Correlation coefficient is applied when analyzing different types of stocks and asset behavior. Asset correlation in personal investing guards against exposure to excessive risks. It however doesn’t account for the reasons, causes or effect of the risks. (Markowitz 2009)
1a. Efficient frontier in the portfolio theory
It’s a theory in modern portfolio management that was initiated by Markowitz and it involves various combination of assets or portfolio in a way that brings out the best level of expected returns in an efficient way considering its level of risks. The standard deviation of the asset returns is plotted against the portfolios expected return which is obtained against the tangent of a risk free rate. The part of the hyperbola that represents the opportunity with the highest amount of expected return for a particular level of risk is known as the efficient frontier. (Elton & Gruber 2011)
1b. The rationale would be that the tyre manufacturer basically produces enough tyre for the UK market and also enough for export to other countries that would have a different kind of weather some may be dry. UK tyre manufacturer would have to satisfy even the markets that require the tyres that are needed in dry weather.
1c. i) The best assets would be Rolls-Royce and BSkyB stock. The stock represents very high returns but the risks are also high. The relationship that exists between the above stocks and the gains in the FTSE are very strong and positive relationship with the portfolio. For example a positive relationship shows a positive gain in the FTSE and the portfolios while a negative correlation coefficient shows that could actually lose some portfolio value as the FTSE gain gains value.
1c. ii) investors prefer investments with higher returns as well as investments with low risks. The best option is to select the most suitable and profitable option from the efficient frontier. The best way to point out the best option is by evaluating the indifference curves which represent the preference of the investors on different combination of risks and returns.
Optimal Performance calculations of EasyJet
|Expected Val mon %||2.32||0.30||1.31||1.22||1.77||1.07||1.70|
|Expected Ret (ann %)||31.72||3.60||16.89||15.72||23.48||13.60||22.35|
|5 yrs Beta||0.86||0.45||0.65||0.49||0.67||0.52||0.69|
|5 yr Alpha %||27.20||0.42||13.04||12.42||19.57||10.20||18.39|
|5 yr Sharpe ratio||3.55||0.40||2.98||2.08||3.77||2.98||3.90|
|5 yr total return||222.44||11.51||102.10||81.98||160.65||80.28||152.56|
|Expected Val mon %||0.17||1.25||1.95||2.14||-0.18||1.07|
|Expected Ret (ann %)||2.10||16.05||26.06||28.86||-2.11||13.66|
|5 yrs Beta||0.26||0.56||0.91||0.88||0.73||0.79|
|5 yr Alpha %||-0.43||12.52||21.38||24.26||-6.22||9.34|
|5 yr Sharpe ratio||0.07||2.57||4.01||4.44||-0.06||2.09|
|5 yr total return||-0.78||92.07||186.51||219.17||-19.70||72.23|
The minimum risk is 5%
1d. i) Diageo
1d. ii) 5.3%
1d. iii) The proportion of Easyjet shares would be 50%.
1e. The lowest standard deviation and the average return of the portfolio and the capital allocation line gives the Sharpe ratio. The optimal portfolio balance is usually where the line’s slope is highest.
2a. i) The major challenge in the management of investment is basically the choosing of a convenient and appropriate investment while also designing a particular unit that will meet the expectation and the objective of the investor while also considering his constraints. These constraints could be the liquidity, need for regular monthly or periodical income, age, the risk tolerance or even the tax liability. Investments can be classified broadly as financial or real investments while financial investment can be further classified as fixed income or variable income investments.
To protect their shares portfolio, Mr. Mark Brisley and EviePetrikkou should sell a call that’s covered. For example, if they owned 100 or more shares that they intended to sell as stock (writes) that’s a call option. The buyer of the option would pay a premium so as to gain the right to buy the 100 shares at an agreed price known as the strike price for a certain limited time that’s until the options expire. If the stock’s value appreciates the option owner gains otherwise all the gains would have all ended up with the stockholder. The cash ensures protection from the stock price devaluation. They can also protect their shares portfolio by buying puts. For example during the 2008 economic crisis, the value of puts would generally have increased as the stock’s value deteriorated. The put owners have a right to sell their shares at the agreed strike price. The main advantage of buying puts is that the losses are mostly limited. The owner is allowed to pick a strike price that can match the risk tolerance and the minimum selling price is also guaranteed. The value of the portfolio cannot be allowed to fall beyond a certain amount. The other alternative is to replace all the stocks with options.
2a. ii) They can increase their chances of getting more income by taking options with a longer period of time that the option can be exercised.
2b) The potential loss per share would increase if the value of the shares reduces to 45 per share or less. After buying the options for 50 per share, the potential loss would increase to 5 per share which will culminate to a loss 500 for the 100 shares excluding the 200 premium.
2c) The risks in the extract can be analyzed from two approaches, the sellers and the buyers. When a trader purchases an asset that has a three months expiration and within that period the potential stock remains at a price that is lower than its original purchase price, then the risk of getting losses is inevitable.
The sellers also incur losses as there are some options that have unlimited risks or possibility of ending up in losses which largely depend on the movement of the potential stock. There are instances where the sellers are under obligation to sell even when the trading is not profitable.
Risks are inherent to any form of trading as the higher the risk the higher the profits.
2d) Derivatives have contributed largely to the need of increased risk management procedures. Derivatives have to led to the growth of the financial economy which had been preceded by the production economy in the late 1960,s and early years of 1970’s. (Ciner 2006)
Derivatives can affect systematic risks as its nature and implication go beyond the realms of the entire financial economy, social and also political framework of most economies. (Dodd 2005) This is possible as derivatives do not affect the underlying asset but only the price change of the asset which predisposes the assets to wide range of systematic risks. (Williams 2010) With increased innovations derivatives have evolved into new forms which have created cross-linkages in different asset valuation and price changes through different forms of automated digital platforms like swaps. (Blackburn 2008) Swaps provide the means and capacity to exchange one asset risk which is in a different class to another without actually gaining ownership of any asset with the investors. Such innovation has increased systematic risks that are associated with different forms of derivatives and has contributed to the interdependency of several different assets and their relative price changes. (Zeyu, Podobnik, Feng and Baowen 2012) Instability in only one class of a certain assets can cause a very widespread effect on the systematic stability several other related assets hence create a complex manifestation of associated risk in a financial economy. (Brownlees, Engle 2010)
3b) Alpha is also known as the Jensen index and it measures the risk adjusted return of an equity security while beta measures the volatility of the security as compared to its benchmark index. It basically indicates the securities or the stocks ability to gain value and it’s based on the company’s rate of earnings growth. Volatility measures the riskiness of a particular stock compared to the market. R-squared determines the exact proportion of a stock or security’s return. The F&C r-squared of 0.92 indicates that 92% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. Its Sharpe ratio is 0.08 or 8% and it’s the most risky security among the three as its ratio is the lowest. A higher ratio indicates a less risky investment. The F & C beta of 0.99 shows that the market has similar risks as the security while the r squared of 0.92 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. It’s very high and it’s also referred to as the coefficient of determination. The volatility for F & C shows that its lower than 50% hence its acceptable as the beta is also close to 1.
The Baillie r-squared of 0.91 indicates that 91% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. Its Sharpe ratio is 0.72 or 72% which is the best among all the portfolio and it’s the safest to invest in as it’s less risky than all the rest of the securities. A higher ratio indicates a less risky investment. The Baillie beta of 1.07 shows that the market has similar risks as the security while the r squared of 0.91 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. The volatility for Baillie shows that it’s lower than 50% hence it’s acceptable as the beta is also close to 1. (Elton & Gruber 2011)
The HSBC r-squared of 0.92 indicates that 92% of the returns of the security are basically due to the gains in the market while 8% is due to other factors related to the security. Sharpe ratio compares the overall relationship of risks and related rewards while exploring different investment strategies. The 0.46 or 46% shape ratio indicates that its return is risky. A higher ratio indicates a less risky investment. The HSBC beta of 1.03 shows that the market has similar risks as the security while the r squared of 0.92 indicates that the bench mark index is almost wholly determined by the portfolio’s performance. The volatility for Baillie shows that it’s lower than 50% hence it’s acceptable as the beta is also close to 1.
Brownlees, C.T., Engle, R.F., 2010. Volatility, correlation and tails for systemic risk measurement,
Blackburn, R., 2008, The Subprime Crisis, New Left Review, 50 Mar- Apr 2008.
Ciner, C., 2006, Hedging and Speculation in Derivatives Markets: the Case of Energy Future Contracts, Applied Financial Economics letters, 2, 189-192
Dodd, R., 2005, Derivatives Markets: Sources of Vulnerability in US Financial markets, In Gerald A. Epstein (Ed) Financialization and the World Economy, Edward Elgar: Cheltenham
Elton, E.J. & Gruber, M.J., 2011, Investments and Portfolio Performance. World Scientific. pp. 382–383.
Gray, D. F. and Andreas A. J., 2011, “Modeling Systemic and Sovereign Risk,” in: Berd, Arthur (ed.) Lessons from the Financial Crisis (London: RISK Books), pp. 143–85.
Markowitz, H.M., 2009, Harry Markowitz: Selected Works. World Scientific-Nobel Laureate Series: Vol. 1. Hackensack, New Jersey: World Scientific. p. 716
Williams, M.T., 2010, “Uncontrolled Risk: The Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System”. Mcgraw-Hill
Zeyu, Z., Podobnik, B., Feng, L. and Baowen L., 2012, “Changes in Cross-Correlations as an Indicator for Systemic Risk” (Scientific Reports 2: 888 (2012))