Overview You have £1 million to invest in a portfolio of seven (7) shares. Three of them are from companies that constitute Dow Jones Index and the other four from companies that constitute FTSE-100 index. You are an English investor, so all your computations and cash have to be in GBP. Analysts’ target prices may be used to compute ‘expected returns’, while 12 months expected T-bill rates would be used to compute ‘risk-free rate.`
You are required to compute the efficient frontier under three scenarios:
• a.Short selling is allowed with a risk-free rate equal to your estimate of the one-year risk-free rate in the UK.
• b.Short selling is allowed but there is no risk-free rate.
• c.Short selling is not allowed You need to do these using the following expected return models:
• 1.CAPM • 2.Market Model
You must then compare these six portfolios (a1, b1, c1, a2, b2 and b3) to the returns generated by your portfolio over that one year and critically discuss the models used and the forecasting issues that have arisen.
Step 1 Take a list of FTSE-100 and Dow Jones Index companies at 29th September 2024 from the respective file available in this unit in moodle and choose seven (7) companies. Justify your selection, as this should not just be random.
Step 2 You are constructing the efficient frontier and your time period is one year. For each share you need the expected annual return (for the coming year), the standard deviation of returns for each share (annualized standard deviation), and the correlation coefficient (or equivalently, the covariance), between each pair of shares
Note that this is a forecasting problem. You want the expected returns, standard deviations and co-variances for the coming year. Initially you need to use five years of historical data (so October 2018 to September 2024) to do this. However this may be changed once you have reflected upon your results.
Step 3 Once you have your forecasts, use Solver on Excel to solve the optimisation problem. This will be covered in the lectures, so it is a good idea if you are up-to-date with the computations of the previous steps so you can fully benefit from these classes.
You are required to compute the efficient frontier under three scenarios:
• Short selling is allowed with a risk-free rate equal to your estimate of the one-year riskfree rate in the UK.
• Short selling is allowed but there is no risk-free rate.
• Short selling is not allowed
You need to do these using the two following expected return models:
• CAPM
• Market Model
Step 4 You need to examine the weights given by the optimizer. Critically discuss the advantages and disadvantages of the method you chose to get your forecasts. Critically discuss the advantages and dis-advantages of using this technique as a solution to the general asset allocation problem. Refer to possible solutions, in a context that refers to current literature (books, papers examined). The critical discussion must be integrated with the particular quantitative results you have obtained, i.e. you must demonstrate that you understand the issues you talk about by relating them to and illustrating them with your own results. Critical discussion should include, ideally but not necessarily, reference to both (a) at least three (3) books and (b) at least five (5) papers published in 3-star or 4-star journals in 2020, 2021, 2022, 2023, 2024. Published papers can be retrieved by using google scholar. An indicative list of 4star journals under the ABS AJG ranking is provided in the appendix.
Part 2. IPS Limit 700 words, 20%. (Hint: See Ch.2 MTPM and Handout: Investment Policy) You have been recently appointed as an asset manager. You have three new customers. Siddhartha is a confident investor who may undertake limited risk. Amrita is a young entrepreneur who is a risk-taker. Benjamin is a gentleman that is, to a large extent, financially independent. Categorise your customers according to the life-cycle view, the Bailard, Biehl and Kaiser model and the Barnewall model. (5 marks) Judging from the income and the personality, what strategy (Income, growth, Income and growth, Total Return Policy) will you follow for each of your customers, and why? (5 marks) Write a concise Investment Policy Statement (IPS) for each of them (10 marks). See Appendix for details.
