Assignment: Investment and Portfolio Management

Introduction

The focus of this assignment is on risk, return and portfolio analysis. The expectation is that students will develop skills in measuring returns, risk assessment and analysis and valuation. Students are required to use the data provided in the case problem and exhibits to answer questions.

Required:

You are required to complete this assignment in teams of four. It is important that you form your teams as soon as possible. WebCT can be used to identify other students who are seeking partners for a team.

Please note this is a group assignment and is not allowed to be submitted by individuals.

Note that marks will be deducted for poor presentation. Assignments should be stapled in the top left hand corner. Please do not submit assignments in folders. It is also a requirement that all assignments be submitted with a cover sheet.

Assignments will not be accepted or marked if they are lodged without the cover sheet.

The assignment requires each team to undertake independent work. No further assistance will be provided to teams in completing the assignment.

The assignment accounts for 25% of the subject's assessment.

Assignment Presentation

• Students are expected to complete the calculations to the questions in the assignment in part one. This will require the development of a spreadsheet and the creation of formulas. The answers to your questions can be presented on a word document with the supporting excel spreadsheet calculations clearly referenced in an appendix.

• NOTE: Your answers should be clearly labeled on an answer sheet(s) by referencing to the question number, with any further supporting calculations referenced to an appendix. There is no word limit requirement in part two.

• In part two you are required to write a small essay of about 1000 words. There is no calculation required in part two of the assignment.

Assignment Submission

The assignment must be submitted with a signed assignment cover sheet to your tutor in the week beginning 1 October 2013.

Part One

The exhibits contain financial information on Lorton Ltd, Truganina Ltd and Woods Ltd. It also contains return information and dividend information for four companies and the stock market index.

Exhibit 1: Monthly Values for the Market Index and Four Traded Stocks.

Exhibit 2

Dividend History: Annual dividends paid for the last 8 years.

Questions

Your team has been instructed to answer all of the following questions:

1. Use the price data in Exhibit 1 for the Market index, Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd to calculate the holding-period returns for the 24 months ending June 2013.

2. Calculate the average monthly holding-period return and standard deviation of the returns for the Market index, Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd using the data provided in exhibit 1.

3. Assume that your team has decided to invest equally in the securities of these four companies. Calculate the monthly holding-period returns for your four-share portfolio. (The monthly return for the portfolio is the average of the four shares' monthly returns.)

4. Calculate the standard deviation of the asset portfolio comprised of Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd shares. Assume equal weightings of each share within the portfolio. What happens to total risk when you combine shares into a portfolio?

5. Use the numbers in Exhibit 1 to determine the systematic risk (Beta) of Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd.

6. Which measure, standard deviation or beta is used for analyzing stocks that are placed in a diversified portfolio?

7. Use the capital asset pricing model to calculate the required rate of return for Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd. Use the Treasury notes data in exhibit 1 to determine an annual average for the risk-free rate of return.

8. Using the required rates of return calculated in question 7 above and the historical dividend information in exhibit 2, calculate the intrinsic value for Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd. Use an annual compounded average rate of return when calculating the historical growth rate in dividends.

Part 2 Trading Negative Beta Portfolios

David Smith believes in modern portfolio theory and efficient financial markets. It has served him well in managing the personal investments of his clients over the past four years. However, he seriously worried about whether current stock market investors have gone bonkers. The dividend yield of the S&P 500 Stock Index has remained below a historic low of 2% per year. Below average dividend yields may be followed by stock price decreases to raise the yield back to the average.

David was advised to hedge his stock market risk with stock index futures contracts. Hedging is like adding a negative beta portfolio that quickly reduces the risk.

Futures contracts are obligations to either buy or sell an asset at a time in the future. Futures contracts have features that permit the frequent transfer of ownership or delivery obligations, such as centralized trading, standardized contract terms, and a guarantee of contract performance. The futures position can be offset or covered later at low cost because the terms of the contract are standardized. Because the obligation only becomes real at contract maturity, a unique characteristic of futures trading is that it is easy to sell the obligation to deliver without owning the asset. To guard against default at maturity, earnest monies or performance bonds are required of traders that buy or sell the obligations. Coincidentally, the performance bonds required to trade futures are called margin, but futures margin is radically different than stock margin.

David has each client holding enough in reserve (short-term, liquid assets) to meet their planned expenditures over the next nine months. The remainder of the clients' financial assets, $13,900,000 in total, is split 65%-35% between equity and debt securities. Herb tells his clients to only expect to earn a return for bearing the portfolio risk that he cannot diversify away. Currently, the beta of the portfolio is 1.10. Changes in the S&P 500 Stock Index explain a high proportion of the variability of the stock portfolio's returns, just like the Dreyfus S&P 500 Index mutual fund.

If David could create a futures position that makes money if the stock market falls, the position's beta is negative. If the market does fall, the gains from the negative beta portfolio based on futures counter-balance the losses from the clients' positive beta stock portfolio. A major question in David's mind is how many; contracts should be traded to effectively counter-balance the stock portfolio. Which futures contract should be used? The costs of trading the chosen futures contract and the idea of margin as a performance bond are also a concern.

1. Explain how futures margins as performance bonds are different than margin used in the purchase of stock. (Write about 500 words)

2. If the stock market rises instead of falls as Herb expects, what will happen to a a hedged stock portfolio? Explain. (Write about 500 words)