Introduction:
The report is based on the quantitative results derived from the regression analysis conducted between the excess returns of two stocks and the excess return of S&P-ASX 200(market index) over risk free return( 30 day bank accepted bill(BAB) rate). Our findings revealed the average returns, risks, beta and R-square multiple for each stock.
Stocks Analyzed
As noted from the above table, West Bank Corporation has a higher risk multiple with standard deviation of 7.42% and is thus offering a higher return of 1.75%. On the other hand, Metcash Limited which although has a lower risk than WBC, but offering a negative return even when the standard deviation is at 6.26%, surely makes the stock inefficiently priced.
Data and Risk Free Asset:
All the data related to stock prices for the period January, 2012 till January, 2014 has been sourced from Yahoo Finance. However, since the website offered only the monthly prices, we then converted the monthly price data to monthly returns using excel based formula that can accessed in the spreadsheet attached. The data for the market index, i.e. S&P ASX 200 was sourced from the similar financial website and the same procedure was followed to convert the monthly prices to monthly returns. The reason we chose the S&P ASX 200 as market index as it provides a good cumulative performance overview of the major stocks in the Australian financial market.
As for the risk-free rate instrument, we used the 30 day Bank Accepted Bill rate from RBA website. The reason for choosing it as risk free rate is it being sold to the primary banks of Australia with credit rating as high as A+. Hence, with almost negligible risk involved in these instruments, it will perfect to use them for risk free rate.
Stock splits and dividend adjustments:
Important to note, all the prices sourced from yahoo finance is adjusted for stock splits and dividends. For instance, if any of the company announces a stock split, let’s say, 2:1 split, this means that the preceding closing prices will be adjusted for the split and hence will be multiplied by 0.50. Then , the dividend multiplier is computed by subtracting the dividend paid as a proportion of the closing price of the previous day from 1. For example if a dividend of $0.05 is paid in Sep 17th and the closing price for Sep 16th was $25, then the multiplier is (1-0.05/25) = 0.998. Just like in the case of split multiplier, the preceding prices are adjusted by multiplying them with dividend multiplier. An Example is as in the following table
Single Index model that is usually abbreviated as SIM is one of the most popular asset pricing model in the finance industry. The model focus on the idea that the stock returns are influenced by the Beta, has a firm specific expected value and an unexpected component known as residual. The model is used by the analyst for ascertaining stock betas and to evaluate their stock selection. Below is the equation for the single index model(SIM):
ri-rf=αi+βirm-rf+ei
Where αiis the firm specific expected return,ri is the return on the stock,rf is the risk free interest, βi is the firm’s beta, rm is the market return and ei indicates the residual returns.
Regression Results
The SIM model is conducted by us through the excel regression function where the excess returns of both the stocks, i.e. MTS and WBC and the S&P-ASX 200 over the risk-free rate of return of Bank Accepted Bills were regressed against each other. The final solution is attached here and is also available in the spreadsheet:
Summarized results of the SIM Model:
Referring to the above table, we can find that both the stocks are least sensitive to the market. In other words, while Westbank Corporation has a beta of 0.051, Metcash Limited has beta of only 0.019. The findings were confirmed with the measure of goodness of the fit, i.e. R square. While WBC has R square multiple of 2.13% , MTS has R square of 0.04%. This indicates that both the stocks has a greater capacity to diversify the major portion of total risk, i.e. they majorly constitutes of unsystematic risk that can be eliminated through portfolio diversification.
Varied beta multiple:
It is highly possible that the beta multiple calculated by us through excel regression is different from the one provided on the other financial websites, Yahoo Finance or Reuters. There are many factors behind such differential over the beta multiple of same stocks and the same are discussed below:
i)While we calculated the beta multiple only on the basis of excess returns of stocks and monthly index, many financial websites also incorporates factors as growth rate, leverage, etc. to calculate beta and hence, a possible reason for varied beta exists.
ii) Unlike our beta calculation, where we used monthly returns to calculate beta, other analysts use annual returns to calculate beta multiple.
iii) Beta can also be calculated using sole returns of the stock rather than the excess returns over the risk-free rates.
Trade Idea:
Considering the results achieved by us by performing the regression analysis, we have found that the stocks have least sensitivity to the market, i.e. WBC stock has a beta of 0.051 and MTS stock has a beta of 0.019. In other words, including both the stocks in our portfolio we can surely avail the diversification benefit because of lower correlation between S&P/ASX 500 ETF, WBC and MTS Stock. In addition, inclusion of these two stocks will not expose our portfolio to the high risk levels and thus, a sustainable return can be achieved on trading on these two stocks in our portfolio. Important to note, both the stocks also has least R2 multiple of 2.30% and 0.04%, that means they have higher capacity to diversify away the non-market risk and thus can be a good inclusion in the stock portfolio to offer diversification.
Risk involved:
Although, the investors will be availing the diversification benefit from inclusion of these stocks, but the portfolio is still exposed to other risks such as overall stock market volatility, macro-economic activities, both internally and externally, affecting stock market and thus the stock prices.
Works Cited
Metcash Limited: Historical prices. (n.d.). Retrieved September 24, 2014, from Yahoo Finance: http://finance.yahoo.com/q/hp?s=MHTLY+Historical+Prices
S&P-ASX 200 Historical Prices. (n.d.). Retrieved September 24, 2014, from Yahoo Finance: https://in.finance.yahoo.com/q/hp?s=%5EAXJO
Single-index model. (n.d.). Retrieved September 24, 2014, from Nasdaq.com: http://www.nasdaq.com/investing/glossary/s/single-index-model
The Adjusted Close. (n.d.). Retrieved September 24, 2014, from Yahoo Finance: https://help.yahoo.com/kb/finance/SLN2311.html?impressions=true
