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James T, AMP’s quantitative analysis, has developed a portfolio construction model about which he is excited. To create the model, James made a list of the stocks currently in the ASX SPI 200 Index and obtained annual operating cash flow, price, and total return data for each issue for the past five years. As of each year-end, this universe was divided into five equal-weighted portfolios of 40 issues each, with selection based solely on the price/cash flow rankings of the individual stocks. Each portfolio?s average annual return was then calculated.

During this five-year period, the linked returns from the portfolios with the lowest price/cash flow ratio generated an annualized total return of 18.5%, or 3.9% percentage points better than the 14.6% on the ASX SPI 200 Index. James also noted that the lowest price-cash flow portfolio had a below-market beta of 0.88 over this same time span.

(1.1) Briefly comment on James? use of the beta measure as an indicator of portfolio risk in light of recent academic tests of its explanatory power with respect to stock returns.

[You should refer your discussion to the existing literature such as Fama, E. and K. French 1993. ?Common risk factors in the returns on stocks and bonds? Journal of Financial Economics 33 (1): 3-56.]

(1.2) You are familiar with the literature on market anomalies and inefficiencies. Against this background, discuss James? use of a single-factor model (price-cash flow) in his research.

[You should refer your discussion to the existing literature such as Jacobs, B. and K. Levy, 2007. ?20 Myths about enhanced active 120-20 strategies? Financial Analysts Journal 63 (4): 19-26.]

(1.3) Identify and briefly describe four specific concerns about James? test procedures and model designs.

[The issues already discussed in your answers previous parts may not be used in answering here. These other issues may include issues such as survivorship bias, look-ahead bias, improper reference portfolio, ignoring the real world, time period, holdout sample, market efficiency and data mining. You need to cite relevant publications when you discuss the above-mentioned issues in your discussion.]

Part 2 (8 marks)

Referring to the data contained in a excel file ?part 2 spreadsheet.xlsx?, which lists 30 monthly excess returns to two different actively managed stock portfolios (A and B) and three different common risk factors (1,2 and 3).

[You may find it useful to use Excel to calculate the basic statistic in the following questions 2.1-2.5]

2.1 Compute the average monthly return and monthly standard return deviation for each portfolio and all three risk factors. Also state these values on the annualised basis.

[Monthly returns can be annualised by multiplying them by 12, while monthly standard deviations can be annualised by multiplying them by the square root of 12.]

2.2 Based on the return and standard deviation calculations for the two portfolios from 2.1, is it clear whether one portfolio outperformed the other over this time period?

2.3 Calculate the correlation coefficients between each pair of the common risk factors (i.e., 1&2, 1&3, and 2&3).

2.4 In statistics theory, what should be the value of the correlation coefficient between the common risk factors? Explain why.

2.5 How close do the estimates from 2.4 come to satisfying this theoretical condition? What problem(s) is created by a deviation of the estimated factor correlation coefficients from their theoretical levels?

[You may find it useful to use Excel to estimate regressions in the following questions 2.6-2.9. I attached a word document for the information for how to install the data analysis tool pack before you can use regression and how to run regression in Excel]

2.6 Using regression analysis calculate the factor betas of each stock associated with each of the common risk factors. Which of these coefficients are statistically significant? [Report your regression results following a format/syle of a published finance journal article.]

2.7 How well does the factor model explain the variation in portfolio returns? Which one of these factors will be the most likely candidate for the market factor? Explain why.

2.8 Suppose you are now told that the three factors in the data provided represent the risk exposures in the Fama-French characteristic-based model (i.e., excess market, SMB and HML). Based on your regression results, which one of these factors is the most likely to be the market factor? Explain why.

2.9 Suppose it is further revealed that Factor 3 is the HML factor. Which of the two portfolios is most likely to be a growth-oriented fund and which is a value-oriented fund? Explain why.

# ASX SPI 200 Index Quantitative Analysis

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