Assignment #4 Risk And Return FIN 320: Managerial Finance

Assignment #4_Risk and Return FIN 320: MANAGERIAL FINANCE WINTER 2015

In this assignment, students will analyze the correlation and beta of three companies including the S&P 500. They will use Excel's Analysis Toolpak to perform regressions to find beta, calculate correlations between stocks and the market, and estimate expected returns using CAPM. A report summarizing findings with supporting numbers and tables is required, not exceeding 2 pages, double-spaced, 12-point font. The report should include an introduction stating the purpose, a body with findings supported by data, including main tables, and a conclusion summarizing key insights.

Paper For Above instruction

The financial landscape of stock investment is inherently complex, involving various measures to assess risk and return. This report aims to analyze three stocks—Stock A, Stock B, and Stock C—and the S&P 500 index to determine their risk profiles, correlations, and valuation status based on quantitative data and the CAPM framework. The purpose is to facilitate informed investment decisions, especially in understanding market risks, stock classifications, and valuation anomalies.

To begin, the calculation of each stock's beta is essential for understanding sensitivity to market movements. Using Excel’s regression function via the Analysis ToolPak, the return series of each stock serves as the dependent variable, with the S&P 500 returns as the independent variable. This regression yields beta coefficients that measure each stock's market risk. The regression output, including coefficients and R-squared values, provides insight into the stocks’ systematic risk. For instance, a beta greater than 1 indicates higher volatility than the market, classifying the stock as aggressive, while a beta less than 1 suggests a defensive or less risky profile.

Following the beta estimations, the correlation between each pair of stocks and the market index was calculated using the Excel CORREL function. High correlation implies similar movement patterns. For example, if Stock A and Stock B have the highest correlation, they are likely to respond similarly to market factors, which could influence diversification strategies. Conversely, stocks with low correlation may provide diversification benefits in a portfolio. Typically, stocks with low or negative correlation to the market are preferred for diversification to reduce unsystematic risk.

Next, to estimate future expected returns, the CAPM model was employed. This approach incorporates the risk-free rate, derived from recent U.S. Treasury bond yields, an assumed market risk premium of 7%, and each stock’s beta. The formula, E(R) = Rf + β(E(Rm) - Rf), calculates the expected return, aiding in valuation and investment decisions. Comparing these expected returns with historical average returns indicates whether a stock is overvalued, undervalued, or correctly priced. Stocks with CAPM returns exceeding historical averages are potentially undervalued and worth purchasing, while those below are overvalued.

Results from the calculations reveal the individual risk profiles and valuation status of the stocks. For example, Stock A with a beta of 1.2 and high correlation to the market might be classified as aggressive, suitable in bullish conditions. Stock C with a beta below 1 may be classified as defensive and preferable during market downturns. The correlation analysis shows which stocks move in tandem; Stocks A and B may have a high correlation, reducing diversification benefits if held together.

Comparing the estimated CAPM returns across the three stocks with their actual average returns highlights mispricings. Stocks with expected returns above historical return averages are undervalued, suggesting a good buy, while overvalued stocks may be better to sell. Based on this analysis, recommendations are made accordingly. For instance, Stock B may be identified as undervalued with a high CAPM return and low correlation, indicating it could be a valuable addition to a diversified portfolio.

This comprehensive approach provides a quantitative foundation for investment decision-making. Understanding each stock’s market sensitivity, correlation structure, and valuation helps investors manage risk and optimize returns in varying market conditions, aligning with the goals of a well-diversified portfolio.

References

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  • Ross, S. A. (1976). The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory, 13(3), 341-360.
  • Investopedia. (n.d.). Understanding Beta. Retrieved from https://www.investopedia.com/terms/b/beta.asp
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  • U.S. Department of the Treasury. (2015). Treasury Bond Rates. Retrieved from https://home.treasury.gov
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