Investment and Portfolio Management

BAO3403
Assignment Semester 2 2013

Nahulan Sreethararaj
Mathew Berkery
Stewart Louden
Shiraz Patel

3886641
3891369
3801726
3798548

Solutions
1. Use the price data in Exhibit 1 for the Market index, Lorton Ltd,
Truganina Ltd, Wonders Ltd and Woods Ltd to calculate the holdingperiod returns for the 24 months ending June 2013.
The holding-returns for the respective companies over the 24 month period is
as follows:
Market
index
(points)

Lorton
Ltd
($)

Truganina Wonders
Ltd
Ltd
($)
($)

Woods
Ltd
($)

Jun-11
July
August
September
October
November
December
Jan-12
February
March
April
May
June
July
August
September
October
November
December
Jan-13
February
March
April
May
Jun-13

0.0394
-0.0116
-0.1458
0.0624
0.0803
0.0591
0.0564
0.0410
0.0029
0.0024
0.0379
-0.0250
0.0544
-0.0320
-0.0063
-0.0286
0.0625
0.0191
0.0578
-0.0509
-0.0201
0.0967
-0.0308
-0.0219

0.0377
0.0382
-0.0792
0.3152
-0.0040
-0.0715
0.2032
0.3665
-0.1988
0.0205
0.0076
-0.1639
0.0743
0.1049
0.1940
-0.1434
-0.0402
0.0715
0.1860
-0.2463
0.0617
0.3217
-0.0706
-0.1396

-0.0128
0.1272
-0.0440
0.2340
0.0616
-0.0409
0.0694
0.3397
0.0556
0.0105
-0.0792
-0.2432
0.1061
0.1049
0.1940
-0.1434
-0.0402
0.0715
0.1860
-0.2463
0.0617
0.3217
-0.0706
0.0199

-0.1083
0.0449
-0.0805
-0.2179
0.0796
0.0691
0.2134
-0.0728
0.0134
0.0624
0.2776
0.0265
0.0190
-0.3808
-0.0151
0.0830
0.0968
-0.0239
-0.0847
0.3169
0.0984
0.2745
-0.3248
0.0579

0.0688
-0.2163
-0.2464
0.1464
0.1990
0.0632
0.2168
-0.0723
0.0158
0.0613
0.3165
-0.0016
0.0184
-0.3810
-0.0159
0.0830
0.0973
-0.0232
-0.0870
0.3196
0.0978
0.2755
-0.3254
0.1247

Total return
for the 24month
period (%)

29.95

84.56

104.32

42.44

73.49

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.
The average monthly return for the respective stocks is calculated by dividing
the return for the 24-month period by the number of periods (24):
Total return
over 24months
Total
return/24

29.95

84.56

104.32

42.44

73.49

1.25

3.52

4.35

1.77

3.06

Standard deviation is calculated by finding the square root of variance. Taking

the square root of the following formula will yield the standard deviation
calculation:

variance formula

The expected return is taken from the benchmark, the Market Index. The
Market Index achieved a return of 1.2478% per month over the 24 month
period. Using this data, the variance of each stock in each month was
calculated by taking the sum of the square of each stocks monthly return
minus the expected return, which was the Market Index return. The monthly
calculations are detailed in the appendix. The square root of the final values
are taken to calculate the standard deviation:

Month

Market
index
(points)

Lorton
Ltd

Truganina Wonders
Ltd
Ltd

Woods
Ltd

($)

($)

($)

($)

Variance
over the
period

0.0662

0.6472

0.5402

0.6685

0.7983

STANDARD
DEVIATION

0.2573

0.8045

0.7350

0.8176

0.8935

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.)
The monthly holding-period returns for the share portfolio is as follows:
Month
Jun-11
July
August
September
October
November
December
Jan-12
February
March
April
May
June
July
August
September
October
November
December
Jan-13
February
March
April
May
Jun-13

Portfolio
Return
-0.0037
-0.0015
-0.1125
0.1194
0.0841
0.0050
0.1757
0.1403
-0.0285
0.0387
0.1306
-0.0956
0.0545
-0.1380
0.0892
-0.0302
0.0284
0.0240
0.0501
0.0360
0.0799
0.2984
-0.1979
0.0157

The average monthly holding period return for the portfolio is calculated by the
sum of the weighted monthly averages of each individual stock:
= (0.25* 3.523465957) + (0.25* 4.346874698) + (0.25* 1.768186842) + (0.25*

3.062233895)

= 3.18% per month

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?
The standard deviation of the asset portfolio is calculated by the sum of the
weighted standard deviations of each individual stock in the portfolio as
follows:
SDPORTFOLIO =
(0.25*SDLORTON LTD) + (0.25*SDTRUGANINA LTD) + (0.25*SDWONDERS LTD) +
(0.25*SDWOODS LTD)
Using the calculated values shown in the appendix, the standard deviation
(SD) of the portfolio is calculated as follows:
= (0.25*0.8045)+(0.25*0.7350)+(0.25*0.8176)+(0.25*0.8935)

= 0.81

Theoretically, when you combine shares into a portfolio, the overall risk
should decrease. The aim of diversification is to reduce unsystematic risk
(that is, the risk that is unique to an individual asset) so that primarily
systematic risk remains.1 Systemic risk can be defined as the variability of
risky assets caused by macroeconomic factors. 2 It cannot be diversified
away.3
Adding additional shares to a portfolio smoothes out unsystematic risk so that
the positive performance of some shares neutralises the negative
performance of others.4 However, the benefits of diversification hold only if
the shares in a given portfolio are not perfectly correlated.5

FK Reilly and KC Brown, Investment Analysis and Portfolio Management (10th ed, 2012) 212.
Ibid.
3
Ibid 213.
4
<http://www.investopedia.com/terms/d/diversification.asp> at 8 October 2013.
5
Ibid.
2

5. Use the numbers in Exhibit 1 to determine the systematic risk (Beta) of

Lorton Ltd, Truganina Ltd, Wonders Ltd and Woods Ltd.
Beta is calculated using the following formula:

Beta Lorton
Ltd

Beta
Truganina
Ltd

Beta
Wonders Ltd

1.635756137

1.339326575

0.701618957

Beta Woods
Ltd
1.654598819

6. Which measure, standard deviation or beta is used for analyzing stocks

that are placed in a diversified portfolio?
Standard deviation is a statistical measurement which is used to calculate an
investment's volatility in terms of its returns.6 It is based on historical data and
can be used to gauge the expected volatility of an investment in the future.7
Stable blue-chip stocks will generally have a lower standard deviation than
riskier stocks.8
The beta co-efficient is used to calculate the level of a stock's systematic risk,
or volatility, compared to a market portfolio.9 A stock with a beta of 1 is
expected to move equal to the market, while a beta of less than 1 indicates
that a stock will be less volatile than the market.10 If a stock's beta is 1.3, it is
theoretically 30% more volatile than the market.11
In terms of analysis of stocks in a diversified portfolio, beta is more effective
than standard deviation as it eliminates unsystematic risk and measures a
security's correlation with the market as a whole.

<http://www.investopedia.com/terms/s/standarddeviation.asp> at 8 October 2013.

Ibid.
8
Ibid.
9 FK Reilly and KC Brown, Investment Analysis and Portfolio Management (10th ed, 2012) 216.
10
<http://www.investopedia.com/terms/b/beta.asp> at 8 October 2013.
11
Ibid.
7

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.
RFR+B(MR-RFR)
Lorton Ltd
= 0.059125+1.6358(0.1497-0.059125)
= 0.2073
Truganina Ltd
= 0.059125+1.3393(0.1497-0.059125)
= 0.1804
Wonders Ltd
= 0.059125+0.7016(0.1497-0.059125)
= 0.1227
Woods Ltd
= 0.059125+1.6546(0.1497-0.059125)
= 0.2090

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.

ER=D1/k-g

Lorton Ltd
g= [(2.50/2.15)^1/7] -1
g= 0.0218

ER= 2.5545/(0.2073-0.0218)
= 13.7709

D1= (2.50*1.0218)
D1= 2.5545
Truganina Ltd
g= [(1.50/1.20)^1/7] -1

ER= 1.5486/(0.1804-0.0324)

g= 0.0324

ER= 10.4635

D1= (1.50*1.0324)
D1= 1.5486
Wonders Ltd
g= [(2.80/2.50)^1/7] -1

ER= 2.8456/(0.1227-0.0163)

g= 0.0163

ER= 26.7444

D1= (2.80*1.0163)
D1= 2.8456

Woods Ltd
g= [(2.85/2.20)^1/7] -1

ER= 2.9574/(0.2090-0.0377)

g= 0.0377

ER= 17.2644

D1= (2.85*1.0377)
D1= 2.9574

Part Two
Question 1
The term margin, when used in the context of the futures market, has a
meaning that is distinct from the way the same term is used in reference to
the stock market.12
Futures contracts are an obligation to either buy or sell an underlying asset at
a specified date in the future.13 Traders of futures contracts do not receive or
pay the full value of the contract at the time of the trade.14
As the full payment is not made until the delivery date, futures exchanges
require both the buyer and the seller to post collateral, or margin, to protect
against the possibility of default.15 This initial good faith deposit, also called
a performance bond, can be in the form of cash, bank guarantees, shares or
government securities, and is held in the exchanges clearing house until the
delivery date.16
The margin funds are marked to market (that is, adjusted for contract price
movements) at the end of each trading day to ensure that both end users
maintain sufficient collateral to guarantee the successful completion of the
contract.17
The minimum-level margin is set by the futures exchange and is generally 5%
to 10% of the futures contract.18 Margin amounts are continuously reviewed
and can be raised at times of high market volatility.19
Upon completion of the futures contract, the performance bond is refunded,
plus or minus any gains or losses which occurred over the span of the
contract.20
In contrast to the futures market, when the term margin is used in the
context of the stock market, it refers to where borrowed money is used to
purchase securities.21
When investors purchase stock they can pay with cash, or they can potentially
borrow a portion of the cost, thereby leveraging the transaction.22 Leverage
is achieved by buying on margin, meaning that the investor pays for the stock

12

<http://www.investopedia.com/university/futures/futures4.asp> at 3 October 2013.

<http://www.asx.com.au/products/futures-margins.htm> at 3 October 2013.
14
Ibid.
15
FK Reilly and KC Brown, Investment Analysis and Portfolio Management (10th ed, 2012) 78.
16
Ibid 744.
17
Ibid 744, 785.
18
Investopedia, above n 1.
19
Ibid.
20
Ibid.
21
Ibid.
22
Reilly and Brown, above n 4, 113.
13

with some cash and borrows the rest (through a broker or bank) using the
stock as collateral.23
After the initial purchase, changes in the market price of the stock will result in
changes to the investors equity, which is calculated by subtracting the
amount borrowed from the market value of the collateral stock.24 If the stock
price increases, the investors equity as a proportion of the total market value
of the shares also increases.25 Conversely, if there is a drop in stock prices,
equity reduces.
To protect against the possibility of negative equity, margin lenders will only
lend a certain proportion of the overall investment amount. 26 This initial
margin requirement (or loan to value ratio LVR) can vary according to the
lender.27 If example, if a margin loan's maximum LVR is 80%, borrowing to
invest in $20,000 worth of shares, will require a 20%, or $4,000 deposit.
In addition to the initial margin requirement, there is also a maintenance
margin which is an investors minimum required equity in proportion to the
total value of their stock portfolio.28 The maintenance margin protects the
lender in the event that share prices fall and the investors portfolio value falls
below a certain point.29 If this happens, the account is considered to be
under-margined and the investor will receive a margin call, that is, a request
to provide more equity.30
The purchase of shares via leveraging is risky because margin loans not only
magnify investment gains, but they also magnify losses if the stock market
falls.31
Question 2
Hedging, in broad terms, is a technique used to try to offset the volatility of an
investment position with another. For the purpose of investments, the
objective of creating a hedge is to create a position that can offset the price of
another more fundamental holding.32 As such, Herb will be concerned about
price risk affecting the value of the portfolio in his control. If the market falls,
so too will the value of his investments, affecting shareholder wealth. To try to
reduce the potential losses in a falling market, Herb will take a position in the
futures market that will allow him to profit from the falling market. Herb will
sustain a loss in the fundamental holding, the stock portfolio, however by
selling futures contracts of the same magnitude as the holding, he will realize
a profit in the futures market. It is hoped that the profit earned in the futures
23

Ibid.
Ibid.
25
Ibid.
26
<http://www.ratecity.com.au/margin-loans/articles/margin-loans-australia> at 3 October 2013.
27
Ibid.
28
Reilly and Brown, above n 4, 115.
29
Ibid.
30
Ibid.
31
<http://www.leveraged.com.au/products/margin_loan.asp> at 3 October 2013.
32 Reilly and Brown, above n 4, 767
24

10

trade will offset the loss in the stock market; if it does cover the loss, it is
known as a perfect hedge.
In attempting to neutralize exposure to price risk, Herb must also take on the
risk that the market may move in the opposite direction. Given the current
conditions and Herbs concern that the market may fall, he is expected to
create a short hedge, done so by taking a short futures position (selling)
against a long position (buy) in the stock market (in this case, to hold the
stocks and not sell them). The following table summarizes the possible
outcomes33:
Economic event
Stock value FALL
Stock value RISE

Actual stock exposure

Loss
Gain

Desired hedge exposure

Gain
Loss

In the case that the market rises, Herb will enjoy a gain in the value of
stock holdings. This gain will, however, be offset somewhat by a loss in
futures market, as the value of the futures contracts will be less than
market value of the portfolio is represents (i.e. Herb will receive less for
futures contract than the stocks are worth in the market).

his
the
the
the

Such a hedging strategy does potentially reduce the upside, or the overall
potential return of a portfolio. This is a necessary evil in attempting to limit
the costly effects of losses incurred in a falling market. While the hedging
strategy does act as a parachute of sorts as the market is on the way down,
it also does burden the portfolio on the way up. This would be of particular
concern for those who involve in hedging as speculators, however, as an
investor, it may be necessary to incur the loss of a particular hedging strategy,
which would be offset by the rise in stock prices (and thus negate the upside
of rising prices), if there is particular concern that real and absolute losses
may be incurred in a falling market.

33 ibid

11