APPLIED PORTFOLIO MANAGEMENT
PROBLEM SET 2A
This problem set will be marked out of 30. It contributes 15% to your overall mark. You should answer all three questions.
Question 1 (13 marks)
You are employed as a research analyst and have been given six stocks to analyse. The six stocks are the ANZ Bank (ASX code ANZ), BHP Billiton (BHP), CSL Limited (CSL), Rio Tinto (RIO), Telstra (TLS) and Woolworths (WOW). Monthly dividend adjusted price data for these six stocks for the period January 2000 to December 2014 are provided in the Problem Set 2A Data.xls Excel spreadsheet. The ASX200 index value and 10-year government bond rate are both also provided in this spreadsheet. Using the data provided, you are required to undertake the following:
- Calculate the Sharpe ratio and beta for all six stocks you are analysing and identify which stock has performed best over the period you are evaluating.
- Construct a covariance matrix for the historical returns of the six stocks that you are analysing, Identify which pair of stocks has the highest covariance of returns and explain this result.
- Use Microsoft Excel’s Solver add-in to apply a mean-variance optimisation to derive the effective frontier of risky assets for a portfolio comprising the six stocks that you have been asked to analyse. When calculating expected returns, should use the Capital Asset Pricing Model. The market consensus forecast for the expected market return is 12% p.a. (1% per month) and the expected risk-free rate of interest is 6% p.a. (0.5% per month).
- In 200 words or less, discuss two problems with the use of mean-variance optimisation, such as the one undertaken above.
Question 2 (9 marks)
The data in worksheet Q2_data provides monthly returns across 25 assets (labelled P1 through to P25) for the period from 1936 to 2014. You have been asked to back test a cross-sectional momentum strategy using this data. Within this strategy, you are required to demonstrate the monthly returns on a portfolio of past winners and the returns on a portfolio of past losers. The momentum strategy that you should apply is the 12/12 strategy, whereby stocks are allocated into portfolios based on their performance over the past 12 months and each portfolio is then held for the subsequently 12 months and rebalanced annually.
- Create a portfolio of past “winners” and past “losers” and report the historical mean and standard deviation of returns for these portfolios. Calculate the Sharpe ratio and Jensen’s alpha for these two portfolios.
- In 300 words or less, discuss whether the evidence reported in Part 1 above is consistent with the empirical evidence on the momentum premium reported by in pages 65-70 of Jegadeesh and Titman (1993). In your answer, you should consider both the direction and magnitude of the momentum premium that you observe and provide at least one explanation for any differences that you observed.
Question 3 (8 marks)
One strategy applied by growth investors is to exploit IPO underpricing. Evidence on IPO underpricing is provided in several empirical studies, including a seminal paper by Loughran and Ritter (2004).
- In 250 words or less, explain the “IPO underpricing” phenomenom and provide a brief summary of the empirical findings on IPO underpricing.
- In 300 words or less, discuss the three main explanations that are provided for IPO underpricing.
- In 150 words or less, explain why it is difficult for individual retail investors to profit from IPO underpricing.
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