Risk Management Assignment: Portfolio Investment In US Stock Market

Question

Task:
The goal of this individual risk management assignment is to gain a better understanding of the portfolio investment (in the US stock market) and risk management process.

Answer

Introduction 

The report on risk management assignment aims to shed light on the investment risks and investment risk management. The risk management is most important for the investment to gain maximum benefits from the investment in stocks. The risk management is not only useful in managing the underlying risks of investment but also ensuring reasonable return from the investment in the stocks and portfolio of stocks. The report has produced an efficient analysis of two different portfolios one is of $400,000 and another is $10,000,000 and the portfolios are prepared as per instructions. The value at risks has been calculated for these two portfolios by subsequently model building approach and historical simulation approach. The risk management method like hedging is also discussed elaborately in this report and regarding this matter, both future hedging and option hedging are considered and discussed as these are effective ways to minimize the investment risks and protect the investor from any undesired situation.

Portfolio A

Determination of the weight and number of shares for the other stock

Weight = 69.4602

Number of shares = 818

Portfolio B

Determination of the weight and number of shares for the other stock

Weight = 43.965

Number of shares = 434

Trading philosophy

• Growth investment: it is a strategy of investment that focuses on increasing the capital of an investor. Investors invest in stocks that are young or stocks of small companies expecting an increase in their earnings in comparison to their industry or whole market.
• Value investment: it is a strategy of investment involving stocks that are trading lower than their intrinsic value. Value investors invest in stocks underestimated by the stock market.
• Mixture investment: a blend of both value style investment and growth style investment is known to be a mixture investment. Value investment and growth investment do not always face the same kind of ups and downs hence there is a need of balancing the two or consider a blend or mixture style of investment.

Reason to choose value investment: 

1. Lower prices than the market: Value investment offers to invest in stocks of competent companies as they will rebound in time before other investors recognize their value
2. Prices lower than the similar companies: the value of company stocks are created due to overreaction to recent problems of a company like negative publicity, lower earnings, or legal problems, which raises skepticism regarding the long-term prospect of the company
3. Lesser risk than the broader market: underestimated stock takes time to bounce. Although they carry the risk of price fluctuation value stocks are well suited for long-term investment for rewarding returns.

Although growth and value both strategy of investment has their benefits however according to studies value investment is seen to outperformed growth over time. Value investing is not for short-term return but long-term return.

The basic philosophy behind value investing is that valuable products purchased during the sale can save a huge amount of money. The sale or not the product value will remain the same. The same goes for stocks as well. If the value remains the same the stock price of the company would change. However certain kinds of stocks have to pass through higher demand and lower demand in the market which in turn leads to fluctuations in price, however, the value remains the same. The process of value investing requires a lot of investigation work to find secret sales of some stock and then buying them at a discounted price in comparison to their market value. Holding these values for the long term rewards the investor handsomely. The concept of value investment was developed by Professor Benjamin Graham in 1934 in his book “The Intelligent Investor”.

 Various metrics are used by investors to find the intrinsic value of a certain stock. As value investors intend to obtain maximum profit from the share they bought at a discounted price, there is a lot of investigation to do before buying stocks and find the intrinsic value. A combination of financial analysis is used to get intrinsic value such as cash flow, profit, revenue, earnings, the financial performance of the company along with some fundamental factors such as the business model of the company, brand, competitive advantage, and target market. Other significant metrics used for finding the intrinsic value of a company’s stock are:

Price- to-book: also known as book value is used for measuring the asset value of a company while comparing them with the stock price. If the price turns out to be lower than that of the company value, the stock is undervalued, meaning the company is not under any financial difficulty.

Price-to-earnings: the earning track record of the company is studied to determine if the stock is undervalued.

Free cash flow: cash generated from revenue or operation of the company after subtracting the expenditure cost. Expenditure cost includes operating expense and capital expenditures. Whatever remains after subtraction of expenditure cost is called free cash flow. A Company generating free cash flow will have money left for future investment, debt pays off, paying dividends or reward to the shareholders.

However, there are other metrics also present that are used for analyzing debt, revenue growth, and equity sales. Reviewing all these metrics is important then the only decision is taken whether to purchase company shares or not.

Portfolio Construction 

The portfolio A has been constructed by two highly performed shares in the market 1 is Amazon and another is Facebook one of the top performers in S&P 500 index. These two companies’ shares have been chosen for investment purpose as though the recent performances of these two shares are comparatively low but for long-term investment these are ideal as these two high profile shares will definitely improve in future. For initial portfolio creation, these two companies share are ideal. It is expected that at the point, the market will revive from the recent pandemic and crisis, the share price of both the companies Amazon and Facebook will be increased and will give handsome returns. 

The Portfolio B has been constructed with the shares of Tesla a high-profile company and three other companies named Dollar Tree Inc., Eli Lilly & Co and AutoZone Inc. However, currently the share price of Tesla is declining but it is anticipated that in future, the company will provide good return on investment as its innovative technology like environment friendly electric car will be highly demanded in the market as the people are currently becoming environmental concern and preferred environment friendly products. From the other three shares Dollar Tree Inc. and Eli Lilly & Co are two high performing companies in S&P 500 index and the third company AutoZone Inc is also top performing firm and placed in top 10 performers. Furthermore, all these four companies have significant prospects in the market in future thus these companies are selected for constructing the initial portfolio. 

At the time of creating a portfolio, it is most important to determine the investment goals and objectives. The portfolio is mainly a collection of different financial investments and while developing a portfolio the investors must assess the possibilities of the decided investment options in short and long term investments. The ideal portfolio is investment in mixed types of shares. The investment must be on a mixed, portfolio which can be safest as well as aggressive so that the desired returns can be earned within a certain period. The portfolios A and B are also constructed in this investment philosophy along with the value investing philosophy. In portfolio A, both the stocks Amazon and Facebook are regarded as safest investment option as the probability of reduction of these stocks is relatively low. At the same time for long term investment these two companies share is ideal as it is assumed that in long term investment these two shares will give good returns. In the same ways, in portfolio B, Tesla is an aggressive investment and in long term it has great possibilities. The other three companies are safe as they are performing well in the stock market and it can be projected that in near future will perform well. hence, both the portfolios are mixed investment to minimize the market risks and at the same time to maximize the return from investment.

News and the overall market and macroeconomic condition

Macroeconomic conditions: profit revenue and debt load are not the only factors that drive the stock price of a company. There a various broader market economic factors that affect the market prices of stocks in various degrees.

GDP: Gross domestic product is the most comprehensive indicator of the economy that measures the value of everything produced within the country related to goods and services. A fundamental measurement indicating growth or contraction of the economy is provided by GDP that measures the health of the economy. Hence it creates an impact on the stock market. Concerning the stock market, the price of a stock reflects the expectations of profit in the near future of the concerned company. A business will generally incur profits, earnings, and growth when the economy is healthy.

Rate of unemployment: also creates an impact on the stock market reflecting the weakness of the economy. The U.S. Bureau of Labor Statistics is capable of showing when hiring is increasing and when it is slowing down. Investors are required to follow these numbers in order to obtain benefits from their investment.

Consumer Price Index and Producer Price Index: both measures changes of process on a variety of services and goods. This is important because higher prices hurt consumer spending. Consumer spending makes approximately two-third of the economy and is a reason for raising the interest rate of the Federal Reserve.

Retail sales: gives an indication of the health of the economy

Industrial output: though its importance has been reduced still it is regarded as a vital signification of economic health.

There are many factors influencing stock prices. Investors are required to consider all of them in order to get a competent investment strategy. 

Financial news helps in understanding the condition of the economy and the economic health of the country. News is the most genuine source of information and it is updated on a daily basis. Financial news helps to decide where they should invest and where they should not. Newspapers, magazines, websites offer financial updates with optimum coverage. The more informed an investor is the more advantage they have. Investment requires detailed work and investigation regarding economic health and of the country and market. If there is any mistake in the calculation, that might cause a huge loss in the future.

Risks with value investment:

Like any other investment method, there is an associated risk with value investing as well. Mitigating risks require acknowledging them first.

Figures are important: in the case of investment, it is important to analyze the financial condition of the company. Often time investors make use of the financial statement. Confidence in reading financial statements is the key here.

Extraordinary gain or loss: exceptional and extraordinary incidents that come up in the financial statement must be read carefully. Critical analysis of such incidents is required in order to get a clear view. If the financial statement shows an unexpected loss in the subsequent years this can be an indication the company is going through a financial crisis.

Ignoring the flaws of ratio analysis: 

Diagnosis of the financial health of the company is important before investing. However, there is no one particular method of ratio analysis and that makes it more difficult. There are various methods of ratio analysis such as before-tax or after-tax numbers, earnings per share, and comparing different companies on the basis of their ratio, which seems difficult as companies often opt for different methods of accounting practices.

Buying stocks that are overvalued: overpaying is another risk associated with value investing. This involves the risk of losing a part of the money or all the money by overpaying. Buying stocks that are close to fair market value then there is a risk of losing money. 

No diversification: investing in individual stocks is prone to risk. Hence it is advised to invest in more than one stock in order to have exposure to various economic sectors and companies. However, the statement is controversial.

Initial weightings of the portfolio and the rationale for that composition

Portfolio A

Weight = Stock’s value /total portfolio value *100

Amazon 

=122141.44/399,942.42*100 = 30.539

Facebook 

= 277,800.98/399,942.42*100 = 69.4602

The portfolio A is composed of two famous companies subsequently Amazon and Facebook’s share and however, in present market situation these two companies’ shares are declining but it is assumed that in long run these two companies will perform better. Both of them are technology company and Amazon is associated with e-commerce business and it is anticipated that in next few years the numbers of internet users will be increasing in many folds across the globe and thus will bring substantial growth and development opportunities to these two companies, which in turn will support in increasing the price of these companies shares. 

Portfolio B 

Weight = Stock’s value /total portfolio value *100

Tesla 

= 560199.27/999744.27*100 = 56.034

Dollar Tree Inc.

=10051/999744.27*100 = 1.005

Eli Lilly & Co 

=23036/999744.27*100 = 2.304

AutoZone Inc.

=406458/999744.27*100 = 40.656

The portfolio B is composed of one of famous companies in the US like Tesla along with the companies Dollar Tree Inc., Eli Lilly & Co and AutoZone Inc. These three companies are top 10 high performing companies in S&P 500 index and it is projected that in future the companies will grow further. Hence, as al thee companies have significant growth prospects in future thus there are substantial growth and development opportunities for the investment portfolio.

Risk identification

Calculation and discussion of the five-day 99%-Value at Risk of portfolio A using model-building approach

According to the model building approach, which is called parametric or variance-covariance method, the return distribution is normal. The method stresses on two factors for estimation which are subsequently forecasted return and standard deviation. It is a most suitable method for risk assessing issues in case of known distribution as well as reliable estimation. The specific method is not reliable in case of very small sample size but in case of the portfolio A the sample size is big and thus it is most suitable method for calculation of value at risks for the particular portfolio. The portfolio value is 100. The average or min return of the portfolio is 86227.81668 according to the calculation and as per the calculation the standard deviation of the portfolio is 832.7561472 and the confidence level is 0.99 and the minimum return probability is 88165.09717. The value of portfolio is 8816609.717 and, in this context,, the value at risk is -8816509.72.

Calculation and discussion of the five-day 99%-Value at Risk of your portfolio B using a historical simulation approach

The historical simulation approach helps in computing the average as well as standard deviation of the portfolios, it resulted that the value at risk of the Portfolio B is high.

Performance of VaR based on calculation approaches in (a) and (b), VaR results and actual five-day returns

The performances of the portfolio A and B based on VaR calculations states that the portfolio A is more secured portfolio than the portfolio B as the investment risk in case of the portfolio A is relatively low than the portfolio B.

Hedging using Futures

The market risks related to portfolio B can be managed by using the hedging technique and thus it has been decided that the future hedging method will be used to protect the portfolio B from the underlying investment risk and as the possibility is existing in this case to decline the market thus the hedging will be jus opposite. The investor can sale E-mini S&P 500 future contract for predefined 1st Oct 2021. During this period if the market is really declining then the investor can earn from the sale of future and the loss from the share portfolio may be reduced significantly.

The total value of Portfolio B is $999,744.27 and to hedge it with E-mini S&P 500 future contract, it is required to sell future contract. The current value of E-mini S&P 500 future contract is $4287.25 and the contract size is $50 per index point. Hence, the single contract worth is $4287.25*$50 = $ 214362.5. The total portfolio value is $999,744.27 and its must be divided by a single contract value to get hedge value. Hence, $999,744.27/$214362.5 = 4.663802064. Therefore, to hedge the portfolio value in the context of market declining the investor has to sell 4 E-mini S&P 500 future contracts.

Comparison between the portfolio performance with hedging and the portfolio performance without hedging

The performance with hedging can be poor in case the market is moving opposite direction of the anticipation mean if the market is increasing instead of declining then, the investor may loss the investment done in the selling of future. Moreover, it may reduce the investor’s actual profits from the original investment. However, in alternative case the hedging will be useful for the investor as if the market movements are happened according to the forecasted direction then the hedging in mini S&P 500 future by selling it may be fruitful for the investors. The heading may balance its loss in share trading by the earnings from the future trading. According to calculation on 1st Oct. 2021, the portfolio value of portfolio B was $999,744.27, without considering hedging; it was the final value of the portfolio was $999,744.27. But in case of hedging, the investor has to invest $857450.00 more and thus total investment value will be $1857194.27. Here, the investor has to invest more to protect its investment in the stock market. here if the stock market decline then the selling of future contract can shield losses from the share market as the profit from the selling of future contract may balance the loss. However, if the market is bullish and the investor earns from share investment then the hedging will reduce the profit from share investment.

Hedging using Options

 With options, hedging stocks have to be sold at a specified price in a given time. Options give the right of selling assets at a specific price within the time frame. The pricing of option hedging depends on the downside risk. The option is an effective instrument that provides the buying or selling rights to the investors. Hence, in case of option the investor does not need to buy a stock or future but they only need to buy the rights by giving a small amount that is called premium for the stack or future. The projection is that the market will be declining as well as in this situation, it will be a wise decision to sell the call option of Facebook as it can be assumed that the selling of option may minimize the risk investment risks as the loss from the share portfolio can be minimized by option hedging. Option expiry date is 1st Oct. 2021. 

Calculation of European option price for Facebook

The option can be bought in the strike price and the options normally have expiration date and at the expiration date the option must be traded by the investors. In case of market runs as per the assumption then the option help in minimizing the loss of the investors. On the other hand, in case of the opposite direction of the market instead of anticipated direction then the investor may loss only the premium paid for the option. At the strike price the option will be sold automatically. 

Conclusion 

The risk management analysis can be concluded with the ending notes that by adopting effective risk management concepts the investor can manage their investment more effectively. The risk management technique will ensure that the investors will loss minimal in case of movement of the market in opposite direction instead of anticipated direction. The value at risk is an efficient way to assess the investment risk that support in understanding the underlying risk with the investment portfolio. The hedging is an efficient technique to manage the investment risks. The hedging can be future hedging and option hedging. The future hedging support in managing the investment risk but it is a costly tool and may reduce the profitability of the investment portfolio in this case the option hedging is effective as it minimizes the loss to the premium paid for the option right only.

References

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Appendix

Portfolio A

Portfolio B