You are on page 1of 4

METHODOLOGY

We decided to use quantitative approach to our research. This is because our research tries to
analyse whether an investor should invest in a country or international portfolio, or whether
restricting investors choice to either country or international portfolio is sub-optimally relative to
combining both assets.
In order to answer our research questions, we analyse data provided by the Central Banks and
Stock and Security Exchanges that are in the following countries: Kenya, Uganda Tanzania and
Mauritius. To make sure that the optimal portfolio is chosen, we use non-random sampling
method.
Secondary data used will include indices provided by different security and stock exchanges. The
importance of using indices, is that it provides real time measure of the different stock exchange.
Also, since the paper uses Macroeconomic factor model, the factors are defined by economic
theory and observed externally to the security returns data. Macroeconomic factor models use
observable economic time series as measures of the pervasive factors in security returns. Some
of the macroeconomic variables used in analysis include: inflation, excess return to oil prices,
interest rates excess return of share index and exchange rates. The Macroeconomic data is also
secondary data obtained from the National Bureau of Statistics.

To analyze the portfolios we use the Arbitrage Pricing Theory, because we can factor in the
macroeconomic factors. In order for the APT. In order the model to get linearity of expected
return with systematic risk the following assumptions must be made:

Each asset has small idiosyncratic variance.

Each asset has small supply in the economy (at least in the limit).

There is a portfolio which, up to a constant, mimics factor j

Some agent holds a well-diversified portfolio that does not contain any idiosyncratic risk.

There is no arbitrage (directly or in some asymptotic sense).

There is Pareto efficiency and/or aggregation.

There are many assets.

All assets are in positive supply.

Since the APT cannot hold unless many of the above assumptions are good
approximations. Because these assumptions are reasonable to make about
fundamental traded assets in our economy for example stocks and bonds,
the APT can be expected to hold for these assets.
The APTs descriptive equation is:
E ( Ri )=R f + 1 i 1+ 2 i 2 +.. + j ij
Where:

E ( Ri )

Rf is the return on the asset that has no risk.


ij Is the reaction coefficient describing the change in asset is return for a unit

is the expected return on asset

change in factor j, and

j is the premium for risk associated with factor j .

covariance ( Ri , m )
vari a n ce m

Where:

RP

and

Rm are the Return on the index and return on the factors.

The macro economic factors obtained that are used to obtain risk associated with factor j

can

be evaluated by:
inflation= ln ( CPI ) =ln CPI t ln CPI t1
Where CPI is the consumer price index. CPI can be used to index that is to adjust the effect of
inflation of the portfolio. The change in the CPI reflects the changes in time preference.

Interest Rate=ln ( B10 tBT 3t )ln( B10 (t1 )B T 3 (t 1 ))


Where: B 10t
BT 3t

is the long term bond rate of ten years.

Is the short term bond rate of a 3month T-bill rate.

The difference between the long term bond and short term bond reflects on the changes in the
interest rates.
KES
USD /

Exchange Rate
Fluctuations in exchange rate have a substantial effect on the portfolio. In that, if the dollar
dampens global demand for commodities as they are priced in dollars. Lower demand for dollars
can affect earnings and valuation for domestic equities.
Oil price=ln Pt ln Pt1

Oil prices affect different sectors in the market, one is unable to avoid the overall impact.