Fin 6301 Spring 2014

Assignment 1 March 16, 2014

Anh Nguyen Diem Nguyen Vivian Wang

The seven stocks we chose for the portfolios were General Mills Inc. (GIS), Kellogg Co. (K), Exxon Mobil Corp. (XOM), MetLife, Inc. (MET), Netflix, Inc. (NFLX), Starbucks Corp. (SBUX), and Amazon.com, Inc. (AMZN). These stocks were chosen after a discussion about the stock or company and its market performance. The most recent 5 years of stock price histories as well as market betas were obtained from Yahoo Finance and used to calculate the expected return using the following formula:

The standard deviations, covariances, and correlations of each stock were calculated using the following equations:

The standard deviations, market betas, and expected returns for individual stocks can be found in Table 1. Covariances and correlations of each stock can be found in Tables 2 and 3 respectively. The Solver add-in function in Excel was used to adjust individual stock weights for different portfolio expected returns while minimizing portfolio standard deviation. The portfolio expected returns, portfolio standard deviations, and portfolio weights for each expected return are detailed in the Efficient Frontier Calculations section below. The portfolio standard deviation was calculated by taking the root of the summed weighted standard deviations of each stock. The portfolio expected return was calculated using the following equation, where the weight of the each stock is changed to reflect a specific target return:

The efficient frontier graph was graphed based on the Solver minimum standard deviation and expected returns. We expected to generate a curved line where the the safest portfolio was located at the minimum portfolio standard deviation. After adjusting the axes, the EFF graph showed the curved line we expected, as seen in Figure 1.

1. Explain, in detail, why you chose the three stocks you believed to be low volatility stocks. Examine the historical standard deviation of each stock return series. If one of these stocks had a higher than expected standard deviation (relative to the others), explain why this might have happened. Do you expect this will continue over the next year? We chose General Mills, Inc. (GIS), Kellogg Co. (K) and Exxon Mobil Corp. (XOM) as our low volatility stocks. When choosing our stocks, we also took into consideration the market beta, and looked for stocks with a beta of below 1. None of our low volatility stocks had a

noticeably higher standard deviation than the others. The standard deviations and market betas can be found in Table 1. In the case of General Mills, Inc., we believed that the company would have a stable history because it produces staple food products, namely several popular cereals, which has a steady target demographic of school age children who eat cereal for breakfast. Because it produces staple foods, there is very little volatility in product pricing and volume of product consumed because everyone requires food In addition, General Mills has a history of generating the most profit from its ventures in addition giving stockholders the greatest dividends of the three major cereal companies, with no significant reductions or interruptions in payout in the past. We expect that General Mills stock returns will remain consistent over the next year. The historical standard deviation on General Mills stock return was 13.05%, and the market beta was 0.25. Kellogg Co. was believed to have a stable history of stock returns for the same reasons as General Mills, Inc., namely that it has well defined target demographics. In addition to the appeal sugary cereals hold for school age children both in the US and abroad, Kelloggs branch of Special K targeted an older female demographic with an emphasis on healthy lifestyles and weight-loss. In addition to its famous cereals, Kellogg has also acquired a diverse manufacturing portfolio over the years, ranging from healthy snack food brands like Kashi to the iconic Pringles brand potato chips. Kellogg enjoys great brand recognition with its distinctive red K symbol throughout the world in addition to great brand loyalty. Due to its widespread reach and universal appeal, we believe that Kellogg is unlikely be adversely affected by events in any specific country or region, which means that it will be able to post stable earnings no matter what is happening in the world. We believe that Kellogg stock returns will remain steady over the next year. The historical standard deviation on Kellogg Co. stock return was 15.06%, while the market beta was 0.57. Exxon Mobil Corp. was believed to have a stable history of stock returns because of its status as a large international energy company. As a large energy company, Exxon Mobil was expected to have a stable source of income, since everyone consumes energy, whether in the form of gasoline or electricity. In addition, Exxon Mobil, Co.has a strong history of high returns on capital employed, with profits being returned to the shareholders. With this in mind, we believed that Exxon Mobil would have strong, steady stock prices. We believe that Exxon Mobil stock returns will remain constant over the next year. The historical standard deviation on Exxon Mobil stock return was 16.22%, while the market beta was 0.93.

2. Explain, in detail, why you chose the three stocks you believed to be high volatility stocks. Examine the historical standard deviation of each stock return series. If one of these stocks had a lower than expected standard deviation (relative to the others), explain why this might have happened. Do you expect this will continue over the next year? We chose Starbucks Corp. (SBUX), Amazon.com, Inc. (AMZN), Netflix, Inc. (NFLX), and MetLife Inc. (MET) as our high volatility stocks. We took into consideration the market beta on each of these stocks, and preferred stocks with market betas close to or greater than 1. The standard deviations and market betas of each stock can be found in Table 1. Starbucks Corp. was believed to be a high volatility stock because its best known product, coffee, is a luxury good. Starbucks, in particular, demands a higher price on its premium coffee, compared to chains like Dunkin Donuts and McDonalds. We believed that due to its higher

pricing, Starbucks sales would suffer more than other coffee chains when the economy contracts and consumers are either unwilling or unable to accept the cost of Starbucks coffee. Since the US entered a recession in 2008, we therefore believed that Starbucks sales would fluctuate greatly from 2009 through 2014 as the economy struggled to recover. In addition, Starbucks brick and mortar stores are so common in the US that the company has started to reach market saturation, precluding its ability to further expand domestically. Over the next year, we expect that Starbucks stock prices will remain consistent. The historical standard deviation on Starbucks stock return was 28.74%, while the market beta was 0.81. Amazon.com, Inc. was believed to be a volatile stock because of its retail business model. In particular, we believed that Amazons stock price woul d change with the announcement of each new quarter earnings report, which would in turn fluctuate based on the time of year. For instance, we expected that Q4 earnings, which encompass the majority of the holiday season, would post higher numbers than that of Q2, which spans much of the summer, traditionally a slow time for retailers. In addition, Amazon has posted very inconsistent earnings over the last 3 years, and has had a history of operating in the red. With Amazons recent push to increase its subscription price, we expect that its stock prices will continue to be rocky over the next year or so. The historical standard deviation on Amazon stock return was 29.88%, and the market beta was 0.77. Netflix, Inc. was believed to be a high volatility stock because of its non-traditional business model. As one of the forerunners of subscription internet television, Netflix has always had issues with program availability and hardware compatibility. With regards to program availability, Netflix has had to bargain for streaming rights for popular shows, which vary greatly from production company to production company. In particular, very large production companies have had great pricing leverage against Netflix when discussing rights for shows like House of Cards and Dreamworks movies, which Netflix was hard-pressed to meet while keeping subscription prices constant. In recent years, the rise of rival internet television providers like Hulu, Amazon, and ITunes, which offer free as well as subscription television, has affected Netflixs customer base. In addition, Netflix has faced difficulties spreading overseas in areas in which copyright laws are not as strictly enforced as in the US, which has made it difficult for Netflix to claim content exclusivity. However, we also noted that in the last year alone, Netflix has made a push to be accessible on more hardware platforms, life the Xbox and Roku. We believed that all of these factors combined would make Netflixs earnings and therefore stock price fluctuate greatly during the observed time. Netflix is the most volatile of our seven stocks, and is expected to remain so over the foreseeable future. The historical standard deviation on Netflix stock return was 70.77%, while the market beta was 1.97. MetLife Inc. was believed to be a volatile stock due to the nature of its primary services, life and health insurance. With the passage of the Patient Protection and Affordable Care Act (PPACA) in 2010, the healthcare system in the US has had to prepare for reform set to take action over the next several years. In particular, all health insurance companies are having to deal with an increased patient base as the PPACA seeks universal health insurance by preventing patients from being denied coverage. As a result, health insurance risk pools are facing an influx of high cost, high consumption patients who are expected to drive health insurance premiums higher over the years. In addition, the PPACA set new standards in coding and billing, and mandated implementation of electronic medical record systems, all of which cost huge amounts of money to upgrade. Due to the unforeseen consequences of expanding health insurance, we believe that MetLife and like companies have and will continue to face rapidly changing

conditions that will affect both their earnings and their stock returns as a result. However, we expect that the standard deviation on Metlife stock returns will remain constant over the next year, as many major health insurance firms have made preparations to weather changes in the insurance market. The historical standard deviation on MetLife Inc. stock return was 34.43%, while the market beta was 2.22.

3. Explain why you chose the 2 highly correlated and highly uncorrelated stocks. Did the correlations turn out as you expected? Why or why not? We expected that General Mills, Inc. and Kellogg Co. would be highly correlated stocks, while Netflix, Inc. and General Mills, Inc. would be highly uncorrelated. The correlations of each stock can be found in Figure 3. Since General Mills and Kellogg operate within the realm of cereal and snack food, we expected the correlation between General Mills and Kellogg to be high due to consumer market overlap. However, correlation between General Mills, Inc. and Kellogg Co. turned out to be 0.55, which was much lower than expected. Upon researching the two companies, we realized that we had overestimated the amount of overlap between the two companies. In comparison to General Mills, Kellogg has much greater diversity in its product line with a growing emphasis on healthy foods. Therefore, there was less market overlap between the two companies, and less correlation than expected. The stocks we believed would be high uncorrelated were General Mills, Inc., and Netflix, Inc. Much as we believed General Mills and Kellogg would be highly correlated due to market overlap in the same industry, we believed that General Mills and Netflix would have no significant market overlap, as they work in the processed and packaged goods sector and the service sector respectively. Correlation between General Mills and Netflix was 0.02, which supports our hypothesis that they do not have significant market overlap.

4. Calculate the Sharpe Ratio for each of your stocks (E(r)) Ratio for one of your portfolios with an expected return above the minimum variance portfolio. What can you say about the difference between the portfolio Sharpe Ratio and the Sharpe Ratio on the individual stocks? Explain why they are different. GIS E( R) St. Devi. 3% K 4% XOM 7% NFLX 13% MET 14% SBUX 6% AMZN 6% Portfolio 4.00%

13.05% 15.06% 16.22% 70.77% 34.43% 28.74% 29.88% 10.20% 0.29 0.41 0.18 0.42 0.20 0.19 0.39

Sharpe ratio 0.19

The Sharpe Ratio tells us whether the portfolio's returns are due to a smart investment decisions or as a result of excess risk. It is also known as the reward-to-volatility ratio provided by a portfolio.

The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. The portfolio with the highest Sharpe ratio is the portfolio where the line with the risk-free investment is tangent to the efficient frontier of risky investments. The portfolio that generates this tangent line is known as the tangent portfolio. The conservative investors will invest a small amount in the tangent portfolio and invest more in the risk-free asset, while the aggressive investors will focus more in the risky investment. Because the expected return for each individual stock is calculated by using the Capital Asset Pricing Model, while the portfolio expected return is calculated using Weighted-Average method, the Sharpe ratios are different. When using the CAPM, investors make some of assumptions. These assumptions are all investors have the same estimates concerning future investments and returns, and investors can buy and sell all securities at competitive market prices (without incurring taxes or transactions costs) and can borrow and lend at the risk-free interest rate. These assumptions are reasons causing the difference between each individual stock and the portfolios Sharpe ratio. Another reason is the risk can be reduced through diversification by combining stocks and exercising the portfolio.

5. Suppose you had some information that one of the stocks in your portfolio might significantly outperform the market. Should you still invest a portfolio of stocks? Why or why not? If you continued to invest in the portfolio, how would you alter your portfolio weights? Provide numerical evidence for your answer. Since one of the stocks in the portfolio might significantly outperform the market, we can assume that the market beta and expected return of the stock will increase. Since the stocks return and market beta have both increased, the stocks risk has also increased. According to portfolio theory, when several stocks are combined into a portfolio, there is an overall decrease in risk while maintaining expected returns. We modeled this phenomenon by simulating seven stocks of arbitrary standard deviations and market betas and graphing the efficient frontier (see Table 5). We then repeated the simulation but increased the market beta and expected return of stock D to indicate that this stock may significantly outperform the market (Table 6). The standard deviations, market betas, and expected returns of the modified set of stocks is presented in Table 4. The original market beta of stock D was set to 0.55. In Figure 2, we see the efficient frontiers for both of these simulations. The blue line indicates the original simulation, while the red line indicates the simulation with the modified stock D. We see that though the most efficient portfolio has an increased risk in the modified simulation than the original simulation, as we increase the amount of risk we are willing to take, we also have proportionally higher returns. In addition, we find that at the safest possible portfolio, the original set of stocks has a minimum standard deviation of about 9.8% while the modified and risker set of stocks has a minimum standard deviation of about 10% while the expected earnings are 3% for the safer stocks compared to 4% for the riskier stocks. When we compare the weights of the portfolio stocks (see Tables 5 and 6), we can also see that stock D has a greater weight in the modified simulation than in the original simulation. Therefore, we would still choose invest in a portfolio and increase the weight on the outperforming stock rather than in an individual stock.

EFFICIENT FRONTIER CALCULATIONS portfolio E(r) port std dev GIS K 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% 12.5% 13.0% 13.5% 14.0% 14.5% 15.0% 15.5% 16.0% 16.5% 20.0% 25.0% 50.0% 12.83% 12.00% 11.29% 10.74% 10.37% 10.20% 10.24% 10.48% 10.92% 11.53% 12.28% 13.15% 14.12% 15.18% 16.29% 17.46% 18.67% 19.91% 21.18% 22.48% 23.79% 25.13% 26.47% 27.83% 29.20% 30.58% 31.96% 33.35% 34.75% 36.15% 37.56% 47.51% 61.90% 134.70% 0.655 0.626 0.596 0.566 0.537 0.507 0.477 0.448 0.418 0.388 0.359 0.329 0.299 0.270 0.240 0.210 0.181 0.151 0.122 0.092 0.062 0.032 0.003 -0.027 -0.057 -0.086 -0.116 -0.146 -0.175 -0.205 -0.235 -44.22% -73.88% -222.21% 0.121 0.114 0.108 0.102 0.096 0.090 0.083 0.077 0.071 0.065 0.058 0.052 0.046 0.040 0.033 0.027 0.021 0.015 0.009 0.003 -0.003 -0.009 -0.015 -0.022 -0.029 -0.034 -0.040 -0.047 -0.053 -0.059 -0.065 -10.98% -17.21% -48.36%

XOM 0.299 0.307 0.315 0.323 0.330 0.338 0.346 0.354 0.361 0.369 0.377 0.385 0.392 0.400 0.408 0.416 0.423 0.431 0.439 0.446 0.454 0.461 0.469 0.477 0.485 0.492 0.500 0.508 0.515 0.523 0.531 58.60% 66.34% 105.05%

NFLX -0.004 0.000 0.004 0.007 0.011 0.015 0.018 0.022 0.025 0.029 0.033 0.036 0.040 0.044 0.047 0.051 0.055 0.058 0.062 0.065 0.069 0.073 0.076 0.080 0.084 0.087 0.091 0.094 0.098 0.102 0.105 13.09% 16.73% 34.91%

MET -0.258 -0.215 -0.173 -0.130 -0.087 -0.045 -0.002 0.041 0.083 0.126 0.169 0.212 0.254 0.297 0.340 0.382 0.425 0.468 0.510 0.553 0.596 0.638 0.681 0.724 0.766 0.809 0.852 0.895 0.937 0.980 1.023 132.10% 174.77% 388.14%

SBUX 0.218 0.198 0.177 0.157 0.136 0.116 0.096 0.075 0.055 0.034 0.014 -0.007 -0.027 -0.048 -0.068 -0.088 -0.109 -0.130 -0.150 -0.170 -0.191 -0.211 -0.232 -0.252 -0.272 -0.293 -0.314 -0.334 -0.354 -0.375 -0.395 -53.81% -74.25% -176.44%

AMZN -0.032 -0.030 -0.028 -0.025 -0.023 -0.021 -0.018 -0.016 -0.014 -0.012 -0.009 -0.007 -0.005 -0.003 0.000 0.002 0.004 0.007 0.009 0.011 0.014 0.016 0.018 0.020 0.023 0.025 0.027 0.030 0.032 0.034 0.036 5.22% 7.50% 18.90%

TABLE AND FIGURES

GIS K XOM NFLX MET SBUX Standard 13.05% 15.06% 16.22% 70.77% 34.33% 28.74% deviation Market 0.25 0.57 0.93 1.97 2.22 0.81 beta Expected 3% 4% 7% 13% 14% 6% earnings Table 1: Annual standard deviations, market betas, and expected earnings.

AMZN 29.88% 0.77 6%

GIS GIS K XOM NFLX MET SBUX 0.017023 0.010904 0.002450 0.001967

XOM

NFLX

MET

SBUX

AMZN

0.010904 0.002450 0.001967 (0.003826) 0.000758 0.005379 0.022693 0.006445 0.010254 0.016863 0.006445 0.026303 0.004167 0.023694 0.010254 0.004167 0.500806 0.051421 0.012780 0.013233 0.005584 0.015468 0.014563 0.038983 0.055249 0.023331 0.082626 0.028993 0.028993 0.089263

(0.003826) 0.016863 0.023694 0.051421 0.118529 0.000758 0.012780 0.005584 0.014563 0.055249 0.013233 0.015468 0.038983 0.023331

AMZN 0.005379

Table 2: Covariation matrix

GIS GIS K XOM NFLX MET SBUX AMZN 1.00 0.55 0.12 0.02 (0.09) 0.02 0.14

K 0.55 1.00 0.26 0.10 0.33 0.0 0.29

XOM 0.12 0.26 1.00 0.04 0.42 0.12 0.32

NFLX 0.02 0.10 0.04 1.00 0.21 0.07 0.18

MET (0.09) 0.33 0.42 0.21 1.00 0.56 0.23

SBUX 0.02 0.30 0.12 0.07 0.56 1.00 0.34

AMZN 0.14 0.29 0.32 0.18 0.23 0.34 1.00

Table 3: Correlation Matrix

Efficient Frontier for 7 Stock Portfolio

18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 0.00% Portfolio Expected Return (annual)

5.00%

10.00%

15.00% 20.00% 25.00% 30.00% Portfolio Standard Deviation (annual)

35.00%

40.00%

Figure 1: Efficient frontier graph

A Std dev Market beta E(r) 15.00% 0.25 3%

B 15.00% 0.35 3%

C 20.00% 0.45 4%

D 20.00% 1.00 7%

E 25.00% 0.65 5%

F 25.00% 0.75 6%

G 30.00% 0.85 6%

Table 4: Question 5 Model standard deviations, market betas, and expected earning rates.

portfolio port std E(r) dev A B C D E F 2.0% 11.26% 0.666 0.352 0.259 0.302 -0.241 -0.378 2.5% 10.60% 0.513 0.345 0.217 0.331 -0.175 -0.311 3.0% 10.37% 0.359 0.339 0.175 0.360 -0.109 -0.243 3.5% 10.60% 0.206 0.332 0.132 0.390 -0.043 -0.176 4.0% 11.28% 0.053 0.326 0.090 0.419 0.023 -0.109 4.5% 12.31% -0.101 0.319 0.048 0.448 0.089 -0.042 5.0% 13.63% -0.254 0.313 0.006 0.477 0.155 0.026 5.5% 15.16% -0.408 0.307 -0.036 0.507 0.222 0.093 6.0% 16.84% -0.561 0.300 -0.078 0.536 0.288 0.160 6.5% 18.63% -0.714 0.294 -0.120 0.565 0.354 0.228 7.0% 20.50% -0.868 0.288 -0.162 0.594 0.420 0.295 Table 5: Model Eff Calculations. This set of portfolio earnings was calculated using unmodified market betas.

G 0.041 0.080 0.119 0.159 0.198 0.237 0.276 0.316 0.355 0.394 0.433

Portfolio Port std E(r) dev A B C D E F 2.0% 12.16% 0.802 0.395 0.268 0.082 -0.317 -0.267 2.5% 11.40% 0.689 0.381 0.245 0.153 -0.264 -0.261 3.0% 10.83% 0.577 0.366 0.221 0.223 -0.212 -0.255 3.5% 10.48% 0.465 0.352 0.197 0.294 -0.159 -0.249 4.0% 10.37% 0.353 0.338 0.173 0.365 -0.106 -0.243 4.5% 10.51% 0.241 0.324 0.149 0.435 -0.053 -0.238 5.0% 10.89% 0.129 0.310 0.126 0.506 -0.001 -0.232 5.5% 11.49% 0.017 0.296 0.102 0.577 0.052 -0.226 6.0% 12.27% -0.096 0.282 0.078 0.647 0.105 -0.221 6.5% 13.20% -0.208 0.268 0.054 0.718 0.158 -0.215 7.0% 14.26% -0.320 0.253 0.031 0.789 0.210 -0.209 7.5% 15.41% -0.432 0.239 0.007 0.859 0.263 -0.203 8.0% 16.64% -0.544 0.225 -0.017 0.930 0.316 -0.197 8.5% 17.93% -0.656 0.211 -0.041 1.000 0.369 -0.192 9.0% 19.27% -0.768 0.197 -0.064 1.071 0.421 -0.186 9.5% 20.65% -0.880 0.182 -0.088 1.142 0.474 -0.180 Table 6. Model Eff Calculations. This set of portfolio earnings was calculated after modifying Stock D to reflect new information indicating that Stock D would outperform the market.

G 0.037 0.058 0.079 0.100 0.120 0.141 0.162 0.183 0.204 0.225 0.246 0.267 0.287 0.308 0.329 0.350

Efficient Frontier for 7 Stock Portfolio

8.0% 7.0% 6.0% 7.0% 7.0% 6.5% 6.5% 6.0% 6.0% 5.5% 5.5% 5.0% 5.0% 4.5% 4.5% 4.0% 4.0% 3.5% 3.5% 3.0% 3.0% 2.5% 2.5% 2.0% 2.0%

Portfolio Expected Return (annual)

5.0%
4.0% 3.0% 2.0% 1.0% 0.0% 0.00%

5.00%

10.00% 15.00% 20.00% Portfolio Standard Deviation (annual)

25.00%

Figure 2: Model efficient frontier graph