Assessment 3 - Statistical Group Report

1. Using the information in Exhibit 1, calculate the historical returns for each company
and the market index. With the use of the excel functions calculate the average
monthly return and standard deviation of returns for each company and the market
index (no need for comments in this question)

Market Index Excalibur Ltd ($) Wizard Ltd

($)
AVG. RETURN 0.82% 1.79% 0.81%
HISTORICAL
RETURNS 21% 50% 18%
VOLATILTIY 2.14% 4.59% 5.41%
(STDEV)

2. Using your answers to Question 1, above, and assuming that investors can only
invest in one of the two alternative shares in Exhibit 1, use the average return and
standard deviation to determine which share would be the most appropriate for a
risk-averse investor. Provide numerical justification for your selection based on the
coefficient of variation.

Based on the information in the table above the coefficient of variation (standard deviation
divided by average monthly return) for the Excalibur Ltd shares is 2.56 (4.59 ÷ 1.79) and for
the Wizard Ltd shares is 6.68 (5.41 ÷ 0.81). Given that my client is a risk-averse investor and
would prefer to “stay away from high-risk stocks or investments” (Investopedia 2019), I would
suggest that my client invests towards Excalibur Ltd as they offer the best risk/reward ratio
(Investopedia 2019). Excalibur has the lower of the two in reference to the volatility
percentage, whilst also having the larger average monthly return percentage. Out of the two
companies Excalibur Ltd offers the more favourable return of 2%, whereas Wizard Ltd cannot
satisfy my client with the percentage of 0.81 which fails to provide a substantial return
(Investopedia 2019). In consideration to my clients wishes of a lower risk investment yet still
making profit on return I believe that Excalibur Ltd is the company to invest in given the facts
provided.

3. Calculate the the correlation coefficient of returns between the two shares. Provide
an explanation of your results and the implications for diversification (be very
specific).

A Correlation Coefficient is a statistical measure that calculates the strength of the

relationship between the relative movements of two variables. A correlation can be
measured from ranges -1 to +1 Ganti 2019).
The correlation coefficient calculation that I have done in excel between Excalibur Ltd and
Wizard Ltd was 0.62, which indicates that there is a reasonably strong relationship between
the two returns.
The implications of diversifications in a share portfolio are impacted by two news which are;
(Berk et al 2018, p.340):
1. Unsystematic risks – which are company or industry specific news e.g. earnings
announcement
2. Systematic Risks – Market-wide news e.g. economic growth and inflation forecasts.

4. Determine the the expected return and standard deviation of a two-asset portfolios
comprised of Excalibur Ltd and Wizard Ltd; Assume equal weightings of each share
within the portfolio. Interpret your results and comment and illustrate the impact on
risk when combining shares into a portfolio. Also, quantify the amount of risk
reduction that has directly resulted from diversification. Ayse

a) Excalibur Ltd Wizard Ltd

Expected Returns – 43.04% Expected Returns – 19.51%
Standard Deviation – 4.59% Standard Deviation – 5.41%

b) An equal weighting in a portfolio means that investing money equally in each share,
decreases volatility (Berk et al 2018, p. 356). When combining shares in to a portfolio
1. The risk would be reduced through diversification and
2. When the amount of risk is eliminated in a portfolio, it depends upon the degree to
which the shares face common risks and move together.
c) With diversification combining shares in a portfolio reduces unsystematic risks for each
share by averaging out risk. The volatility will therefore will decline only the systematic
risks which affects all firms (Berk et al 2018, p341).

5. Determine the systematic risk (Beta) for both shares. Interpret your answers. What
is the implications of the betas you have calculated on asset pricing? The use of
excel slope statistical function should be used to calculate Beta.

Measuring the relationship between the companies returns and the market returns gives us
beta for both companies, which is Excalibur Ltd with a beta of 0.95 and Wizard Ltd of -1.97.
This data shows that both Excalibur and Wizard are less volatile than the market as the market
represents 1 and both companies are below. Beta is a measurement of the stock’s volatility
 in comparison to that of the market, in this case both companies don’t deviate more than the
market (Grant & McClure 2019).

6.
a) Assuming a risk-free rate of 3% and market risk premium of 7%, calculate the
required return for both shares.

Excalibur Ltd: 3% + 0.95(7%) = 0.0963

= 9.63%

Wizard Ltd: 3% + -1.97(7%) = -0.1079

= -10.79%

b) What concerns do you have, if any, in regard to your valuations?

Although the Required Rate of Return (RRR) is only a guiding principle and not an actual
predictor of investment success (Levinson, 2019). It is still concerning that Wizard Ltd has a
negative RRR. There are many factors that can cause an RRR to be negative including loss
of value, poor management etc (Investopedia 2019). Wizard Ltd is more of a risk to invest in
compared to Excalibur Ltd.

c) In the last ten (10) years the dividends for Excalibur Ltd have grown from $1.00
to $1.20 and for Wizard from $0.70 to $0.85. There is an expectation that this rate
of growth in dividends will continue into the foreseeable future. What value
would you place on each share (use the dividend growth model).

EXCALLIBUR LTD WIZARD LTD

Growth per year ($) $0.020 $0.015
Growth Rate 2% 2.14%
Price (Dividend Growth Model) $16.05 $-6.71
References

Berk J, DP, Harford J, FG & V., M 2018, Fundamentals of corporate finance, 3rd edn,
Pearson Australia, Melbourne.
Ganti, Akhilesh 2019, Correlation Coefficient, Investopedia, 9 May 2019,<
https://www.investopedia.com/terms/c/correlationcoefficient.asp >.

Grant, M & McClure, B, What Beta Means When Considering a Stock’s Risk,
Investopedia 2019, viewed 13 May 2019 <
https://www.investopedia.com/investing/beta-know-risk/>.

Investopedia 2019, What can the Coefficient of Variation (COV) Tell Investors?,
Investopedia, viewed 13 May 2019
<https://www.investopedia.com/ask/answers/031715/what-can-coefficient-variation-cov-
tell-investors-about-investments-volatility.asp >

Levinson, C, 2019, Differences Between an Expected Rate of Return & a Required Rate
of Return, XO Group, viewed on 15 May 2018
<https://budgeting.thenest.com/differences-between-expected-rate-return-required-rate-
return-23874.html>.