Average historical return is the average monthly return of the portfolio. The expected return of a portfolio can be calculated by multiplying the monthly return of each stock with its respective weight in the portfolio. Summing the above product, that was calculated for each stock return and its weight.
Sharpe ratio is the excess return we are getting on the financial product for every unit of the risk we are taking. TO calculate the Sharpe ratio we need to calculate excess return (portfolio return – risk-free return) and divide it with the standard deviation of the portfolio return.
Relative Sharpe ratio is portfolio Sharpe ratio dived by market Sharpe ratio. One we will calculate the portfolio Sharpe ratio, we will calculate the market Sharpe ratio ((market return – risk-free return)/standard deviation of the market return) and then get the value of relative Sharpe ratio by portfolio Sharpe ratio/market Sharpe ratio.
Jensen’ alpha = (return of portfolio-risk free return)/ (beta of portfolio multiplied to market return – risk free return).
In 2006, the demand for house loan was at its peak, banks were also ready to give loans to house owner as they assumed that the loan back by asset is safe. Soon it turns into a myth and the decent of the sky-high home prices in 2007 spread quickly to the overseas financial market following the U.S. financial sector. This phenomenon had an adverse effect on several entities like a) the biggest insurance company b) entire investment banking industry c) largest savings and loan d) enterprises chartered by the government to facilitate mortgage lending e) the largest mortgage lender f) two of the largest commercial banks. We will Study here the cause of such a big disaster and also try to figure out the loopholes in the system that lead to the life biggest crash of the stock market.
The major reason for such a crisis was the irresponsible mortgage lending. Even the people who were marked as the ‘Subprime” borrowers and had poor credit histories were given away loans, which lead to surge supply of mortgage loan, thus the interest rate fall and everyone was getting east loan against the high valuation of their house. These were the people who later on struggled to payback. In an attempt to control the situation, the financial engineers at the big banks put large numbers of them together in pools claiming that they will supposedly become the low – risk securities. Uncorrelation of the risks of each loan is the key requirement for the pooling of the loans to work. The argument that the rise and fall of the properties present in the different American cities will be independent of one another formed the base of such decisions taken by the banks. However, this proved wrong and America witnessed a nationwide downfall of the house – prices.
Fault in System
As the bank was giving more and more loan, which was many folds larger than their assets, they even started selling the loans to investor and got more money to loan creating a leverage of 20 to 30 times the capital they had. As there was no strict regulation of maintaining certain level of capital adequacy ratio or leverage ratio, the greedy banks kept increasing their leverage to generate more and more profit for their shareholders.
The figure above shows that Subprime mortgages rose to nearly 20% as compared to below 10%(until the year 2004) in the year 2005-2006.
There was a trend of selling away the loans to a bank or the two government-chartered institutions (Fannie Mae or Freddie Mac). These institutions were created to provide money lenders with more money to lend in addition to buying up the mortgages. These were further sold out to the investment banks so that they could pool the mortgages and then back the securities known as collateralized debt obligations (CDOs), which were sliced into tranches by degree of exposure to default. These tranches were then very generously rated by the agencies the triple-A credit ratings. The investors were fooled and they made a mistake of buying these tranches. These agencies such as Moody’s and Standard & Poor’s were beholden to the banks that created the CDOs.
above figure shows that U.S. households and financial businesses significantly
increased borrowing (leverage) in the years leading up to the crisis
The insurance industry also got affected due to “credit default swaps”—in effect, insurance policies take a fee and in return, they ensure the debtors that the loss will be covered in case of mortgage holder default. This turn insurance into speculation as financial institutions bought or sold credit default swaps on assets that they did not own. About $900 billion in credit was insured by these derivatives in 2001, but the total soared to an astounding $62 trillion by the beginning of 2008.
All seemed bright and sunny until the housing prices kept rising. Despite of inadequate sources of regular income, the mortgage holders were capable of borrowing against their rising home equity as it was deemed to be safe because of the constant demand of credit against which anyone is ready to lend. The agencies that ranked the securities on the basis of their safety wrongly assessed the mortgage-backed securities to be relatively safe. Finally when the House owner started defaulting and the bank was not able to get an assumed price for those houses as demand drastically fall for the house after the boom cycle of real-estate. The end of the September month witnessed the foreclosure of 3% home loans and there was a leap of 76% in just a year. Another 7% of homeowners with a mortgage were at least one month past due on their payments, up from 5.6% a year earlier. Soon started the period of Fire sale where everything was at sale at very cheap rates. By the advent of the year 2008, a mild slump turned into a free fall and thus took birth the loss of confidence in mortgage-backed security.
above figure shows how the subprime mortgages started to default i.e. Number of
U.S. residential properties increased considerably to foreclosure actions by
In 2008, the Bank of America bought the largest American mortgage lender, Countrywide Financial Corp. It was on the verge of insolvency. Another giant who was rescued by JP Morgan on a similar background was the Wall Street investment house, Bear Stearns. It too had a thick portfolio of mortgage-based securities.
The above figure shows how the banks have leveraged themselves on subprime assets thus increasing into exposure very high that even 10 to 15% slump of prices can make the bank insolvent.
Subprime defaulters caused even a greater loss to the Fannie and Freddie as
compared to the other mortgage companies. This forced the U.S. Department of
the Treasury, to take over both of them on September 7 and replace the CEOs
with a promise of $100 billion to each if necessary to balance their books.
This step was taken in order to avoid the turmoil and failure that would have
Following the suit of Bear Stearns, the share prices of the 2 more similar investment banks, Lehman Brothers and Merrill Lynch dipped. It was impossible to withstand the heat. On September 14, the succumbed to the pressures of the Treasury and was sold to the Bank of America at a half of its market value within the past year, $50billion. Lehman was declared bankrupted as it wasn’t able to manage to get a Bear Stearns-style subsidy a day after Merrill’s sale.
The American International Group (AIG), the country’s biggest insurer was the next in line in the hit list. It too faced a huge loss on credit default swaps. Since there was no normal channel left out to secure credit, a loan of $85 billion was granted on September 16 and an additional amount of $38billion more was provided by the treasury as it proved insufficient. In return, 79.9% of the equity interest in AIG was granted to the government.
Towards the end, the two companies that stood there were Goldman Sachs and Morgan Stanley. Its investors worried that they would be the next targets and so they began moving their billions to safer places. They chose to transform into an ordinary bank holding companies rather than going bankrupt. This was a respectable thing to do to come under the regulatory umbrella of the Fed. As a result, they got access to the Fed’s various kinds of credit for the institutions that it regulates.
Towards the closure of the frenetic September month, on 25th the country’s largest savings and loan company Washington Mutual (WaMu) which was based out of Seattle was sold to JP Morgan Chase by the federal regulators for $1.9billion. there was an agreement that the JPMorgan would absorb at least $31 billion also in WaMu’s losses. Finally, in October, the Fed gave regulatory approval to the purchase of Wachovia Corp., a giant North Carolina-based bank that was crippled by the subprime-mortgage fiasco, by California-based Wells Fargo. In November the Treasury shored up Citigroup by guaranteeing $250 billion of its risky assets and pumping $20 billion directly into the bank.
This collapse was the result of reckless and faulty risk management systems of the investment banks and also the lack of any strict regulation by the Fed to keep such high leverage in the financial sector in check. After 2008 Basel III came into effect to insure that banks should maintain a minimum capital adequacy ratio of 8% to cushion the sudden shock in the market. The leverage ratio was also determined to be maintained and strict regulation of banks by central banks was brought to effect.
1. Download BOTH the Assignment Question file and Data
file to complete your assignment.
2. Use Microsoft Word for the main assignment
3. Use Microsoft Excel wherever possible for numerical calculations and
4. Copy and paste Excel
outputs (e.g. plots, tables) into your Microsoft Word document (to protect the
formatting of Excel output, use the “paste as picture” option in Word.
5. Submit the completed
assignment (as a Word document) electronically via “Written Assignment Submission Point: Word Document ONLY” in the Assessment
Task 2 folder.
6. Submit the Excel file
used for calculations/estimations electronically via “Excel Workbook Submission Point” under Assessment Task 2 folder.
7. Keep a hard copy of the
submitted assignment, in case there are problems with the electronic submission.
Any answer in the Excel document, but not in the
main Word document will NOT
As this is an individual assessment, students
should submit their own assignment.
All assignments submitted will go through a matching process. If found to have
cheated/plagiarised, all submissions will receive a mark of zero for this
assessment item. It is up to you to keep your assessment
This Assignment consists of 4 parts. Attempt all parts.
Consider the following scenario:
You will be asked a series of questions to guide your
analysis. You will need to manipulate the data to answer the questions below.
Some Excel formulas are provided in the worksheet.
1: Average returns [5 marks = 3 + 2 marks]
the monthly return on the shares of each company and the ASX200 index by using
the following formula:
where is the share price (or the value of ASX200
index) in time period . (Please note that you
lose the first observation when calculating returns.)
(a) Using the monthly returns, calculate the average return
on shares of each company from February 2015 – December 2017. Compare them with
the average return on the ASX200 index.
(b) Suppose an investor created an equally weighted
portfolio of these five companies (i.e. invested 20% of funds in each company).
What would be the average return on the portfolio? Explain how you derived your
2: Volatility [9 Marks = 2 + 2 + 5 marks]
(a) Calculate the standard deviation
of returns for the five companies. What does the standard deviation tell us
about the overall risk of these companies?
(b) Compute the standard deviation of the equally weighted
portfolio of these five shares. How does it compare to the standard deviation of
the individual companies?
(c) How does the standard deviation of returns of the ASX200
index compare with that of individual shares and the equally weighted
portfolio? Provide a brief explanation.
3: Beta’s [6 Marks = 3 + 3 marks]
Based on the data provided find an estimate of beta for each company.
this you will have to first calculate the covariance of a company’s returns
with the ASX200 index. Use the following formula in excel:
Beta’s can then be calculated by
Briefly explain why each company has high/low values of beta.
4 Forecast & Investment strategy [10 Marks = 7 + 3 marks]
The research department of Tri-Star Management has come up
with the following forecast of the share prices and the ASX200 index for the
month of June 2018:
They have also concluded that in 2018, the annual risk free
rate is going to be steady at 1.5%.
(a) Based on the forecasts given above, write a short report
for the clients of Tri-Star Management. Your report should be approximately 500
words long and contain: (i) an assessment of risk of each company, (ii) an
evaluation whether a share is overpriced, underpriced or correctly priced and
(iii) your recommendation regarding investment in these companies.
(b) Would you recommend the clients of Tri-Star Management
to invest in an equally weighted portfolio of these five companies? Provide a
Please answer – and in doing so, provide the data to
substantiate – the following items in your deliverable for your assigned
company. This project’s main deliverable
should not exceed eight pages, front & back, 12 font, double spaced
(although you may include an appendix of any length or form necessary).
To simplify this assignment, you may want to follow the
following template ….
To make this as straightforward and easy as possible, you
may want to chat with and befriend the TA Emma …
This project is due in hard copy on April 23, 2019. Please, do not wait until the last days of
that week to begin this deliverable as I believe you will find it a little much
to complete in a single setting.
Download and provide the last five years income
Download and provide the last five
years cash flow statements.
Download and provide the last five
years balance sheets.
Provide a short paragraph
suggesting the story that is being told by each statement – for example,
profitability, growth, abundant free cash, etc.
For these last five years, more importantly,
provide the adjustments and/or calculations for the free cash flows needed for the
Discounted Free Cash Flow (DCF) or more specifically, your Free Cash Flow to
the Firm (FCFF) model, either is easily constructed as an addition to the
income statement or as a separate statement starting the after-tax EBIT. Highlight this.
Highlight the abbreviated forecast of the next
five years income statement, explicitly – and only – providing any line items
and explanations that are material to your investment story. The only line
items I want / need to see are the critical ones to your forecast.
Highlight the abbreviated forecast of
the next five years cash flow statement, explicitly – and only – providing any
line item explanations that are material to your investment story.
Highlight the abbreviated forecast
of the next five-year DCF or FCFF forecasts (i.e., year by year) and the
normalized, constant growth calculation for forecast years 6 to infinity. Again, highlight this.
Provide a DCF or FCFF model based valuation
range, explaining in brief, your inputs. This range will serve as an “absolute
valuation” metric and will be calculated by discounting your individual five
year FCFF forecasts by a realistic WACC, discounting the constant growth by the
WACC, subtracting out debt and dividing by shares outstanding. Highlight this absolute valuation range.
Provide 10-year price/earnings, price/book, and price/sales
charts, commenting on today’s relative valuation AND providing the forecasted
P/E, etc. metrics that you selected to use in your forecasts. For example, substantiate your P/E ratio and
earnings per share forecast inputs that will provide your P/E valuation. These “relative
values” will serve as range value inputs for your final valuation range. Highlight this relative valuation range.
Note: The DCF absolute value range will be combined
with the P/metric relative value ranges to form a final range of value. For
example, if the DCF suggests $38/share and the P/metrics suggest $34–37, your
valuation range – combining the absolute and relative values – would be $34–38/share.
Discuss the important “systematic factors”
(inflation, interest rates, industrial production, etc.) that you believe will
drive this security’s return, explaining why you chose to include the ones that
you did. You may wish to supply a simple
regression to prove your point (hint)….
Discuss the important “fundamentals”
(profitability, growth, cash flows, etc.) that you believe will drive this
security’s future return, explaining why you chose the ones that you did. Comment also on the “embedded expectations”
that you believe the market is focusing on (please recall that any good analysis
is about understanding the embedded expectations in the market price and how
those expectations change so as to drive a higher or lower price in the future).
Given your analysis, would you recommend a buy
or a sell on this equity security? Explain your recommendation in a “summary
paragraph” that you would provide as an executive summary with your employer. Highlight this in a single paragraph, seeking
to make sure it is an accurate and complete storyline of your analysis.
Provide the duration, convexity, and yield to
maturity of any fixed income instrument of this company that matures after
Provide the Black-Scholes valuation of any
option of this company that expires within the next 12 months (please be sure
to provide your inputs as well as a brief discussion of your volatility
assumptions). Briefly compare your valuation (V) to that last price (P) traded
in the market.
Why might unemployment not lead to lower nominal wages?
[From 2004] The Chinese economy has been growing at 9% on average for a number of years. Its currency is pegged to the U.S. dollar while its trade surplus with the rest of the world is large. If the yuan were to float freely would it be more likely to strengthen or weaken versus the dollar? What are the three effects you predict of a floating yuan?
Describe a policy that will promote education in the Middle East. Explain how this policy does or does not target incentives at the margin. If you would like to focus your answer, feel free to make a response that applies to specific regions or groups. State your assumptions if you are unsure of specifics; your grade does not depend on detailed knowledge of the Middle East.
Chinese growth will be slower in the next 15 years than the past 15 years. [asked several times]
While in class we focused on fixed vs. flexible exchange rates, many nations have intermediate cases. For example, some nations have band, where rates are fixed plus or minus some percent. For example, a nation may fix its rates at 10 pesos per dollar plus or minus 4 percent, thus fixing between 9.6 and 10.4 pesos per dollar. In other cases the fixed rate has a crawl built into it: We fix at 10 pesos to the dollar, depreciating 1 percent per month. Other nations combine the two: a band each month, with built-in depreciation over time. What are the advantages and disadvantages of these hybrid systems compared to pure fixed rates?
Pick a specific policy to promote growth in Uganda. Defend that policy. (Recall that a policy is not a goal such as “improve human capital” or “reduce corruption,” but sufficiently specific that someone could disagree with it.) Point out at least one weakness of your proposal and a partial solution to that weakness. Note: You are welcome to state your assumptions about Uganda; there is no penalty for good analysis based on sensible, if imperfect, assumptions.
[From 2015] Who are two likely winners if Greece exits the Euro? Who are two likely losers? Explain each answer.
What are two reasons to be optimistic about growth in China over the next decade? What are two reasons to be pessimistic?
Pick a major macroeconomic event in the past year not discussed in this exam, not in the United States. Analyze it using the tools of this class. There is no penalty if you do not recall specific numbers. Be sure you have a topic sentence (a claim) that is worthy of defending.
“Probably the biggest danger is that overambitious hopes for economic growth are taken to justify excessively expansionary fiscal policies and unduly lax monetary policy. In the short to medium run, that might generate a boom and even secure re-election for Mr. Trump, as similar policies did for Richard Nixon in 1972. In the longer term, this could be hugely destabilizing. [Martin Wolf, 2017]
Why might “overambitious hopes [that] justify excessively expansionary fiscal policies and unduly lax monetary policy” be “hugely destabilizing”? Is this a major risk? ‘Another set of risks [face] emerging economies. In particular, the impact of the Trump administration might be highly destabilizing, via rising interest rates and a rising US dollar.” [Martin Wolf, 2017]
Why might the Trump policies lead to “rising interest rates and a rising US dollar”? How could a strong dollar and high-interest rates help or hurt emerging economies?