Problem Set 2 Done - Research Project that is given throughout the second half of semester. PDF

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PORTFOLIO MANAGEMENT (ACFI3018)SEMESTER 2, 2019PROBLEM SET 2Mark: This problem set will be marked out of 30.Weight: It contributes 15% to your overall mark.Due date and time: 11:59pm AEST 29 September 2019The spreadsheet Problem Set 2 Data contains financial markets data that is used for this assign...

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ACFI3018

Isaac Boorer 3282434

PORTFOLIO MANAGEMENT (ACFI3018) SEMESTER 2, 2019 PROBLEM SET 2

Mark: This problem set will be marked out of 30. Weight: It contributes 15% to your overall mark. Due date and time: 11:59pm AEST 29 September 2019 The spreadsheet Problem Set 2 Data.xls contains financial markets data that is used for this assignment. The data is allocated into three tabs: Q1 relates to Question 1, Q2 relates to Question 2 and Q3 relates to Question 3. You are required to submit both an Excel spreadsheet that shows your workings (in a separate link) and a word file (in turnitin) with a report that summarises your responses to each question. The word file should be a standalone report which will be marked. The Excel spreadsheet will not be marked but should be submitted so that your working out can be checked as required. Late submissions: The mark for an assessment item submitted after the designated time on the due date, without an approved extension of time, will be reduced by 10% of the possible maximum mark for that assessment item for each day or part day that the assessment item is late. This applies equally to week and weekend days.

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ACFI3018

Isaac Boorer 3282434

Question 1 (10 marks) You are employed as a research analyst and have been given six stocks to analyse. They are Commonwealth Bank of Australia, Westpac Banking Company, Australia and New Zealand Banking Group, National Australia Bank, Bendigo and Adelaide Bank, Bank of Queensland. Return from ASX200 index and 10-year government bond rate should be considered as market return and risk-free rate respectively. Daily stock price data and ASX 200 index value should be collected from FACTSET.1 10-year government bond rate (annualized in %) is provided in the Problem Set 2 Data.xls Excel spreadsheet. Consider a sample period of 1 January 2005 to 30 June 2019. You are required to undertake the following: a) Use Microsoft Excel’s Solver add-in to derive the efficient frontier of risky assets for a portfolio comprising the six stocks that you have been asked to analyse. When calculating expected returns, you should use the Capital Asset Pricing Model. The market consensus forecast for the expected market return is 12% per annum and the expected risk-free rate of interest is 6% per annum. (6 marks)

Efficient Frontier 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.21

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Quite obviously it is missing the capital allocation line this is due to excel difficulties I apologize. However the point of tangency with the CAL and the efficient frontier will be the most efficient portfolio and will coincide with the optimum portfolio whereby returns are maximised and the risk and minimised. 1 FACTSET tutorials are available in Assessment Problem set 2 folder.

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Isaac Boorer 3282434

b) In 250 words or less, discuss the relationship between the Markowitz portfolio selection model (as applied above) and your belief of market efficiency when developing an investment strategy. (4 marks) Markowitz portfolio selection model is an investment theory that suggests markets are efficient and investors are risk adverse. Therefore the investor can optimise their portfolios returns by structuring the highest expected returns in comparison to the level of market risk exposure which is inherent to the portfolio. This can be accomplished by the investor through developing a portfolio that falls along the efficient frontier. The frontier above is a range of portfolios that offer the highest expected returns for the minimum amount of risk. As noted above, the model is dependent upon market efficiency, assuming this all public information is available to the market, and everyone can interpret the data in the most efficient and effective way to position their portfolios accordingly. By using this model under the current assumptions, investors can correctly identify portfolios that align with the frontier and structure their portfolios to deliver maximum returns and minimize risk. Conversely, the market acts slightly less than efficient as not all information is presented to the market and all market participants. Thus, the Markowitz portfolio selection model is flawed to some regard. In conclusion the investors philosophy of market efficiency is critical to implementing an investment strategy, as slightly strong market efficiency provides both the best and lack of information so investors and managers can optimise their portfolios returns and minimise the inherent risk in choosing the effective capital asset allocation along the frontier.

Question 2 (12 marks) The data in the spreadsheet Problem Set 2 Data.xls provides monthly returns across 100 assets (labelled P1 through to P100) for the period from January 1970 to June 2019. You have been asked to back test a cross-sectional momentum strategy using this data. Within this strategy, you are required to demonstrate the monthly returns on a portfolio of past winners and the returns on a portfolio of past losers. The momentum strategy that you should apply is the 12/12 strategy, whereby stocks are allocated into portfolios based on their performance over the past 12 months and each portfolio is then held for the subsequent 12 months and rebalanced annually. Monthly returns on the market index (Market return) and the monthly risk-free rate (Risk-free rate) are also provided. a) Create an equally weighted portfolio comprising ten assets of past “winners” and ten assets of past “losers” and report the historical mean and standard deviation of returns for these portfolios. Calculate the Sharpe ratio and Jensen’s alpha for these two portfolios. (7 marks)

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Isaac Boorer 3282434

b) In 300 words or less, discuss whether the evidence reported in Part a above is consistent with the empirical evidence on the momentum premium reported in pages 65-70 of Jegadeesh and Titman (1993). In your answer, you should consider both the direction and magnitude of the momentum premium that you observe and provide at least one explanation for any differences (between your result and that of previous studies, particularly Jegadeesh and Titman, 1993) that you observe. (5 marks) It is important to examine the momentum premier reported in Jegadeesh and Titman (1993) to determine whether the evidence reported above is consistent with the empirical evidence that individuals overreact to information. Levy (1967) argues that when investors buy previous winners and sell past losers, there are abnormal returns. Levy supports the notion of longterm losers outperforming long-term winners. While conversely Conrad and Kaul (1998) argue that profiting from momentum strategies is compensation for the risk inherent in the portfolio’s structure. In addition, in Bernards ' (1984) paper, profit is not due to the systematic risk of, but rather to the effect of price lead lag when stocks eventually constitute their correct market price once the information is available. Further findings suggest the holding period of the strategy is critical as positive returns will revert after 12 months and the portfolio will see negative returns. In the journal article, cross-sectional momentum strategy supports the notion of being long past winners and short past losers. The Jensen Alpha can be used to compare and identify the better performing portfolio when referring to the analyzed data from the above study. The winners Jensen Alpha is higher than 1 and thus means the above expected performance of the portfolio providing more return on the amount of risk taken on. Conversely, Jensen Alpha's loser portfolio is less than 0 indicating that portfolio diversification has not eliminated risk. Another performance measure that depicts a similar concept to the alpha of Jensen is the Sharpe ratio that is much higher for the portfolio of winning stocks compared to the loss. The empirical evidence from above supports Jegadeesh and Titman's (1993) paper's inefficient market hypothesis.

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ACFI3018

Isaac Boorer 3282434

Question 3 (8 marks) One strategy applied by growth investors is to exploit IPO under-pricing. Evidence on IPO under-pricing is provided in several empirical studies, including a seminal paper by Loughran and Ritter (2004). 1) The spreadsheet Problem Set 2 Data.xls contains data on a selection of Japanese IPOs across the period 1997 to 2009. The data included in this spreadsheet includes the offer date, the name of the company issuing the shares, the name of industry the company belongs to, age of the company, number of shares offered, offer price, and the first day closing price. Calculate whether, on average, IPOs traded at a premium or discount to their offer price across this period, and in 200 words or less briefly discuss whether this result is consistent with previous empirical studies. (3 marks) On average past data of IPO listings have returned positive on the first day of trading, suggesting that the subscription prices were below the market value of the underlying shares (Loughran and Ritter, 2004). Of the 1561 IPOs that were analysed in the study conducted 78.3% traded at a premium to the offer price, 19.4% traded at a discount and 2.3% stayed the same relative to their first day trading. Which closely aligns with the findings of Loughran and Ritter, where by the subscription price is below the market price. Empirical evidence highlighted in during week 8 is closely aligned with the findings of the Japanese’s IPOs in historical years. Loughran and Ritter’s paper exhibits the notion of money left on the table being a contingent compensation, which constitutes to the under-pricing of newly listed companies. Additionally, empirical evidence identifies that the value of IPOs diminish over time meaning that the value share price exceeds its market value and that to adhere abnormal profits IPOs time horizon is very short. As most investors make their profits at the end of the first day of trading the newly listed company. Given the amount of stocks traded at premium in the given data below it would suggest that the findings support empirical studies presented by Loughran and Ritter (2004).

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Isaac Boorer 3282434

2) Calculate the average annual IPO premium or discount for each year of the sample period. Identify the year in which the IPO discount/premium was a maximum and a minimum and provide a justification for this result. (3 marks)

Average IPO Return 250.00%

200.00%

150.00%

100.00%

50.00%

0.00% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

During 2005 on average IPOs posed the greatest returns to investors on the first day of trading throughout the data analysed. Conversely across 1997 on average IPOs were listed at a premium as they posed the lowest returns for IPO investors on the first day of trading. This indicates that during the period the investors did not see the potential upside to the expansion of these companies being listed.

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ACFI3018

Isaac Boorer 3282434

Furthermore, the year in which IPOs traded at the lowest first day returns proceeded through 2008, this is during the GFC investors were seemingly risk off as the threat of uncertainty in the markets were heightened thus, dampening average demand for newly listed companies.

3) In 150 words or less, explain why it is difficult for individual retail investors to profit from IPO under-pricing. (2 marks) There is a number of reasons it is difficult for individual retail investors to profit from IPO under-pricing. Firstly, most IPO listings are initially presented and distributed to institutional investors due to the large amount of accessible funds that they can commit to the venture. This will inherently drive up the price before purchase and adversely affect potential returns for the individual. Institutional investors also have greater access to information and can analyse the prospectus, ultimately evaluating the underlying value of the company. Therefore institutional investors have a timeliness to the market and can assess the company prior to others outside the realm of institutional investing. Lastly, empirical studies mentioned above by Loughran and Ritter (2004) suggest IPOs abnormal profits when they are sold quickly as their price diminishes post first day of trading. For the individual investor this means they’ve lost by the timeliness of entrance into the market and would therefore fail to yield high profits. In conjunction with the last notion and across all trading when compared to institutional investors, the individual has higher transaction costs which further impedes on positive abnormal returns.

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