This course work is composed of two related parts. Part one is a Case Study on diversification and CAPM application and Part 2 is an Essay on CAPM.
DEADLINE: 30 November 2016 Part 1 – Case Study (30%)
You have just accepted a job with a ABC LTD and on the first day of your employment you are told about company’s retirement plan.
The retirement has several option of investment, most of which are mutual funds. A mutual fund is a portfolio of assets. When you purchase shares on a mutual fund you are actually purchasing part ownership of the fund’s assets. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee, paid to the fund manager.
ABC plc options
uses XYZ Assurance LTD as its retirement plan administrator. Below are the investment offered to employees:
Company shares – One option in the retirement plan is equity ownership in ABC. The company is currently privately held but the plan is to go public in 3 to 4 years. Until then, the company’s share price is set each year by the company’s Board of Directors XYZ Market Index Fund – The mutual fund track FTSE 100 index. Equities in the fund are weighted exactly the same as the FTSE 100. This means the funds return is approximately the return on the FTSE100, minus expenses. Because the fund follows FTSE 100 it means that not much research is needed by the fund manager hence, the expenses are low. XYZ Index fund charges expenses of 0.15 per cent of assets per year. XYZ Small Cap Fund – This fund invests primarily in small-capitalization companies. As the result the returns on the fund are more volatile. The fund can also invest 10% of the assess in companies outside UK. The fund charges 1.7 per cent in expenses. XYZ Large-Company Equity fund – This fund invests primarily in large-capitalization companies based in the UK. The fund has outperformed the market in the last six years. It charges 1.5 per cent expenses. XYZ Bond Fund – This fund invests in long term corporate bonds issued by UK-domiciled companies. The fund is restricted to investments in bonds with an investment grade credit rating. This fund charges 1.4 per cent in expenses.
The standard deviation and the returns of the company’s equity and of the funds over the past 10 years are presented in the table below.
Assume the risk free rate is the return on a 30 day T-bill. The correlation between XYZ Bond Fund and Large-Cap Equity fund is 0.27.
- What advantages do mutual funds offer compared to the company Equity?
- Assume that you should invest at least part of your money in large-capitalisation companies based in UK. What are the advantages and disadvantages of choosing XYZ Large-Company Fund compared to XYZ Market Index Fund?
- The returns on XYZ Small-Cap Fund are the most volatile of all the mutual Funds on offer. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund has also the highest expenses. Does this affect your decision to invest in this fund?
You are now discussing the retirement plan with Holly, a representative of XYZ Financial Services. You mention to Holly that before you joined the company you did your research on ABC and your analyses has led to your belief that the company is growing and will achieve a greater market share in the future. Given these considerations, you are leaning towards investing 100% of your retirement account in ABC Ltd.
- Considering the effect of diversification, how should Holly respond to the suggestion that you invest 100% of your retirement account in ABC’s shares.
- Using the returns for the XYZ Large Cap Equity Fund and the XYZ Bond Fund, graph the opportunity set of feasible portfolios. (For this use equity portfolio weights from zero to 100 percent at intervals of 10 percent)
- After examining the opportunity set, you notice that you can invest in a portfolio consisting of the bond fund and the large-cap equity fund that will have the same standard deviation as the bond fund. This portfolio will also have a greater expected return. What are the portfolio weights and expected returns of this portfolio?
- A measure of risk-adjusted performance that is often used is Sharp ratio. It is calculated as the risk premium of an asset divided by its standard deviation. Calculate the Sharp ratio for company’s shares, each of the funds and the portfolio set up in point 6 above?
- How appropriate is the Sharp ratio for these assets? When would you use Sharp ratio?
Part 2 – Essay (70%)
‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’
|10 year Annual Return (%)||Standard Deviation (%)|
|XYZ Market Index Fund||11.48||15.82|
|XYZ Small-Cap Fund||16.68||19.64|
|XYZ Large-Company Equity Fund||11.85||15.41|
|XYZ Bond Fund||9.67||10.83|
Basic Rules for completing the course work:
Please stick to the rules below when you draft the course work.
- The course work should be a minimum of 2,000 and should NOT exceed 2,500 words. Make sure you are within the word limit
- The coursework should be type-written.
- Font Size: MINIMUM You can use larger font for headings but not for the document.
- Paragraphs should be DOUBLE SPACED!
- Use references from published work, i.e. books and more importantly academic journals (especially if you want a 2.1 or 1st class mark). Using only books may give you a passing mark. Using only websites may not even give you the passing mark.
- Be careful when you use sources (i.e. journals/books/websites) to refer to them in the document. Best way is through the use of footnotes where you write the name of the first author, the year of publication and the relevant pages you borrowed the saying or paragraph from. You need to do that even if you only used a word from someone’s work. You cannot present other peoples’ work as your own. Doing that, will be plagiarism, which is a serious offence, taken very seriously by the College and may lead to failing the course or even your degree!
- There is nothing wrong in using other people’s work as long as you refer to it. The more ideas you use, the better for you (regarding your mark) since it shows you are aware of the main literature/ideas out there! However, make sure that you also write your own thoughts! I know what other people say…what I am interested to read is what you think (and why) about this! So…blend information from other sources with your own work.
- For the case study part answer all the points listed in the case study.
- The essay part should have the following elements:
- Introduction: here you briefly explain what the essay is about and how you intend to approach the issue – what follows in the essay.
- Main concepts behind the problem and discussion: Here you have the opportunity to present the main theory behind the question, the main ideas, or the whole debate. Then (or along the presentation) you should express your own views, linking them with the other researchers’ and debate views/elements. In this part you can get very creative, but make sure the above are definitely included!
- Conclusions: here you say what the essay’s purpose was and sum up all your arguments (made in section B above) in order to highlight the fact that you have addressed the main issues concerned with the essay question.
- References: Here you should list in Ascending alphabetical order ALL the references you have used or referred to in the document. Please see published papers on the style of presenting references (they are always included at the end of journal papers) and stick with a style. I would suggest the style used in the papers published in the Journal of Finance.
Marking – Please see the Assessment Rubric in the last page
Ang, A., R.J Hodrick, Y. Xing and X. Zhang (2006) “The cross section volatility and Expected Returns”, The Journal of Finance, 61, 1, 259 – 299
Banz, R (1981) ‘The Relation between Return and Market Values of Common Stock’, Journal of Financial Economics, 9, 3-18
Berk, J.B (1995) ‘A Critique of Size Related Anomalies’, Review of Financial Studies, 8, 275-286 Fama, E. F. and K.R.French (2012) “Size, Value, and Momentum in International Stock Returns”,
Journal of Financial Economics, 105, 3, 457 – 472 Fama, E. F. and K.R.French (2006) “The value premium of CAPM”, The Journal of Finance, 61, 5, 2163
– 2185 Fama, E & French, K (1993) ‘Common Risk Factors in the Returns on Stocks and Bonds’, Journal of
Financial Economics, 33, 3-56 Fama, E & Macbeth, J (1973) ‘Risk Return and Equilibrium: Some Empirical Tests’, Journal of Political
Economy, 8, 607-636 Graham, J &Harvey, C (2001) ‘The Theory and Practice of Corporate Finance: Evidence From The
Field’, Journal Of Financial Economics 60, 187-243 Kothari Et Al. (1995) ‘Another Look at the Cross Section of Expected Stock Returns’, Journal of
Finance, 50, 185-224 Lewellen, J and S. Nagel (2006) “The conditional CAPM Does not Explain Asset Pricing Anomalies”,
The Journal of Financial Economics, 82, 2, 289 – 314. Roll, R (1977) ‘A Critique of the Asset Pricing Theory’s Test’, Journal of Financial Economics, 4, 129-
176 Sharpe, W.F (1964) ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk’,
Journal of Finance 19, 425-442 Also read chapters 10, 11, 12 and 13 from Corporate Finance by Berk &DeMarzo (2009)