Security Market Line Case Study
Initially the stocks are analyzed using historical returns to derive expected returns and standard deviations, or deviations from the mean or average market return. Standard deviation is used as a measurement of volatility as it describes the degree of fluctuation in stock prices that occurs. Thereafter the stocks are compared by their respective betas, which measure the risk relative to the market and the responsiveness of the security to macroeconomic events.
To accomplish this task a graphical approach Is used as the stocks are plotted on a Security Market Line (SMALL as It will be easier to visually ampere each stock’s risk to return ratio relative to the market. In this way the stocks will be interpreted by means of a comparison relative to the market’s performance. As mentioned later, the risk and returns are heavily based on economic and accompanied factors.
Subsequently these stocks will be studied by means of regression analysis. A variance-covariance matrix will be used to derive the appropriate weights of each stock for the purpose of forming an optimum portfolio using an efficient frontier approach.
The efficient frontier of risky assets will present the combination of stocks and their relative weights needed that will result in the highest possible expected rate of return, given a level of portfolio standard deviation.
The last step of the analysis requires an assessment of what kinds of options, whether put or call, should be purchased for the stocks chosen In the prior step based on option market parameters using the Black-Schools option valuation, a comparison of implied volatility and historical volatilities, and the put-call parity relationship. The main factors affecting the options price, including the stock price, exercise price, time to expiration, the risk free rate (based on the one month and three month labor and implied and historical volatility, are manipulated to understand the different measures affecting the options pricing.
In selecting the stocks chosen for the final step in terms of put/call options, three strike prices are used to understand the wide range of possibilities. Through this thorough analysis one can theoretically deduce the appropriate selection of stocks in the correct ratios in order to selectively purchase options that will attain the highest return on an Investment decision.
Analysis of Historical Returns and Standard Deviation The SIX stocks chosen, the majority of which are traded on NASDAQ, are Google, Sony, Exxon-Mobil, Apple, Dell, and Microsoft. They are all actively traded and have actively traded options.
These particular stocks were chosen for reasons of mere random curls Sony Ana Apple are Innovative leaders In technology (Walt Palpitations and ‘pad), while Google, Microsoft, and Dell are companies I use daily, and Exxon-Mobil weekly. Additionally these companies have received considerable attention in the media during the two year span, beginning from November 1st, 2005 ND ending in October 31st, 2007 Using data from these two years, the expected returns and standard deviations (volatility) were calculated for all six stocks for each of the two years and the entire two year period. For the two year period the market had an 1 1. % return, and for the two years individually they were 10. 57% and 13.
29% for the first and second years respectively. The annulled standard deviation was . 119. Apple ranked highest in terms of return for the two year period primarily because it had a very high return during the first year at an astonishing 84. 7%, fleeting their cyclical innovative product development, as its yearly return for the second year was lower yet still amazing at 33.
5%. Again considering past performance, and as would be expected from looking at its returns for the past two years, Apple was most volatile with an annulled standard deviation of . 64. The next highest in terms of volatility were Google and Sony who shared similar levels at around . 287 and . 281 respectively.
Google however had a return more than double Sonny’s for the first year at 37. 84%, while the second year returns were similar for both t 24%. Google did outperform Sony for the two year period with a 31% return, and was the second highest performer after Apple overall, while Sony had a 20% return for the two year period. Next in terms of volatility is Dell and Microsoft, with an annulled standard deviation of . 75 and .
206 respectively. Dell’s volatility is surprisingly low considering it had a return of 24% for the first year and was the only stock with a negative return for the two year period at -3%, due to its second year return which was a devastating -31%. Microsoft had returns of 23. 5% and 1 1. % for the two years respectively, and nearly 18% for the entire two year period. As the majority of stocks more than outperformed the market, only Dell and Microsoft performed poorly in comparison due to below market returns during the second year.
This can be attributed to the overall performance of the particular industry which has seen dramatically lower returns. Specifically, Michael Dell managed to rectify this drastic situation before the fourth quarter of this year, while Microsoft has been involved in antitrust lawsuits overseas throughout this period, and this has undistributed to its relatively high volatility and below average returns. Lastly, Exxon- Mobil had a volatility of . 206 with steady returns for the two years individually at approximately 27% and 25% for the first and second years respectively, and a 26% return for the two year period.
The relatively high returns reflect record profits for the company and the oil industry as a whole during these two years. In comparison with the market’s volatility, Exxon-Mobiles relatively high volatility can be traced mainly to abnormally high returns, the aftermath of the local natural disaster Racine Strain, global geopolitical instability in oil producing countries, and the war in Iraq all took place within this two year span.
All stocks were more volatile than the market by a pretty healthy margin, and in general had very high returns overall when compared to the market.
As mentioned earlier, this can be attributed to company specific problems, the current state of each stocks respective industry, as well as outside natural and political factors both locally and globally. [See Appendix Beta and the Security Market Line As mentioned earlier, the beta of a stock measures the sensitivity of a security turn to systematic or market factors. As beta measures the responsiveness of a security to macroeconomic events, the specific aforementioned situations for each industry are reflected in the betas of the individual stocks.
A security’s beta is another way to measure the rockiness of a stock. As a fundamental rule, the beta of the market is always 1, hence if a stock has a beta greater/lower than the markets, that particular stock is considered riskier/less risky than the overall market.
Looking below at the security market line (SMS) graph for the first year period, rather than using current 30 day Labor rated of . 6, to getting a better understanding of this case I used rates from November 2005 to October 2006, the SMS has a risk-free rate of 5. 29% and a reward to risk ratio, or slope, of 5. 2% that were used respectively for both years. Almost all stocks lie on a vertical line at or around a beta of one, except for Exxon-Mobil which has a slightly higher beta at 1.
2, and Google with a lower beta at approximately . 8. For the first year Apple appeared to be the best investment as its expected return to risk ratio was highest, and thus it’s Sense’s alpha greatest, with a beta of 1 and expected return of 84. 7%. As it provided the highest return compared to its relatively low risk level, it was the most overvalued and underpinned stock.