Investment Management Assignment 2
Investment Management Assignment 2
Investment Management Assignment 2
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QUESTION 1
1a)
Year Black Sun Golden Meat Black Sun Golden Meat [Ri – E (Ri)]
Rate of Rate of Ri – E (Ri) Rj – E(Rj) * [Rj –
Return Return E(Rj)]
Covij = -23.2
= -4.64
Having computed the covariance, it shows that these two products have a negative relationship.
1b)
= 75.44
= 65.44
2
Standard deviation σi = √𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒i
2
= √75.44
= 8.6856
2
Standard deviation σj = √𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒j
2
= √65.44
= 8.0895
rij = covij
σi σj
= -4.64
(8.6856)(8.0895)
= -0.066
1c)
This indicates a negative correlation. The correlation coefficient of the two products is 0.066
which is low. The low correlation is not good for diversification for both Black Sun and Golden
Meat. The two variables indicated a low correlation coefficient that signaled an unsubstantial
relationship between the two. There is no correlation or relationship between the two variables
and it would be ideal for both Black Sun and Golden Meat to diversify if their correlation
coefficient was +1. Thus no recommendation of diversification is granted.
QUESTION 2
2a)
An efficient market is a market in which security prices are instantaneously reflecting all
information about the security. The efficient market hypothesis states that all securities are to be
traded at their fair value on exchange since there are large buyers and sellers in the market. This
however makes it impossible for investors to buy undervalued securities or sell securities at a
higher price. With the help of market timing and expert stock selection, investors will not beat
the market but will tend to gain better returns if invested in riskier investments. The efficient
market hypothesis accepts the theory as true that investor’s act randomly and that the market is
right for example, it is normal for an investor to follow other investors heading in the same
direction. The investor will not be provided any analysis benefit over other investors in the
market. Efficient market hypothesis have three variations which represents different levels of
market efficiency and these include the weak form, semi strong form and strong form
The weak form market hypothesis assumes that all security prices fully reflect information
contained in the historical security prices. The selection criteria of securities for investment
purports that information on trends in security prices is useless. Information contained in the
security prices cannot be used by investors to make abnormal profits. It's easy to validate the
hypothesis through serial correlation and statistical tests among past time series. The serial
correlation involves looking for correlation between successive security prices. A statistical test
involves looking for trends in security prices. The time series implies that future security prices
are random.
However, it is difficult to outperform the market since the weak form doesn’t consider the
technical analysis. For example, any investor who engages in this type of efficiency believes that
there is no need to have a financial advisor. The previously earnings growth doe not predict the
growth of the future.
The efficient market hypothesis of semi strong form states that the reflection of security prices
disseminates publicly information about a security. If the market is efficient under the semi
strong form, there will be no opportunity for any investor to make abnormal profits from using
published data as price adjustments immediately changes due to duplication of information. If no
abnormal profits can be made after the announcement of the new information, then the market is
efficient in the semi strong form. Publicly available information includes published financial
reports, press releases and dividends announcements among many others. It is however difficult
to identify the relevant publicly available information in the semi strong form as the information
does not clearly show which shares it does and does not affect.
The most applicable form of the efficient market hypothesis is the semi strong form. It
discourages the technical analysis belief that investors can use it to achieve excess gains in the
market.
A strong form of efficient market hypothesis is desired in any market. The strong form of the
EMH holds that all security prices are a reflection of available information. No investor gains
advantage over the market as information from both private and public is priced into securities.
With the interest to know if insiders make abnormal profits by using privileged information in
the market, the basis test is however used.
In a strong form efficient market, neither technical analysis nor fundamental analysis can assist
in predicting future price movements. This form of efficiency reveals overall information about a
market. Investors do not benefit as a result of revealed insider information for example,
information about a newly product to be launched will not affect the stock price of the company.
2b)
(i)
Based on the reason to make decisions, the risk averse investor has a personal opinion towards
the variance or standard deviation of the portfolios return as an appropriate measure of risk.
When an individual investor has wide range of portfolios, the variance or standard deviation of
the portfolios return is viewed as an appropriate measure of risk. The variance of each individual
security's return will no longer be useful to the risk averse investor. An investor shows interest in
the contribution of the individual security against the variance of the portfolio. Investor
eliminates unsystematic risk when investment is done in a diversified portfolio.
(ii)
If an investor holds one security, then variance of the security's return will be ideal for variance
portfolio's return. Through the assumption of similar expectations, risk is measured as individual
security contribution against the market portfolio variance. The contribution of the individual is
the beta of a security. Investors hold onto variety portfolios which results in the beta of a security
being a sensible measure of risk since these portfolios will not be in the nearby market. The beta
of a security shows a constant risk premium of an individual as well as the risk premium of the
market.
REFERENCES:
Scott,B.S. (2017). Fundamentals of Investing. 13th Edition. New York, London : Pearson
Reilly, F.K., Brown, K.C. and Leeds, S.J. (2019). Investments Analysis and Portfolio
Management. 11th Edition. Nashivlle, USA : South - Western Publishing Co.
Elton, E.J. (2014). Modern Portfolio Theory and Investment Analysis. 9th Edition. New
Jersey, USA : John Wiley & Sons. Inc.