- Introduction
This report presents an assessment of two stocks, Westpac and Whitehaven Coal Ordinary, in terms of their stock conditions and prices. Regression model has been used to critically analyze the co-relation between the returns of both the Companies and relationship of these variables with other components like Australian interest rates and yield and treasury bills has been studied.
- Stocks Analyzed
Of the two stocks, in my opinion, Westpac is most inefficiently priced. The reasons for this assessment may be the following two observations:
- Lesser return: A lesser return signifies that the yield on investments is less. Negative returns occur when there is financial loss or poor returns on an investment in a company or business, during a certain period of time. Sometimes, businesses have negative capital due to the outflow of capital that goes into the business. It is difficult for new businesses to make profit under a few years of establishment.
- High Standard Deviation: Standard deviation usually represents the data what is away from the mean or average score. A high standard deviation signifies that the data encompasses a wide value ranges.
- Data and Risk free asset
The adjustment of historical prices is done to remove gaps caused by stock splits, dividends and distributions. This can result in the chart looking different than other services that may not be able to perform the same adjustments.
Adjustment is to done to prevent these types of misleading signals appearance on our charts. The method to this is that whenever there is a 2 for 1 split, we divide all the historical prices for the stock by 2 and then again multiply by 2.
There are also smaller gaps in the historical data caused by dividends and distributions that also needs to be adjusted. The adjustment ensures that the movements of prices on the charts are due to pure market forces i.e. those forces attempted by Technical Analysis. These adjustments prove to be crucial for accurate technical signals; however, problems may be created at times in the following cases:
- When we cannot determines the actual buy or sell price for a stock from our historical price data.
- There may not be a match between our adjusted historical price data and unadjusted data from other sources.
Suitability of Instrument used as Risk free asset:
- Single Index Model
Single Index model is a system which simplifies analysis, by the assuming that there is only one macroeconomic factor that results in the systematic risk affecting all stock returns. This factor may be correctly represented by the rate of return on a market index, such as the S&P 500.
As per the Single Index model, the return of any stock can be further broken down into the expected excess return of individual stock due to various firm-specific factors, usually denoted by its alpha coefficient (α), the return received due to events that affect the market, and the unexpected events that affect only the firm. The calculation of the return of stock I is given by,
ri = αi + βirm + ei
Here, the term βirm denotes the stock's return due to the movement of the market customized by the stock's beta (βi), while the unsystematic risk of the security due to firm-specific factors is represented by ei.
The systematic risk is affected by macroeconomic events, like interest rates or the cost of labor, and this in turn affects the returns of all stocks, and conversely, firm-specific events are defined as those unexpected microeconomic events that affect the returns of specific firms. This may include incidents like death of key people or the decreasing of the firm's credit rating that would affect the firm, while having a negligible effect on the economy. Diversification can be used to reduce this unsystematic risk due to firm-specific factors of a portfolio to zero.
The index model is based on the following:
Since all stocks respond similarly to macroeconomic factors, most stocks have a positive covariance. However, there is higher sensitivity of some firms to these factors than others, and beta denotes this firm-specific variance. It measures stock’s variance compared to the market for one or more economic factors.
Different responses to the macroeconomic factors result in the Covariance among securities result. Hence, the covariance (σ2) of each stock is calculated by multiplying their betas and the market variance:
Cov (Ri, Rk) = βiβkσ2.
This equation reduces the calculations required to determine covariance as the historical returns must be used while calculating the co-variance of a portfolio. Another thing to note is that the covariance of each possible pair of securities in the portfolio must be independently calculated. With this equation, covariance can be easily calculated from only the betas of the individual securities and the market variance.
- Regression results and Interpretation:
Interpretation: The high value of R square indicates that the data is better suited to the model. Adjusted R square means that the numbers have been adjusted for the number of predictors in the model.
Simply put, alpha is generally considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return. It is taken that a positive alpha of 1 means that the benchmark index has been outperformed by the fund by 1%. Corresponding to the same, a negative alpha indicates that there is an underperformance of 1%. For investors, the more positive an alpha is the better situation it is.
Beta coefficient, simply known as the beta, is defined as a measure of the systematic risk, of a security or a portfolio as compared to the market as a whole. By definition, the market has a beta of 1 Individual security and portfolio values are measured according to how they deviate from this value in the market.
The indication of a beta of 1.0 is that the investment’s price will crawl in lock-step with the market. The low volatility of the investment than the market is represented by a beta of less than 1, and correspondingly, the high volatility to the investment’s price is denoted by a beta of more than 1.
For the given portfolio, alpha falls within the favorable range whereas beta is less than one meaning that there is low volatility of the investment than the market. The systematic and unsystematic risks involved may be:
Interest rates, recessions and wars are the conditions that represent the systematic risks of the market.
A new competitor, regulatory change, management change or a product recall may represent unsystematic risks.
- Trade ideas and risks:
There exists a statistical mispricing between a set of securities that we look to exploit; this is the premise of statistical arbitrage. A statistical arbitrage can be constructed between our stock of Whitehaven Coal Ordinary and S&P bonds. The stock indices can be used for this purpose.
The statistical arbitrage between these two stocks can be created on the basis of indices system. There are various methods in which this arbitrage can be created, one of the main being using the system of putting weights into the system.
The investment weights on this portfolio can be assessed with the fact the return in S&P is higher than that in Whitehaven so the investment opportunities are higher in S&P given by the better position it displays.
The risks on this trade may be that there are a number of systematic and unsystematic risks involved due to the differences in the values of alpha and beta.
Debt securities issued by the Australian Government are the Exchange-traded Australian Government Bonds (AGBs). These offer an easy and readily accessible way to invest in Australian Government Bonds.
When the Australian Government issues medium to long-term debt securities that have an annual interest rate fixes over the life of the security, called the coupon rate, it is known as treasury bills. These interests called the Coupon Interest Payments are made every six months. On the Maturity Date, payment is made to the bondholder of the last Coupon Interest Payment and the Face Value amount of the Treasury bond. The liability of these payments is on The Australian Government is liable.
There is more favor of Institutional and other large investors on Treasury Bonds because they provide stable, regular income paid by the Australian Government. They are liquid too easing the process of buy and sell.
References
Historical Price Data is Adjusted for Splits, Dividends and Distributions: StockCharts.com - Support. (2009, January 7). Retrieved from http://support.stockcharts.com/entries/20634-Historical-Price-Data-is-Adjusted-for-Splits-Dividends-and-Distributions
Loth, R. (2007, May 11). Welcome to Forbes. Retrieved from http://www.forbes.com/fdc/welcome_mjx.shtml
The Single-Index Model for Security Returns. (n.d.). Retrieved from http://thismatter.com/money/investments/single-index-model.htm
Systematic And Unsystematic Risk - Complete Guide To Corporate Finance | Investopedia. (n.d.). Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/systematic-risk.aspx
Treasury Bonds | Australian Government Bonds. (n.d.). Retrieved from http://australiangovernmentbonds.gov.au/etbs/treasury-bonds/
