The report presents the analysis which is related to the risk and expected return of share portfolios of two stocks from the ASX in Australia. There are two approaches which refer to Mean-Variance and CAPM model to be applied in the analysis of the portfolios in this report. The two stocks which construct the portfolio are Asia Pacific Holdings Limited (AXA) and Caltex Australia Limited (CTX).Each stock occupies a certain proportion in one portfolio and their weights are varied in different portfolios. The rule of the portfolio construction is basis on varying the weights of each portfolio at 2.5% intervals. Then through the calculations and theoretical research which is related to the two approaches, the recommendation can be illustrated to the investors who desire to invest the portfolio of the two stocks. The report consists of 5 sections, which are: ● The Introduction of the two model
● Justify the selection of data which refer to the share prices of the two companies and the relevant data which satisfy the condition of the calculation under the two approaches. ● Calculation
● The Calculation which is relevant to Mean-Variance model ● The Calculation which is relevant to CAPM model
● Analyze the two models on the basis of their assumptions and present the criticisms of two models. ● The Recommendation for investors
● Mean-Variance Approach
The classical mean-variance approach was presented by Harry Markowitz is the first systematic treatment of a dilemma which is how to balance the high profit and low risk; meanwhile, it is also the first quantitative treatment of the tradeoff between profit and risk in the analysis of the selection of optimum stock portfolios (Steinbach, (2001)). The theory recognizes that the expected return of an asset can be estimated by the average of its one period returns, namely mean return and the total risk can be estimated by the standard deviation of these returns. Through the estimation of mean return and the standard deviation, the efficient portfolios which are the subset of minimum variance portfolios possessing the highest return for a certain level of risk can be found (Frino, (2009)). In other words, the efficient portfolios includes two meanings which is it provides each expected return with the minimum variance and it maximize the expected return for a given variance, respectively. Britten Jones (1999) illustrates that this approaches plays a pivotal role in the application of portfolio management and it is the basis of a multitude of asset pricing theories, such as CAPM (P.G.Cédric, M.Victoria-Fese, (2004)).
● CAPM Approach
This approach reflects a liner relationship between the expected return of one asset and the premium of market risk. The relationship can be expressed as a linear equation in which the slope is Beta and the intercept is the risk-free rate (Brailsford, (1997)).The application of CAPM approach is based on a series of assumptions, in spite of some criticism of this model which stems form its assumptions (Roll 1977, Fama and French 1992), it is still more prevail in the investment domain (Brailsford, (1997)).
2. Justify the selection of the data under the two approaches. ● The time period and the return internal
In order to get more precise and reliable results, it is necessary to base calculations on a long estimated period with enough observations. However this can be offset by the fact that the firm itself may change its characteristics over that period (Damodaran, (1999)). A short period with more frequent sampling interval was used to resolve this problem, but meanwhile this could bring the bias in estimation of beta due to the non-trading on an asset. The non-trading on an asset during the return period can reduce the correlation with the market index, and consequently with the beta estimates which can be more significantly affected using daily and weekly returns intervals (Damodaran, (1999))....
References: Marc C. Steinbach, 2001, Markowitz Revisited: Mean-Variance Models in Financial Portfolio Analysis, SIAM Review, Vol.43 no.1, pp31-85
Alex Frino, Amelia Hill, Zhian Chen, 2009, Introduction to Corporate Finance, 4th edition, Pearson Education Australia
Haim Levy, 2010, The CAPM is Alive and Well: A Review and Synthesis, European Financial Management, Vol. 16 no. 1, 2010, pp 43-71
Timothy J. Brailsford, Robert W. Faff, Barry Oliver, 1997, Research Design Issues in the Estimation of Beta, Vol.1
Fama, EF, and French KR,1992, The Cross-Section of Expected Stock Returns.” Journal of Finance, Vol 47,pp427-465.
Fama, EF, French KR, 2004, The Capital Asset Pricing Model: Theory and Evidence, Journal of Economic Perspectives, Vol 18 no 3, pp 25-46
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