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Portfolio management project

on Financial Econometrics

prepared by Konstantin Kravchenko

Almaty 2011

Introduction The portfolio management project is a course work that will be conducting during the semester in order to learn how to make good investment decisions according to mean-variance analysis, by minimizing variance of the portfolio with a predetermined desirable expected return on portfolio. This report contains the material on the investment management process, including the by step description of the process. The project is being conducted as a real life investment in risky assets of large corporations, through the investment similutor, provided by SaxoBank. According to the investment management process, we are required to go through 5 steps. In each of them we need to choose the best strategy for us, according to our preferences. Finally, we need to reconsider the portfolio that we compiled at the beginning of the process, according to the observations and the econometric prediction model that we made during the life-time of the investment project. Theoretical material for the project is taken from the main sources: the textbooks of Rachev and Benninga. The dataset of the stocks is taken from the and

Investment Management process Finance is classified into two broad areas: investment management (or portfolio management) and corporate finance. While financial econometrics has been used in corporate finance primarily to test various theories having to do with the corporate policy, the major use has been in investment management. The investment management process involves the following five steps: Step 1: Setting investment objectives Step 2: Establishing an investment policy Step 3: Selecting an investment strategy Step 4: Selecting the specific assets Step 5: Measuring and evaluating investment performance [2] Step 1 The first step in the investment management process, setting investment objectives, begins with a thorough analysis of the investment objectives of the entity whose funds are being managed. These entities can be classified as individual investors and institutional investors. Within each of these broad classifications, there is a wide range of investment objectives. The objectives of an individual investor may be to accumulate funds to purchase a home or other major acquisitions, to have sufficient funds to be able to retire at a specified age, or to accumulate funds to pay for college tuition for children. An individual investor may engage the services of a financial advisor/consultant in establishing investment objectives. In general, we can classify institutional investors into two broad categoriesthose that have to meet contractually specified liabilities and those that do not. We can classify those in the first category as institutions with liability-driven objectives and those in the second category as institutions with nonliability-driven objectives. Many firms have a wide range of investment products that they offer investors, some of which are liability-driven and others that are nonliability-driven. Once the investment objective is understood, it will then be possible to (1)

establish a benchmark by which to evaluate the performance of the investment manager and (2) evaluate alternative investment strategies to assess the potential for realizing the specified investment objective. [2] Since we are individual ivestors, so our primarily objective is to maximize the return on our portfolio to have sufficient funds to open the business and operate it thereafter. (Suppose we have such kind of imaginary objective).

Step 2 The second step in the investment management process is establishing policy guidelines to satisfy the investment objectives. Setting policy begins with the asset allocation decision. That is, a decision must be made as to how the funds to be invested should be distributed among the major classes of assets. [2] At this step we should identify which stock should we take for our portfolio. So, here some analysis is required. Actually, there are several alternatives in which assets we can invest. In order to maximize our wealth and get the higher return we are choosing the US and non-US common stocks of large corporations. Moreover, the stocks in its origin can be classified into 4 groups, according to the sphere of the corporation to which they belong. The four general classifications are (1) public utilities, (2) transportations, (3) banks/ finance, and (4) industrials. Since the financial world is currently still in a recession since the economic crises of 20082010, the financial industry suffered, and its returns dropped significantly, so the prediction says that investing in financial industry will result in losses that may any investor incur. So we are going to invest in the rest three except the financial industry. According to the analysis provided by Market Watch journal, the most profitable and highly capitalized companies are companies concentrated in the production of IT and communication technologies, in the selling of services, including tourism, hotel business and internet retailing, and also the production and selling of food and beverages, including fast-food restaurant business and whole sale business, and also in oil and gas mining. Due to this analysis, we picked out the companies which are included in the top 10 companies which, according to S&P, will bring the high income if a beginning investor will bet on them. So, we diversified our portfolio into the following industries: (1) IT and communication production and retailing: AAPL, AMZN, RIMM (2) Food industry: SBUX, CMG, GMCR, WFM (3) Tourism and hospitality: WYNN, PCLN (4) Oil and gas mining: DMLP, NEP, GPOR [3]

Here is a description of each of the companies: AAPL is the index of Apple, on e of the largest corporation in the production of IT-technologies, whose price increased significantly in recent years, and the volatility of the company is not very strong. The overall performance of the company is highly marked by leading rating agencies, like Moodys and Standard and Poors. DMLP is Dorchester Minerals, L.P. engages in the acquisition, ownership, and administration of producing and non-producing natural gas and crude oil royalty, net profits, and leasehold interests in the United States. AMZN is the stock of AMAZON.COM, which operates as an online retailer in North America and internationally. It operates retail Web sites, including and The

company serves consumers through its retail Web sites and focuses on selection, price, and convenience. CMG is Chipotle Mexican Grill, Inc. develops and operates fast-casual, fresh Mexican food restaurants in the United States. It also operates restaurants in Toronto, Canada and in London, the United Kingdom. As of July 19, 2011, it operated 1,100 restaurants. GMCR is Green Mountain Coffee Roasters, Inc. engages in the specialty coffee and coffee maker business. The company sources, produces, and sells approximately 200 varieties of coffee, cocoa, teas, and other beverages in K-Cup portion packs and coffee in traditional packaging, including whole bean and ground coffee selections in bags and ground coffee in fractional packs for use in at-home (AH) and away-from-home (AFH). It sells its products primarily in North America through supermarkets and convenience stores, in restaurants and hospitality, and to office coffee distributors, as well as directly to consumers via its Website. NEP is China North East Petroleum Holdings Limited engages in the exploration and production of crude oil in northern China. PCLN is Incorporated, together with its subsidiaries, operates as an online travel company. The company provides price-disclosed hotel reservation services on a worldwide basis primarily under the,, and Agoda brand names; and price-disclosed rental car reservation services in approximately 80 countries through TravelJigsaw brand name. GPOR is Gulfport Energy Corporation engages in the exploration, development, and production of oil and natural gas properties RIMM is Research In Motion Limited (RIM) designs, manufactures, and markets wireless solutions for the worldwide mobile communications market. SBUX is Starbucks Corporation purchases and roasts whole bean coffees. It operates approximately 16,858 stores, including 8,833 company-operated stores and 8,025 licensed stores. The company offers approximately 30 blends and single-origin premium arabica coffees. WFM is Whole Foods Market, Inc. engages in the ownership and operation of natural and organic food supermarkets. WYNN is Wynn Resorts, Limited, together with its subsidiaries, engages in the development, ownership, and operation of destination casino resorts. [4]

Step 3 Selecting a portfolio strategy that is consistent with the investment objectives and investment policy guidelines of the client or institution is the third step in the investment management process. Portfolio strategies can be classified as either active or passive. An active portfolio strategy uses available information and forecasting techniques to seek a better performance than a portfolio that is simply diversified broadly. Essential to all active strategies are expectations about the factors that have been found to influence the performance of an asset class. For example, with active common stock strategies this may include forecasts of future earnings, dividends, or price-earnings ratios.. Active portfolio strategies involving foreign securities may require forecasts of local interest rates and exchange rates.

A passive portfolio strategy involves minimal expectational input, and instead relies on diversification to match the performance of some market index. In effect, a passive strategy assumes that the marketplace will reflect all available information in the price paid for securities. Between these extremes of active and passive strategies, several strategies have sprung up that have elements of both. For example, the core of a portfolio may be passively managed with the balance actively managed. [2] Since we are excercised to reallocate our initial portfolio during the course, we are going to perform active portfolio strategy. We are going to use econometric models for predictions and reallocate the shares according to the results that we will got further. Step 4 Once a portfolio strategy is selected, the next step is to select the specific assets to be included in the portfolio. It is in this phase of the investment management process that the investor attempts to construct an efficient portfolio. An efficient portfolio is one that provides the greatest expected return for a given level of risk or, equivalently, the lowest risk for a given expected return. The purpose of this project is to get the allocation of weights in the chosen stocks according to the lowest portfolio variance, given the desired expected return on the portfolio. Here are some notions and formulas that we need in order to construct the effective portfolio. [2] Given any set of risky assets and a set of weights that describe how the portfolio investment is split, the general formulas of expected return for n assets is:
E (rP ) wi E ri
i 1 n


i 1

= 1.0; = the number of securities; = the proportion of the funds invested in security i; = the return on ith security and portfolio p; and

n wi
ri , rP

= the expectation of the variable in the parentheses.

The variance of a single security is the expected value of the sum of the squared deviations from the mean, and the standard deviation is the square root of the variance. The variance of a portfolio combination of securities is equal to the weighted average covariance of the returns on its individual securities:
2 Var rp p wi w j Cov ri , rj n n i 1 j 1

Covariance can also be expressed in terms of the correlation coefficient as follows:

Cov ri , rj ij i j ij

where ij = correlation coefficient between the rates of return on security i, ri , and the rates of return on security j, rj , and i , and j represent standard deviations of ri and rj respectively. Therefore:
Var rp wi w j ij i j
n n i 1 j 1

Overall, the estimate of the mean return for each security is its average value in the sample period; the estimate of variance is the average value of the squared deviations around the sample average; the estimate of the covariance is the average value of the cross-product of deviations. High covariance indicates that an increase in one stock's return is likely to correspond to an increase in the other. A low covariance means the return rates are relatively independent and a negative covariance means that an increase in one stock's return is likely to correspond to a decrease in the other. An efficient portfolio is the portfolio of risky assets that gives the lowest variance of return of all portfolios having the same expected return. Alternatively, we may say that an effi cient portfolio has the highest expected return of all portfolios having the same variance. Mathematically, we may defi ne an effi cient portfolio as follows: For a given return m, an efficient portfolio p = [x1, x2, . . . , xN] is one that solves [1]

So we have constructed the portfolio of 12 stocks, that were determined in step 2. After the getting the historical data on stock prices from 2006 to 2011, we get the daily return on these stocks. After, we calculated the expected return and variance on each stock. To get more real values, we need to get the nominal expected return by taking exp(E(R)) on each stock. The variance/covariance matrix was taken according to the returns and expected returns that we got. We assumed the weights of each stock in the portfolio. These are subject to maximization of Information Ratio, which is Expected return on portfolio/Standard deviation of the portfolio. We solved it with the help of Solver app. Since the variance of the portfolio is 0, then, the solution was found, but with the error in the key cell. However we got the following results according to which we minimized risks and get the desired expected return. The distribution of assets in the portfolio is guven in the following table:
AAPL DMLP AMZN CMG GMCR GPOR PCLN NEP RIMM SBUX WFM WYNN 0 0.0717 0.049 0.051 0.378 0.058 0.039 0.068 0.08 0.072 0.071 0.0638

In money terms we invest as following:

AAPL DMLP AMZN CMG 0 7167.5 4862 5056 GMCR GPOR PCLN 37834 5750 3903 NEP 6776 RIMM SBUX 7969 7223 WFM 7074 WYNN 6384.7

Step 5 The measurement and evaluation of investment performance is the last step in the investment management process. This step involves measuring the performance of the portfolio and then evaluating that performance relative to some benchmark. Econometric tools are used to construct models that can be employed to evaluate the performance of managers. The last step will be considered later after the reallocation and reconsideration of the portfolio. [2]

References. 1. S. Benninga Financial Modelling, 3rd edition, chapter 8-9. 2. Sv. Rachev etc. Financial Econometrics, introduction chapter appendix on Investment management process. The steps of management proces are quoted. 3. Analysis of companies performance by Shawn Langlois, MarketWatch journal. 4. Data about the companies from Yahoo finance. 5. Historical Data for excel file from spreadsheets of 6.