Beruflich Dokumente
Kultur Dokumente
ECONOMICS
| Ana Preto #2244 | Martim Moreira #2293 | Jos Loureno #2249 | Omar al Fannoush #1949 |
years, as well as the returns of the S&P500, however much lower. In general terms, Exxon Mobil Corp. returns
have been much higher relatively to the market and to the risk-free security. Moreover, there was a continuous
growth from 2003 to 2008, instability from 2008 to 2010, due to the financial and economic crisis and a sharp
growth from 2010 to 2011 demonstrating a very effective recover from the economic crises. In 2014, Exxon Mobil
returns have reached the highest compounded return, meaning that for each dollar invested in August 1980,
investors would have earned $79, 75 in January 2015. The risk-free security has proved to be way beyond Exxon
Mobil Corp. and markets performance over the years.
As already mentioned, historical performance of a security may be used to predict future returns and the cost of
capital of an investment. However, this approach has some disadvantages: firstly, the future behavior of a security
may not be the same it was in the past, secondly the older historical data on returns is not very useful when
predicting future returns. This happens because the constant changes in the financial markets reality, thirdly
investors future expectations may not correspond to past estimations. Additionally expected returns obtained from
historical data are subject errors and volatility distorts results even when expectations and market circumstances
are similar. As a conclusion, despite being helpful, the average return that the investors earned in the past is not a
very reliable estimate of a securitys current and future expected returns. Instead, an alternative strategy based on
the Capital Asset Pricing Model (CAPM) should be used. In the following questions, techniques to estimate a more
reliable value of Exxon Mobil expected return will be properly studied.
Q2: Exxon Mobil (Systematic) Risk Analysis
In the sequence of what was previously referenced, in this section of the report its supposed to elaborate methods
that allow the calculation of the Exxon expected returns. Therefore, analyzing and quantifying the risk of the stock
is a fundamental procedure to keep in mind. All over the world, investors face uncertainty related to stock
performance, since companies returns are subjected to risk. Thus, to obtain Exxon risk profile is crucial to calculate
the firm volatility and its beta. The first objective is to elaborate the company beta defined by the standard
deviation of the returns. The second goal is to elaborate the volatility in order to have all requirements to calculate
the systematic and unsystematic risk. Seeing the fact that the stocks annual volatilities are calculated by using the
excel formula (=STDEV(Monthly Return) x SQRT(12)), it is now required to calculate the Beta. According to
the model, the Security Market Line (SML) equation, which relates the market risk premium, the stocks beta and
the risk-free rate with the companys expected return, must be verified for all stocks, assuming the following
formula: E(re)-rf=+e(E[rm]-rf). In that sense, by using historical data, it is possible to run a regression of the
excel add-in Data Analysis between the values for the excess return of the stock in relation to the risk-free rate (Y
Variable) and the values for the excess return of the market in relation to the risk-free rate (X Variable). All the
necessary data to compute risks was collected in the previous section of the report, except for the industry total
returns necessary to compare Exxon risk with its industry risk. Thus, the data set for total gross returns was
obtained in monthly percentage returns were calculated as before. Nonetheless, only 5 years of data were used, in
order to capture the more recent market circumstances.
After performing all the calculations and running the regressions (see Appendix 2 Table 1, Figure 1, Table 2,
Figure 2 for regression results and risk analysis), some final conclusions can be drawn on Exxon risk. An annual
volatility of 16.36% was obtained for Exxon stock, comparing with a markets annual volatility of 12.99%.
Therefore, it is possible to assume that the companys stock is riskier than the market proxy considered (S&P500
Index). Moreover, the stock has a beta of approximately 0.0427 (C.I. [-0.28; 0.39]) while its industry has a beta of
nearly -0.17 (C.I. [-0.57; 0.22]), which means that Exxon systematic risk is higher than that of the industry and that
their returns (both Exxon and the industry) vary less than those of the market (that, in this case, has a beta equal to
1). The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an
investment with lower volatility than the market, or a volatile investment whose price movements are not highly
2
correlated with the market. Negative betas are possible for investments that tend to go down when the market goes
up, and vice versa. In finance, systematic risk is measured by ^2_e^2_M, while unsystematic risk is
calculated by ^2_e-^2_e^2_M. After the calculations, it is possible to decompose Exxon risk in
systematic risk (0,003%) and unsystematic risk (2,675%).
Finally, one may argue on the performance of the company relative to the use of CAPM, using the estimated alpha
() of the regression as indicator. Since the estimated value of alpha for Exxon stock is positive 0.006, the asset
outperforms the expected return implied by the CAPM and is, therefore, undervalued. This is a conclusion that can
also be easily verified by representing the SML that illustrates the relation between expected returns and systematic
risk. Since investors only take additional risks if expected returns increase and a beta of 1 corresponds to the
expected return of the market proxy (risk-free asset), therefore it is possible to plot the upward-sloping line of the
SML, using historical data (see Appendix 3-Table 2, Table 3 for the Security Market Line graph). In fact, the
stock is positioned above the SML, confirming the fact that it is undervalued - for its level of systematic risk, the
return is expected to be very high, so investors will buy the stock and the price will gradually increase at the same
time that return decreases until equilibrium is reached.
Q3: Exxon Mobil Expected Return
In order to estimate, in the most reliable and accurate way, Exxon expected return (also called cost of equity), one
should apply CAPM widely known and used techniques. As already mentioned, according to this theory, all stocks
must lie on the SML. For that reason, by relying on a forward-looking (not historical) approach, its intended to
adjust SML parameters to solve for a Forward-Looking SML: the one Month US Treasury Bill was replaced by a
1,97% 10 years US Treasury Bill (for a medium term approach), the betas were those determined in the previous
section of this report (Exxon beta - e 0,043 - and Exxon industry beta - I -0,173 - to account for a
comparable approach, since considering the entire industry is more accurate than considering only a few
competitors) and the forward-looking expected return of the market (E[rM]) still had to be calculated.
In order to determine a forward-looking expected market return (S&P500 Index as the market proxy), its supposed
to collect the market value index and total yields between 2001 until 2014 (dividends in 2014 equal the product
between the market value index and the total yield of that year). Moreover, dividends were assumed to grow at
7.70% in the next five years and from 2013 to 2014 (assuming dividends will grow in a similar way, since there is
no data on this value), to after continue to grow at 8.14% forever (an estimate based on the average earnings
growth made available by the professor) and to be discounted by the expected market return. Thus, the forwardlooking expected market return was determined using the excel add-in Solver, so that the present value of future
cash flows (dividends), that is, the present value of the 5 years growing annuity and growing perpetuity, in 2014,
would equal the market value index in that same year, that is, $2058.9 (see Appendix 3-Table 1 for data on the
estimation of the forward-looking expected market return). This resulted in an expected market return of 13.12%.
Exxon cost of equity was, then, calculated by simply solving the SML equation with the previous values (see
Appendix 3-Table 2, Table 3 for the estimation of Exxon expected return). A forward-looking expected return of
2.45% was obtained using Exxon beta, a higher value than the 0.04% obtained using Exxon industry beta, since the
beta is also lower. These costs of equity are lower comparing with the return determined using historical data
(12.99% annual geometric average return). Therefore, it is possible to confirm what was previously stated on the
dangers of using historical data to estimate stocks expected returns. In fact, there is a difference of 10.54% and
12.94% in the cost of equity from using the historical data and not a forward-looking approach. This misleading
information may cause managers to not invest in a project that actually creates value (in this case, future cash flows
would be heavily discounted if an historical approach is followed) or deceive investors that buy companies stocks.
Nevertheless, it is worth to mention that betas were also obtained with historical, despite more recent, data and also
have an impact on the estimates of Exxon cost of equity.
Finally, despite being advisable the use of forward-looking approaches, it can be easily conclude that estimating
expected returns with different methods is important to allow financial and management agents to simulate
different scenarios, with more optimistic and pessimistic estimations, when evaluating investment opportunities.
Q4: Mean-variance Portfolio Choice
For what was previously stated, in this section of the report it is intended to conclude Exxon risk and return
analysis by combining other stocks with Exxon, determining the most efficient portfolios, in an attempt to
approach this study to what actually happens in the financial markets. In addition to the data previously collected
on Exxon and on one Month US Treasury Bills monthly returns, data on Apple Inc. (AAPL)s and on Nike inc.
(NKE)s monthly returns was gathered (using the same total return index available in Bloomberg), so that a
minimum matching sample period of over 10 years was ensured. Excluding the risk-free asset that has a 0 covariance with all companies, annualized co-variances between companies were obtained. Exxon is a considerably
stable company, ranked in S&P 500 as AAA level company. Given the company rating, it is expected that the
company has low risk exposure. In order to assess this information the companies monthly rates of return were
used to compute the annual arithmetic average returns and volatilities (standard deviations). The results were 67%
for volatility and 15.1% for stocks' arithmetic average return. In order for a portfolio be profitable is important to
combine as much stocks from different industries as possible in one portfolio so that risk is eliminated. Even
though diversification benefits always exist, the amount of eliminated risk depends on the degree to which stocks
are exposed to common risks and their returns move together (measured by co-variances and correlation).
Therefore we chose companies from different industries and with different behaviors (regarding the volatility and
arithmetic average return), to have a diversified portfolio.
The companies selected to include the portfolio were Nike (22.63% for arithmetic average return and 35.29% for
volatility) and Apple. (28.49% for arithmetic average return and 46.47% for volatility). Companies monthly rates
of return and annual arithmetic average returns and volatilities (standard deviations) were computed according to
the procedures described in the second section of this report, except the risk-free assets volatility that was set
equal to 0% (see Appendix - Table 1 for stocks annual arithmetic average returns, volatilities and co-variances).
In this report, three different sets of stocks are analyzed: Portfolios I (Exxon & Nike), Portfolios II (Exxon &
Apple) and Portfolios III (Exxon, Apple and Nike), (see Appendix - Table 2; 3; 4). Since the correlation and the
co-variances between stocks returns are positive, one expects diversification benefits to exist.
Mean-variance frontiers are quite helpful in decisions regarding portfolios given that it establishes a relation
between the returns and risk. Through the use of this tool is possible to adjust the weight of each stock in the
investment, in order to achieve the most desirable ratio risk-revenue. The most desirable condition to an investor is
to have the highest revenue at the smallest risk. If a portfolio combines different stocks, its possible to associate
them in order to achieve this scenario. Therefore the most diversified (more stock thus more relation options)
best scenarios are achievable. In our work, we could conclude that the portfolio with more stocks (Portfolio III),
actually present the most benefits of the diversification. Portfolio III (see Appendix 4 Figure 1) is the one
located to the left, meaning that is possible to obtain higher expected returns for any level of risk, comparing
with the other two frontiers. It is also presented the frontiers when the investor cannot take a short position, and we
can verify that if the investor cant borrow from one side to invest on the other (expanding his horizons), the
mean variance frontier gets flatter (see Appendix 4- Table 2). If we were to compare our portfolio option to an
equally weighted portfolio, as a matter of fact, the mean variance frontier of portfolio III already has a point with
similar characteristics (weights of 33,35%; 34,28%; 32,37%, consult Appendix 4- Table 4). Since this line has the
best options to invest, this may mean that an equally weighted portfolio is close to the portfolio best options
(depending on the risk sensibility of the investor). Additionally this could mean that the companies do not differ
4
that much between them (the same portion is a good option) or compensate each other weaknesses. Summing
up, since we have already a point in the mean variance frontier similar to the equally weighted option, we can
assume that it may be a good option for the less risk adverse investors.
Short-selling (transaction in which you sell a stock today that you do not own, with the obligation to buy it back in
the future) involves a short position (negative investment) in a stock and on the other hand a long position in
another stock (positive investment). This opens the opportunity given that is possible to sell a less profitable
stock to purchase a more rentable one. This process is profitable as long as the investment is applied in a stock with
higher expected return. Hence, stocks with lower expected return are the ones in which investors hold a short
position, to invest in other of higher return (in this case, Exxon stock is the first to be short-sold). Portfolios
with
more than two stocks and with no short-selling will result in exactly the same expected returns and volatilities as if
short-selling was allowed for expected returns between the lower and the higher expected returns of the individual
stocks (you can reduce the investment in the one with lowest return and look for other options). This happens
because within this range short-selling is not necessary.1
All the portfolios with an expected return lower than the one of the minimum variance portfolio are
inefficient. Reversely, all the portfolios that have an expected return equal or higher than the one of the
minimum variance portfolio are efficient, given that for their level of risk it is not possible to earn higher returns
(See Appendix 4 - Figure 3). Every investment has its risks, and usually with higher risks comes a higher return.
The choice of a portfolio depends on investors risk susceptibility. So, investors that are completely risk-averse
choose the minimum variance portfolio of the mean-variance frontier and risk-loving investors opt for an efficient
portfolio in which their risk preferences are satisfied (ultimately, risk-loving investors may even short-sale).2
Considering a risk free asset is absolutely important to consider the Capital Market Line. By combining a riskfree asset with a portfolio on the efficient frontier, it is possible to achieve portfolios even more lucrative than the
ones in the efficient frontier.3 To achieve the best solution, the risk free asset should be tangent to the portfolio (See
Appendix 4 - Figure 3) and thus the Sharpe Ratio should as steepest as possible. From what have been mentioned
and the (See Appendix 4 - Figure 3), one can conclude that investors are in a best position if they invest-free
security with risky investments, since portfolios with the maximum expected returns, given any level of risk. The
efficient frontier turns to be the steepest line that links the risk-free and the risky investments (and no longer the
portfolios above the minimum variance portfolio) and all the previous mean-variance frontiers become
inefficient. Given the special scenario that a risk free asset provides, with the Capital Market Line, one can
assume that is always the best option given that it provides highest return per unit of volatility of any portfolio
available.
https://books.google.pt/books?id=pwXWZzxXxfwC&pg=PA207&lpg=PA207&dq=which+portfolios+are+efficient+for+short+selling&sour
ce=bl&ots=a7O_rdWf21&sig=9C8gqof1c0x0lwv0YfqHl3HvAU&hl=en&sa=X&ei=ykUMVcWVLIO1Ue3rgJgB&ved=0CCwQ6AEwAA#v=onepage&q=which%20portfolios%20are%2
0efficient%20for%20short%20selling&f=false
2
http://www.investinganswers.com/
3
http://riskencyclopedia.com/articles/capital_market_line/
Appendix:
Appendix 1 Question 1
Table 1: Exxon Mobil Corp. arithmetic and geometric average return and volatility
VOLATILITY
MONTHLY
1,18%
1,07%
5,00%
ANNUAL
14,21%
12,79%
17,32%
Table 2: S&P500 Index arithmetic and geometric average return and volatility
MONTHLY
ANNUAL
S&P500 INDEX
ARITHMETIC AVERAGE
GEOMETRIC AVERAGE
RETURN
RETURN
1,00%
0,90%
11,98%
10,83%
VOLATILITY
4,36%
15,10%
Table 3: 1 Month Treasury-bill arithmetic and geometric average return and volatility
MONTHLY
ANNUAL
1 MONTH TREASURY-BILLS
ARITHMETIC AVERAGE
GEOMETRIC AVERAGE
RETURN
RETURN
0,37%
0,37%
4,48%
4,48%
VOLATILITY
0,29%
0,99%
08-08-1980
12-12-1981
04-04-1983
08-08-1984
12-12-1985
04-04-1987
08-08-1988
12-12-1989
04-04-1991
08-08-1992
12-12-1993
04-04-1995
08-08-1996
12-12-1997
04-04-1999
08-08-2000
12-12-2001
04-04-2003
08-08-2004
12-12-2005
04-04-2007
08-08-2008
12-12-2009
04-04-2011
08-08-2012
12-12-2013
Cumulative Return
Cumulative Return
10000,00%
9000,00%
8000,00%
7000,00%
6000,00%
5000,00%
4000,00%
3000,00%
2000,00%
1000,00%
0,00%
Exxon
T-Bill
S&P500
Data
Appendix 2 Question 2
Table 1: Exxons Risk Analysis
0,00115367
0,015775929
0,047608937
61
4,725%
16,366%
3,752%
12,999%
0,003%
2,679%
2,675%
ANOVA
Regresso
Residual
Total
gl
1
59
60
SQ
MQ
0,000154459 0,0001
0,133730041 0,0022
0,133884499
F
0,068145157
F de
significncia
0,794965
Coeficientes
0,006170218
Erro-padro Stat t
0,0063791 0,9672
valor P
0,337364788
95% inferior
-0,006594
0,794965879
-0,284970
95%
superior
0,01893
0,37047
9
ExxonMobil Regression
15,00%
10,00%
y = 0,0428x + 0,0062
R = 0,0012
E(re)-rf
5,00%
-10,00%
-5,00%
0,00%
0,00%
5,00%
-5,00%
-10,00%
-15,00%
(E(rM)-rf)
10,00%
15,00%
Industry Regression
SUMRIO DOS RESULTADOS -INDUSTRY
Estatstica de
regresso
R mltiplo
0,11173112
Quadrado de R
Quadrado de R
ajust.
Erro-padro
Observaes
0,01248384
Montly Volatility
Industry
Yearly Volatility
Industry
0,05802884
0,20101782
-0,0042537
0,05815213
61
ANOVA
gl
Regresso
Residual
Total
1
59
60
SQ
MQ
0,0025222 0,00252
0,1995185 0,00338
0,2020408
Coeficiente
s
0,0104666
-0,1727701
Erropadro
Stat t
0,0077917 1,34329
0,2000509 -0,8636
10
F
0,74585796
F de
significnci
a
0,39128819
valor P
95% inferior
0,18432228 -0,0051246
0,391288199 -0,5730712
95%
superior
0,026057
0,227530
Industry Regression
25,00%
20,00%
y = -0,1728x + 0,0105
R = 0,0125
15,00%
10,00%
E(rI)-rf
5,00%
-10,00%
-5,00%
0,00%
0,00%
-5,00%
5,00%
10,00%
15,00%
-10,00%
-15,00%
-20,00%
(E(rM)-rf)
SML
16,000%
y = 0,011x + 3E-05
14,000%
12,000%
SML
10,000%
E(r)
8,000%
Expected Value of Stock
6,000%
4,000%
2,000%
-0,4
0,000%
-0,2
-2,000% 0
-4,000%
0,4
0,6
11
0,8
1,2
Appendix 3 Question 3
Table 1: Estimating Forward Looking Expected Return
7,70%
8,14%
1,97%
108,23
169,59
2.058,90
Historical Beta's
Exxon's Beta (e)
E(re)-rf=+e(E(rM)-rf)
0,042754415
2,45%
-0,172770156
E(re)-rf=+e(E(rM)-rf)
12
0,04%
Appendix 4 Question 4
Figure 1: Mean-Variance Frontiers (With Short-Selling)
40,00%
35,00%
30,00%
25,00%
20,00%
15,00%
10,00%
5,00%
0,00%
0,00%
10,00%
20,00%
30,00%
Portofolio I
40,00%
50,00%
Portofolio II
13
60,00%
70,00%
Portofolio III
35,00%
30,00%
25,00%
Efficient Portfolios
20,00%
15,00%
10,00%
5,00%
0,00%
0,00%
10,00%
20,00%
Inefficient Portfolios
30,00%
40,00%
Portofolio III
50,00%
60,00%
35,00%
30,00%
25,00%
20,00%
Tangency point
15,00%
10,00%
3.94
5,00%
0,00%
0,00%
10,00%
20,00%
30,00%
Portofolio III
40,00%
50,00%
14
60,00%
70,00%
Exxon
Nike
Apple
Risk free asset
Stocks' Arithmetic
Average Return
15,055%
22,629%
28,489%
3,943%
Covariance
Stocks Volatility
16,676%
35,291%
46,470%
0,000%
15
EXXON
2,774%
1,005%
1,565%
0,000%
Nike
1,005%
12,422%
2,889%
0,000%
Apple
1,57%
2,89%
21,54%
0,00%
Investment on
Nike's Stock
Portfolio Expected
Return
Portfolio
Volatility
120,00%
115,00%
110,00%
105,00%
100,00%
95,00%
90,00%
85,00%
80,00%
75,00%
70,00%
65,00%
60,00%
55,00%
50,00%
45,00%
40,00%
35,00%
30,00%
25,00%
20,00%
18,81%
15,00%
13,41%
10,00%
5,00%
0,00%
-5,00%
-10,00%
-15,00%
-20,00%
24,14%
23,76%
23,39%
23,01%
22,63%
22,25%
21,87%
21,49%
21,11%
20,74%
20,36%
19,98%
19,60%
19,22%
18,84%
18,46%
18,08%
17,71%
17,33%
16,95%
16,57%
16,48%
16,19%
16,07%
15,81%
15,43%
15,06%
14,68%
14,30%
13,92%
13,54%
41,91%
40,23%
38,57%
36,92%
35,29%
33,68%
32,09%
30,52%
28,99%
27,49%
26,03%
24,62%
23,26%
21,97%
20,76%
19,65%
18,64%
17,77%
17,05%
16,49%
16,12%
16,06%
15,96%
15,94%
15,99%
16,24%
16,68%
17,30%
18,08%
19,00%
20,05%
16
Investment on
Exxon's Stock
-20,00%
-15,00%
-10,00%
-5,00%
0,00%
5,00%
10,00%
15,00%
20,00%
25,00%
30,00%
35,00%
40,00%
45,00%
50,00%
55,00%
60,00%
65,00%
70,00%
75,00%
80,00%
81,19%
85,00%
90,00%
94,28%
95,00%
100,00%
105,00%
110,00%
115,00%
120,00%
31,18%
30,50%
29,83%
29,16%
28,49%
27,82%
27,15%
26,47%
25,80%
25,13%
24,46%
23,79%
23,12%
22,44%
21,77%
21,10%
20,43%
19,76%
19,09%
18,41%
17,74%
17,58%
17,07%
16,40%
15,82%
15,73%
15,06%
14,38%
13,71%
13,04%
12,37%
17
Portfolio
Volatility
55,19%
52,99%
50,81%
48,63%
46,47%
44,32%
42,19%
40,08%
37,99%
35,93%
33,90%
31,90%
29,95%
28,05%
26,22%
24,47%
22,82%
21,29%
19,91%
18,71%
17,73%
17,54%
17,01%
16,58%
16,47%
16,47%
16,68%
17,19%
17,99%
19,04%
20,29%
Investment
on Exxon's
Stock
235,20%
216,85%
198,50%
180,15%
161,80%
143,45%
125,10%
115,93%
106,75%
102,16%
97,58%
92,99%
88,40%
83,76%
79,23%
74,64%
70,05%
65,46%
60,88%
56,29%
51,70%
47,11%
42,53%
37,94%
33,35%
28,76%
24,18%
19,59%
15,00%
10,41%
5,83%
1,24%
-3,35%
-7,93%
-12,52%
-21,70%
Investment on
Nike's Stock
-53,01%
-45,08%
-37,14%
-29,21%
-21,27%
-13,34%
-5,40%
-1,43%
2,54%
4,52%
6,50%
8,49%
10,47%
12,48%
14,44%
16,42%
18,41%
20,39%
22,37%
24,36%
26,34%
28,32%
30,31%
32,29%
34,28%
36,26%
38,24%
40,23%
42,21%
44,20%
46,18%
48,16%
50,15%
52,12%
54,11%
58,08%
Portfolio Volatility
52,37%
46,65%
41,02%
35,53%
30,24%
25,29%
20,93%
19,09%
17,59%
16,99%
16,50%
16,15%
15,93%
15,85%
15,91%
16,12%
16,46%
16,93%
17,52%
18,22%
19,01%
19,88%
20,83%
21,84%
22,90%
24,01%
25,17%
26,36%
27,58%
28,83%
30,10%
31,40%
32,71%
34,04%
35,38%
38,11%
Return
Constrain
0,00%
2,00%
4,00%
6,00%
8,00%
10,00%
12,00%
13,00%
14,00%
14,50%
15,00%
15,50%
16,00%
17,00%
17,50%
18,00%
18,50%
19,00%
19,50%
20,00%
20,50%
21,00%
21,50%
22,00%
22,50%
23,00%
23,50%
24,00%
24,50%
25,00%
25,50%
26,00%
26,50%
27,00%
28,00%
66,02%
73,95%
81,89%
89,82%
33,33%
74,03%
84,45%
94,86%
105,28%
33,33%
100,00%
100,00%
100,00%
100,00%
100,00%
19
30,00%
32,00%
34,00%
36,00%
22,06%
43,67%
49,35%
55,11%
60,92%
23,03%
30,00%
32,00%
34,00%
36,00%
22,00%