INVESTMENT AND PORTFOLIO MANAGEMENT (CIN 4203)

Individual Assignment.
Question 1

(𝑟̅ p − 𝑟̅ f)
Sharpe’s measure = ᵟ

Portfolio Average Benchmark (r ̅p - r ̅f) Standard Sharpe

Annual Deviation ratio
Return
A 10.2 13.3 -3.1 12.2 -0.254
B 15.4 13.3 2.1 10.1 0.208
C 13.2 13.3 -0.1 14.0 -0.007

The Sharpe measures the reward to total volatility trade off, and a high Sharpe ratio is
favourable as compared to a low Sharpe ratio because a low ratio shows that the investments
portfolio offers little extra returns relative to the greater risks inherent (Willis, 2019). In this
case, comparing the fund managers to each other the manager of portfolio B has a high and
positive Sharpe ratio of 0.208 and this shows that the portfolio offers a high extra return relative
to the risk entailed but the portfolio is however the least diversified at 63, followed by the fund
manager of portfolio C with a little or no extra return given the negative Sharpe ratio of -0.007
and a higher diversification level of 98. Lastly the fund manager of portfolio A has the worst
performance given by the least Sharpe ratio of -0.254. Comparing the returns to the benchmark
portfolio A falls short from all set benchmark values despite a larger diversification level of 80
as compared to portfolio B with a diversification level of 63 but has an excess return of 2.1 and
beta of 1.36 representing the systemic risk. Portfolio C has returns that are almost the same
with the set benchmarks and a large diversification level of 98 making the performance of the
fund manager favourable and second to B.

(𝑟̅ p − 𝑟̅ f)
Treynor’s measure = 𝛽

Portfolio Average Benchmark (r ̅p - r ̅f) β Treynor’s

Annual Measure
Return
A 10.2 13.3 -3.1 0.82 -3.78
B 15.4 13.3 2.1 1.36 1.544
C 13.2 13.3 -0.1 0.99 -0.101
The Treynor’s measure gives excess return per unit of risk by focusing on systematic risk hence
the use of beta (Willis, 2019). As it follows portfolio B has a positive excess return per unit of
risk of 1.544 thereby making the portfolio manager of B the better performing manager
followed by that of portfolio C with measure of -0.101 and lastly A with a negative return of -
3.78 per unit of risk inherent within the portfolio. However portfolio B has the highest beta
value of 1.36 or highest deviation from the benchmark beta of 1.0 thus, representing a high risk
inherent in the security greater than market risk and the portfolio itself is the least diversified
of all. Followed by that of portfolio C with negative returns per unit of risk but the risk of the
security is close to benchmark beta hence showing that there is the same risk between the
security and the market risk.

𝑖=𝑛
b) Total portfolio return = ∑𝑖=1 𝑤𝑖𝑅𝑖

= (0.55*(-0.01)) + (0.15*0.11) + (0.30*0.14)

= 0.053

Total benchmark return = (0.50*(-0.05)) + (0.30*0.09) + (0.20*0.12)

= 0.026

From the returns above there is an excess arithmetic return between the fund portfolios and the
benchmark returns of (0.053-0.027) = 0.027 which needs to be attributed to the fund managers
decisions.

Contribution from Allocation per Asset Class = (wi – Wi) Bi

Equities (0.55-0.50)*-0.05 -0.0025

Bonds (0.15-0.30)*0.09 -0.0135
Property (0.30-0.20)*0.12 0.012
Total -0.004

The total contribution to arithmetic excess return from allocation is -0.004 and is as a result of
the sum of asset class contributions to allocation. The fund weight in equities shows an
overweight position of 0.05 or 5% which when applied to the negative benchmark return of -
0.05 results in a negative contribution of -0.0025. This shows that, under the allocation, the
fund manager over weighted a poorly performing asset or sector. As this follows that, if there
is an over weighted position there should be at least one underweighted position, the manager
took an underweighted position of 0.15 of 15% on bonds, and this combined with a 0.09
benchmark return results in a contribution of -0.0135, implying that the fund manager
underweighted a strong performing asset or sector. There is an over weighted position in
property of 10% and this combined with a 0.12 benchmark return results in a contribution of
0.012, thus implying that the fund manager over weighted a good and strongly performing
asset.

Contribution from Selection per Asset Class = (Ri – Bi) Wi

Equities (-0.01-(-0.05)*0.50 0.02

Bonds (0.11-0.09)*0.30 0.006
Property (0.14-0.12)*0.20 0.004
Total 0.03

Selection within the equities asset class added 400 bps to the benchmark return and applying
the benchmark weight of 0.50 it resulted in a 0.02 or 2% contribution to the total return. Bonds
and property selection also added 200 bps each and combined with their benchmark weight of
0.30 and 0.20 respectively they contributed 0.006 or 0.6% and 0.004 or 0.4% respectively.

Combining the allocation of -0.004 and selection of 0.03 = 0.026 explains the total fund excess
returns.
Question 2

2
(𝐸(𝑟𝑑)−𝑟𝑓)ᵟ𝑒 −(𝐸(𝑟𝑒)−𝑟𝑓)𝐶𝑜𝑣(𝑟𝑑,𝑟𝑒)
a) Wd = 2 2
(𝐸(𝑟𝑑)−𝑟𝑓)ᵟ𝑒 +(𝐸(𝑟𝑒)−𝑟𝑓)ᵟ𝑑 −(𝐸(𝑟𝑑)−𝑟𝑓+𝐸(𝑟𝑒)−𝑟𝑓)𝐶𝑜𝑣(𝑟𝑑,𝑟𝑒)

2
(12−8)45 −(24−8)(−35∗20∗45)
WA = 2 2
(12−8)45 +(24−8)20 −(12−8+24−8)(−315)

= 0.6317

WB = 1-0.6317

E (rp) = (0.6317*12) + (0.3683*24)

= 16.42%

Sdp = [(0.63172 ∗ 202) +(0.63832 ∗ 452 ) + (2*0.6317*0.3683(-315)] ^1⁄2

= 16.96%

E (rp)−𝑟𝑓
b) S =
Sdp

(16.42−8)
=
16.96

= 0.4965

Therefore the slope of the capital allocation line supported by Treasury Bills and P = 0.4965

c) Given a certain degree of risk aversion, an investor chooses a proportion , y, in the

optimal risky portfolio of ;
E (rp)−𝑟𝑓
Y=
0.01∗ASdp

16.42−8
= = 0.9758
0.01∗3∗16.96

The result shows that an investor with A = 3 is attracted to invest 97.58% of the funds in the
optimal risky portfolio with the given data. In this case stock A makes up 63.17% of the risky
portfolio and Stock B takes up 36.83% therefore the proportions of the investment are as
follows

Stock A = 63.17*0.9756 = 61.63%

Stock B = 36.83*0.9756 = 35.93%

This shows that the investor will invest 61.63% in stock A, 35.93% in stock B and 2.44% in
Treasury bills.

Question 3

a) E(r) = rf + βp1[E(r1) – rf] + βp2[E(r2) – rf]

= 5 + (1.2*6) + (0.7*8) + (0.4*3)

= 19%

b) E(r) = rf + β[E(rp) – rf]

Expected return for Delta = 8+1.58(15-8)

= 19.06%

Expected return for Econet = 8+0.88(15-8)

= 14.16%

Expected return for Delta = 8+0.72(15-8)

= 13.32%
 From the SML plot the delta stock has a positive alpha which is greater than zero and
lies closely on the SML and this shows that the stock is fairly priced since it provides
excess returns which are in excess of the one that is required by the CAPM. It also
follows that the Econet Stock and the Old Mutual stocks are overpriced and plot below
the SML with negative alphas.

c) i. Stock XYZ is a better buy because it has a beta of 1 which shows that the stock’s risk
is equal to the market risk whilst the risk of stock ABC has a risk that is higher than
market risk hence a high total risk is inherent in stock ABC. Secondly stock XYZ has
a positive alpha of 1% which is the expected return in excess of the one that is required
by the CAPM as compared to that of stock ABC.

ii. α = E(r) – ( rf + β[E(rm) – rf])

αXYZ = 12 – [5 + 1.0(11-5)] = 1%
αABC = 13 – [ 5 + 1.5(11-5)] = -1%
Question 4
a) Earning per share of $10 and dividend payment of $6 gives a 60% pay-out ratio
Therefore for 2019 dividends paid = 0.60*12 = $7.2
E(D1)+𝐸(𝑃1)
V0 =
1+𝑘
7.2+130
=
1+0.12

= $122.5
The stock should sell for $122.5 in January 2019.
D1
b) V0 =
𝑘−𝑔
(0.05∗1.08)
=
0.11−0,08

= $1.8
Therefore a prospective investor should pay $1.8 for the XYZ Ltd stock.

c) According to the DDM model if the stock is selling at its intrinsic values then E(r) = k
D1
k= +g
P0
(1∗1.05)
= + 0.05
35
= 0.08 or 8%

Therefore the required return applicable to the investment based on the constant-growth dividend
discount model is 8%

d) The two growth method is utilised to find the intrinsic values of the DSK Electricals
shares.
D1 D2 D3 D2(1+G2)/(r−G2)
P0 = + + +
(𝑟+1)1 (𝑟+1)2 (𝑟+1)3 (𝑟+1)3

Where D1 = (3.81*1.05) = 4.0005

D2 = (4.0005*1.05) = 4.200525
D3 = (4.200525*1.05) = 4.41055125
 (4.0005) 4.200525 4.41055125 4.41055125(1+0.07)/(0.1−0.07)
= + + +
(0.1+1)1 (0.1+1)2 (0.1+1)3 (0.1+1)3

= $ 128.61
The intrinsic values of the company’s shares is $ 128.61.

e) The dividend of $2 paid is to grow at constant rate 5% making the constant growth DDM
model applicable in calculating the intrinsic value of the stock.

D1
V0 =
𝑘−𝑔

k = rf + β[E(rm) – rf]
= 5.6 + 1.1 (6)
= 12.2

(2∗1.05)
V0 =
0.122−0,05

= $29.17
The intrinsic value of the stock under the DDM model is $29.17 yet the stock is currently
selling at $40. As an investor, I would not invest in the stock because the stock is overpriced
and under market correction conditions the stock will not yield excess returns but will instead
take a bearish position on the stock if I am to invest.
Question 5

a) Yield to Maturity

Shift

Term to Maturity
The typical yield curve generally slopes upwards and tends to shift downward or upwards

i) According to Latzko (2017), the liquidity preference theory explains an upward sloping
yield curve on the term structure of interest in that it states that the investors will
demand a premium that will compensate them to the interest rate exposure and this
premium increases with maturity. As a result the liquidity theory implies an upward
sloping yield curve.

ii) The market segmentation theory assumes that there is a separation between the markets
for bonds of different maturities and are highly segmented (Latzko, 2017). It further
shows that interest rates for each maturity bond are determined by the supply and
demand for that maturity bond only and at the same time based on the assumption that
borrowers have particular periods for which they want to borrow, hence this
behavioural patterns explains the yield curve. The yield curve slopes upward because
the demand for short-term bonds is relatively higher than the demand for longer-term
bonds given the fact that masses prefer to lend for shorter periods of time (Latzko,
2017).

b) The assumption underlying the calculation of the implied forward rates under the pure
unbiased expectation theory is that, that bonds of all different maturities are perfect
substitutes, hence investors will set interest rates such that the forward rate over the
 second year is equal to the one-year spot rate expected over the second year(Chen and
Scott, 2020).
c) Two year implied rate 5 years from now

This implies a rate that will prevail after 5 years to enable a reinvestment of a 5 year
investment returns to be reinvested for 2 more years and yield the same return as the
one invested at time zero for 7 years based on the unbiased expectations theory.

Spot rate for year 5 = 5.7% and 5% for year 7

Now consider investing 100 for 5 years and 7 years

Total 5 year return = 100*(1.057) ^5 = $131.94

Total 7 year return = 100*(1.05) ^7 = $140.71
The two year implied rate that will turn $131.94 to $140.71 is therefore our two year
implied rate five years from time 0 which is given by
131.94*(1+i) ^2 = 140.71
1 + i = 1.0327
i = 3.27
Therefore the two year implied rate five years from now = 3.27%
cii) Four year spot rate
(1+𝑟𝑛)𝑛
fn =
(1+𝑟𝑛−1)𝑛−1
-1
(1+𝑟4)4
0.052 =
(1+0.06)3
-1

1.2529 = (1 + 𝑟4)4
1.0579 = (1 + r4)
r4 = 0.0579
Therefore the year 4 spot rate = 5.8%
850 1 0.12 10000
d) Vb = ((1 − (1+0.06)40 ) ÷ ( )) + (1+0.06)40
2 2

= 425(15.04629687) + 972.2218771
= 7366.90
The investor will have to pay for $7366.90 which is the price of the bond.
 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
e) Accrued Interest = coupon payment ( )
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑐𝑜𝑢𝑝𝑜𝑛𝑠
308
= (0.095*1000000) ( )
365

= $80164.38
The clean price = dirty price – accrued interest
= 1307995.13 – 80164.38
= $1227830.75

f)
Time Payments Payments Weight Col 1 * Col4
discounted
@5%
1 100000 95238.10 0.2200 0.2200
2 100000 90.702.95 0.2095 0.4190
3 100000 86383.76 0.1995 0.5985
4 100000 82270.25 0.1900 0.7600
5 100000 78352.62 0.1810 0.9050
Total 500000 432947.68 1.000 2.9025

Payments have been discounted by the 5% YTM to find the present value of obligation
(Face Value)
PV = (1+𝑟)𝑡

The present value of future obligations after 5 years is $432947.68. In order to be able to fully
immunize the liability by investing in a zero coupon bond the present value of the bond should
equal the present value of obligation payments.
If the fund is to invest in two zero coupon bonds X maturing in 5 years and a face value of
262815.89 and Y maturing in 1 year and a face value of 238375.8
Consider the following three scenarios to be able to see if the pension fund would be immunised
against small and uniform changes in the rate of interest.

Scenario 1: if rate remains at 5%

Present Value of obligation = $432947.68

Present value of Bond X Present Value of Bond Y
(262815.89) (238375.8)
= + =
(1+0.05)5 (1+0.05)1

= 205923.13 = 227024.57

Both bonds gives a total present value of $432947.70 which is equal to the present value of
the obligation.
Scenario 2: if rates rise to 6%

(100000) (100000) (100000) (100000) (100000)

PV of obligation = + + + +
(1+0.06)1 (1+0.06)2 (1+0.06)3 (1+0.06)4 (1+0.06)5

= $421236.38
Present value of Bond X Present Value of Bond Y
(262815.89) (238375.8)
= + =
(1+0.06)5 (1+0.06)1

= 196391.32 = 224852.83

Both bonds gives a total present value of $421274 which falls together with the present value
of the obligation $421236.38 giving a positive net position of 37.62 if interest rate rise.

Scenario 3: if rates falls to 3%

(100000) (100000) (100000) (100000) (100000)

PV of obligation = + + + +
(1+0.03)1 (1+0.03)2 (1+0.03)3 (1+0.03)4 (1+0.03)5

= $457970.72
Present value of Bond X Present Value of Bond Y
(262815.89) (238375.8)
= + =
(1+0.03)5 (1+0.03)1

= 226707.30 = 231432.82

If the interest rates falls to 3% the present value of the obligation increases to 457970.72 and
so does the present value of the zero coupon bonds X and Y to a total of 458140.12 giving a
positive net position change of 169.
The above scenarios have shown that the pension fund will be immunised against small and
uniform changes in the rate of interest if they invest in zero coupon bonds X and Y.
However an ideal bond will be the one with the same duration with the liabilities of the fund
of 2.9
Where Face value = 432947.68 * (1.05) ^2.9
= $498812.53
And this bond will immunise the fund by maintaining the same net position.
References:
Latzko, D. A., (2017). EC 230 Lecture Notes:Lecture 11 - Term Structure of Interest Rates,
Wilkes-Barre: Wilkes University :Department of Business and Economics.
Scott, J. C. a. G., (2020). Investopedia:Bond Valuation. [Online]
Available at: www.investopedia.com
[Accessed 22 April 2020].
Willis, A. J., (2019). Investopedia:Risk Adjusted Measures. [Online]
Available at: www.investopedia.com
[Accessed 31 March 2020].