FINANCIAL MODELLING

FINANCIALMODELLING

Groupmembers:

FINANCIALMODELLING

Parta)

Portfolioconstruction

Theprimary goal of any rational investor is to maximize return andminimize risk. This can be achieved by ensuring appropriatediversification of the investment. As the entrusted portfoliomanager, I would select a collection of stocks Small Blend, Mid-CapValue, and Large Growth in various listed companies. This selectionwill help to diversify the risk and maximize returns since differentstocks has got different market risks and returns. The portfolio willinclude common stock, Bonds and mutual funds. I would also constructan optimal portfolio which is more efficient and conduct a periodicevaluation of the portfolio so as to ensure that the trend is as perthe expectations of the shareholders. The stock selection was basedthe prices earnings ratio of the respective stock.

PORTFOLIO

Fund Name

EPS

P/E

Total investment ($)

Risk Grade

Indians Tata Motors

0.95

11.6

8,500,000

B+

Arena Pharma

1.90

10.50

7,200,000

B+

Family Dollar Stores

1.05

5.60

6,500,000

B

Zacks Mutual Fund Rank

0.80

8.30

8,200,000

B+

First Trust US IPO Index (FPX)

0.81

10.30

8,400,000

B

Volvo S&ampP Eq Wght ETF

0.82

15.30

10,000,000

B

Guggenheim S&ampP Eq Wght HC ETF (RYH)

0.82

17.00

10,600,000

B

ProShare Ultra Dow30 (DDM)

1.10

5.00

6,000,000

B

iShare Morningstar Mid-Cp Val ETF (JKI)

1.20

19.90

14,000,000

B

American Express (AXP)

3.20

22.30

17,600,000

B

Goldman Sachs&nbsp(GS)

0.80

8.60

3,000,000

B+

TOTAL

100,000,000

Thematrix shown below represent the portfolio with the ration of 5:8:5in each category of the funds.

Value Blend Growth

X

25m

Large

X

35m

Mid

X

$40m

Small

Theportfolio selection methodology begun with determination of theperformance of each individual stock which was then rolled up todetermine the overall investment style of the fund and the respectiveweight. The decision here was based on the components of the stockand the style factor exposures. For example, even though the marketof small Blend stock was considered to have a higher risk, thereturns are high and therefore, I have decided to invest much of thefunds in the stock. Understanding the trend and performance ofdifferent stock type is much crucial in constructing a diversifiedcontrolled portfolio with individual stock funds.

Partb)

Returnvs. Risk

CapitalAsset Pricing Model (CAPM) will be used in evaluating the investmentby estimating the minimum return that the assets are expected toyield. In using this model, the following formula is applied.

Rj=rf+ (rm–rf)* ß

WhereRjisthe expected return

rfisthe risk free rate

rmisthe risk of the market

ßis the market beta

Jensenratio

Thisis the a risk adjusted performance measure that represents theaverage return on a portfolio over and above that predicted by thecapital asset pricing model (CAPM). It is commonly known asportfolio’s alpha and it is gotten from the formula

Alpha= E(Rp)– {rf+ (rm–rf)* ß}

=E(Rp)- (Rj)

WhereE(Rp)is the expected return and (Rj)is the required return.

Calculatingalpha will help will help in gauging whether the stock is undervaluedor overvalued if alpha is negative, that is, the required return isgreater than the expected returns, it means that the stock isundervalued and vice versa. See the calculations of the Jensen ratiosin the excel spreadsheet calculated from the prices collected fromyahoo finance web site.

Partc)

Dueto the dynamism in the stock market, the performance and thebehaviour of the fund since July 1, 2007 to July 1, 2009 has beenobserved to down swings and up swings. In this regard, as a financialmanager I have decided to consider building a portfolio withdifferent coefficients of variations to ensure optimal minimizationof the risks associated. Calculating the covariance of the portfoliois also vital while making investment decisions. Market beta ß hasbeen used to indicate the riskiness of the asset invested in. Smallblend stock has higher beta which is indicating a higher risk.However, the risk seems to be neutralized by the higher returns fromthe investment.

Partd)

Thevariances are much greater than they would be expected since July 1,2009 to date. This signifies that the driving factors are more severein the current years as compared to there before. However, theperformance of the stock has improved since July 2009. Inflation andchanges in the interest rates has greatly contributed to thevariances in the required rate of return and the expected rate. Thetrend and performance of several of the individual funds is as shownin the excel spreadsheet attached.

Parte)

Thefactors that could have triggered the above behaviour of the fundsinclude inflation, risk premium, Interest rate, foreign exchangerate, industrial production, demand and supply of corporate bondsamong others. Whenit comes to inflation, the impact on the portfolio will depend ontype of assets held. For instance investment on stock areinsignificantly affected by inflation while investment in stocksalways keep the investors worried since they are vulnerable theeffect of inflation. The major problem with investment and inflationis that the company’s return tend to be overstated. On the otherhand, inflation is the main reason to behind growth. Changes ininterest rates has an impact on bonds investments.

Partf)

Decomposingreturns model is more useful especially when analysing historic assetreturns, since the model allows the portfolio manager in separatingcomponents of the overall return of the asset. For such purposes itis useful to write the underlying model as:

rit&nbsp=bi1*f1t&nbsp+bi2*f2t&nbsp+…. + bim*fmt&nbsp+eit

Where:

rit&nbsp=&nbspreturnon asset in period tbi1&nbsp=change in the return on asset i caused by factor1f1t&nbsp&nbsp=&nbspfactor1 in period tbi2&nbsp=change in returns on asset i caused by factor 2f2t&nbsp&nbsp=factor 2 in period tfm&nbsp&nbsp=&nbspvalueof factor mbim&nbsp=&nbspthe change in the return on asset i caused by factor mm =number of factorseit&nbsp=&nbspresidual return on asset i in period t

Thedecomposition of stock’s return using Single Index Model (SIM)assumes that there is only one factor causing the systematic riskaffecting the returns. The model provides that this factor can berepresented by the market’s rate of return on a market index suchas S&ampP 500. The returns can be decomposed into the expectedexcess return of the individual funds and it is commonly indicated asthe alpha coefficient (α).The return is therefore gotten from the formula. ri= αi+ ßirm+ ei.The trendof decomposition of stock is as shown in the excel spreadsheetattached.

Conclusion

Wecan therefore conclude that, ascertaining individual financialsituation and the investment objectives is vital in portfolioconstruction and it is also important to consider how much time theinvestment takes to grow. Investment decision will depend on the riskattitude of the decision maker. For instance, an investor who is riskseeker would invest in small blend which is having higher risk asthey feel that the risk is compensated by the higher returns in themarket. A portfolio with extreme value growth orientation and bothvalue and growth helps to enhance diversification and hencemaximizing returns at optimal minimum risk. The philosophy ofanalysing stocks, funds and portfolios is therefore a logicalintegrated system.