry index. Partition the total risk to their respective systematic and unsystematic risk components. (15 marks)
Part 3 (20 marks)
Based on the results of your analysis in Parts 1 & 2 above, comment on the return and risk characteristics of each industry and its performance? Given the nature of the industries that you selected, would you expect the industry returns to have behaved differently? (10 marks)
Comment on the usefulness of the analysis you have carried out for making future investment decisions on the Australian stock market. What limitations do you see in the analysis? If so what further analysis would you wish to carry out for future investment decision making purposes? (10 marks)
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SOLUTION
Part 1 (40 marks)
Calculate the following using the data provided:
(a) The discrete rate of return in each week for each of the three industry indexes and for the ASX total market index, and the arithmetic mean return and the geometric mean return of the respective indexes for the period. (10 marks)
(c) The variance and standard deviation of returns for the total market index and each industry index, and the covariances of returns between each pair of industry indexes, the covariance between each industry index and the total market index, and the corresponding correlation coefficients. Show your results with graphs/charts as appropriate. (15 marks)
(d) Comment on your results in (a) to (c) for the total market index and each industry index, comparing the risk return characteristics and performance of each of your indexes. Relate your comments to finance principles and theories you have learnt in this course, and to possible economic and/or market related events that that may have taken place during this period that could have influenced their performances. (15 marks)
Ans Part (1)
Three industries have been chosen
- Oil & Gas
- Resources
- Industrials
Calculation of discrete rate of return would also require the income produced during
a particular period besides the change in market price. Discrete rate of return is calculated by adding the income during a certain period to the change in price rate and dividing the entire sum by the initial price. Here we have only market prices and hence rate of returns i.e ROR have been calculated only on the basis of given data that is market price. The formula used for calculating ROR= (P1-P0)/P0
This does not reflect the true rate of return and the discrete rate of return will be positive and not negative. Nevertheless these RORs can be used for mutual comparison. Please note that ROR BAB (Bank Adjusted Bill ) is positive, whereas ROR’s for the selected industries are negative because we do not have the data regarding income produced and hence discrete rate of returns are not available.
See Excel Work Book
a and b))Sheet 1. Total Market: provides ROR on Total Market, and the three industries, OR (BAB) and excess returns of Total Market.It also provides the correlation and covariance coefficients between industries and total market and industries.
Sheet2.Oil &Gas, Sheet 3.Resources and Sheet 4 Industrials show the ROR calculations mean rate of return and standard deviation of return for each of the chosen industries and also excess returns for each of the three industries.
c) See sheet 7. Risk and Return. Here the mean risk and standard deviation have been tabulated and also shown on scatter. We can see by comparison that resources is having the best risk return profile whereas industrial is having the least desirable. Investors prefer to earn more returns where more risks are associated and seek to balance their risk and return. Rational investors would not prefer higher risk to lower returns.
Part 2 (40 marks)
(a) Extract for each week, the yield of the 90 day Bank Accepted Bill (BAB) rate or the 3-month Treasury Note rate from the Reserve Bank of Australia (RBA) website: (http://www.rba.gov.au/statistics/tables/index.html#interest_rates) over the same period of March 2011 to February 2012. (Remember that reported yields are usually annualised figures.) Convert the yields to weekly numbers. Use this as a proxy for the risk free rate. (5 marks)
(b) Estimate the ‘Industry Characteristic Line’ for each of your industry indexes relative to the total market index, based on the ‘Market Model’, based on excess returns (discrete returns less the risk free return), and using regression analysis. Show your results graphically. From your results, compute the Beta and the Jensen’s Alpha of each industry index. (20 marks)
(c) Calculate the total risk (the return variance) of each industry index. Partition the total risk to their respective systematic and unsystematic risk components. (15 marks)
Answer:
a)The risk free rate of Bank Accepted Bills, was obtained on daily basis and weekly numbers were selected from the data obtained, from the given website. This rate has been used for calculations in sheet 1, 2,3.
b) Industry characteristic line can be obtained by plotting excess market returns on x-axis and excess industry returns on y-axis. In Sheet 6.Industry characteristic lines, lines for all the three chosen industries have been shown.
For calculation of Betas see sheet 5.Betas.
The formula for the beta of an asset within a portfolio is
For calculating Jensen’s alpha, we use the formula:
Jensen’s alpha = Portfolio Return − [Risk Free Rate + Portfolio Beta * (Market Return − Risk Free Rate)]
Since we do not have discrete returns, values can be compared and cannot be said to be correct.
c) The total risk is given by variance of the industries in Sheets 2,3,4.This is comparative and correct figure is not there because discrete returns cannot be calculated.
Β is the systematic risk. Total risk constitutes systematic and unsystematic risks.
Part 3 (20 marks)
Based on the results of your analysis in Parts 1 & 2 above, comment on the return and risk characteristics of each industry and its performance? Given the nature of the industries that you selected, would you expect the industry returns to have behaved differently? (10 marks)
Comment on the usefulness of the analysis you have carried out for making future investment decisions on the Australian stock market. What limitations do you see in the analysis? If so what further analysis would you wish to carry out for future investment decision making purposes? (10 marks)
Ans:
See work sheet 7.We have returns based on only market prices, as per market dynamics Resources has the greatest returns, followed by oil &Gas and least is for Industrials. The returns for resources is significantly higher than the market, whereas oil and gas has slightly higher returns than the market and industrials has significantly lower returns than the market.
The risk for industrials is the lowest, followed by oil and gas and then resources.Industrials has slightly lower risks than the market, whereas resources and oil and gas have slightly higher risk than the total market.
The risks do not differ significantly and when compared resources can be said to have the best risk return profile in comparison to the other two industries.
Returns and risk (standard deviation) are widely used for assessing the attractiveness of investment options.
Beta is the systematic risk and cannot be reduced by diversification. Total risk comprises of unsystematic and systematic risks.Beta is inherent in the entity and can be reduced by internal measures.A knowledge of Beta enables entities to assess their diversifiable and non diversifiable risks.
Alpha is the risk adjusted excess return and is also a very useful measure for assessing investment options.
The income for each industry will be an average income yields of all the firms comprising the industry. Hence the dividends on stock for each industry will have to be considered.
If the income on investments would have been provided then discrete returns could have been calculated and correct measures could have been arrived at, the above measures are only comparative and not absolute.
Reference
Bhalla,V.K.,1997. Investment Management,1st ed,New Delhi,India:S.Chand and Company Ltd.
KA70
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