Security Analysis and Portfolio Management

Assessment 2 aims to provide students with an opportunity to analyse various investment alternatives based on the respective risk and return so as to choose the most appropriate investment opportunity. You are expected to read beyond textbooks and able to apply the knowledge gain from real life examples either from your working environment or/and case studies read, and are able to demonstrate your competence in the areas indicated in the questions. You are encouraged to provide specific in-depth comments instead of general comments.

Instructions to students:
Part I (20 marks)

a. Download stock prices for any two different companies – 5 years of monthly closing prices for each company. You can use any database to obtain the prices e.g. datastream, yahoo finance (click the Investing tab followed by the Historical Prices tab) etc. Use data from December 2008 to December 2013 to generate average monthly returns. Calculate the annualised mean return, standard deviation and correlation of the stocks. (5 marks)

b. Use investment proportions for the two stocks ranging from 0% to 100% using intervals of 5%. Tabulate the investment opportunity set of the two stocks. (2 marks)

d. Calculate the expected return and standard deviation of this minimum variance portfolio (MVP). Plot the investment opportunity set of the two stocks and the minimum variance portfolio on a graph. Identify the MVP and efficient frontier consisting of the portfolios made up of these two assets. Label them clearly on the graph. (5 marks)

e. Discuss in your report diversification referring to the efficient frontier and expected return and standard deviation of the minimum-variance portfolio in your answer. (5 marks)

Part II (10 marks)
Consider the two securities listed below:
• Risky security: E(R) = 10%, s = 20%.
• Risk-free security: Rf = 4.5%.

You wish to form a portfolio combining the risky security and the risk-free security.

a. What weights would you need to place in the risky and risk-free securities if you are able to tolerate a risk level of 25%? What is the expected return of this portfolio? (2 marks)

b. Draw the capital allocation line (CAL). Label the points and the axes clearly. What is the reward-to-variability ratio? (3 marks)

Now, suppose that instead of one risky security and one risk-free security, you can invest in two risky securities as follows: Security 1: E(R1) = 8%, s1 = 12%; Security 2: E(R2) = 13%, s2 = 20%, and the correlation coefficient , ?12, between them is 0.3.

c. Find the expected return and the standard deviation of the minimum-variance portfolio (MVP) on the investment opportunity set. Draw a tangent from the risk-free rate to the investment opportunity set. (5 marks)

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