Plan for Unit 4

Using the CAPM for Security Selection.

- Download from Bloomberg or from yahoo finance the total return index for the SPDR ETF over the same period and at the same frequency as your other data. Compute the monthly HPR for the ETF. We will use these returns to proxy for the market returns. Compute the descriptive statistics for the market.(40min)
- Choose one of the companies which are in the top three most represented industries in your asset allocation. Which are these most-weighted industries and what are your weights. How can you see their holdings? Which company did you choose? What motivated your choice at this point, i.e. prior to any quantitative analysis?(40min)
- Plot the returns of your stock agains the market returns. Your x-axis will represent the market return and your y-axis will represent the stock's return. It will be a scatter plot similar to the Bloomberg page BETA. (30min)
- Perform an Ordinary Least Squares (OLS) regression of your individual stocks' returns on the market return. Write the equation for this regression. (50min)
- Describe the regression estimates (intercept and beta) and what they mean. (30min)
- Using the intercept and beta coefficients, plot the regression line on the same graph that you created to depict the stock and market returns. What is this line called, and what does it show?(30min)
- In Bloomberg, find the beta of the stock (use the function BETA). Compare the Bloomberg estimate to your estimate of beta. Why are they different? How do they compare to the beta estimate provided by Google finance or any other internet source (i.e. cnbc.com)? (40min)
- Using the market mean (to proxy for the market expected return) you computed in (1) above, your regression coefficients, and your estimate of the risk-free rate, determine what the required rate of return is for the stock. (30min)
- In Bloomberg, find what the expected return for the market is, based on the Bloomberg analysis tools. Hint: Use EQRP. Using the EQRP function in Bloomberg to obtain the expected return on the market and your beta, what is the required return on the stock? Finally, using the Bloomberg beta, what is the required return on the stock? If you do not have access to Bloomberg, see if public sources offer estimates or the market risk premium, otherwise use the average market excess return from the past 20 years. (40min)
- On a new graph, plot the SML. Using your beta estimate, add your stock on the SML line. (30min)
- Using the expected return for the market provided, by Bloomberg, and your beta, what is the risk premium and the required return of your stock? What is the average returns based on your sample? Assuming that the sample average is your expected return value, compare it to the required return provided by the CAPM. Add the point for the expected return on the stock on the graph with the SML. Is it above or below the SML, i.e. is this stock undervalued or overvalued? (50min)
- Replicate the Bloomberg DDM model for your stock. Click here to view the DDM user guide provided by Bloomberg. Compare the Bloomberg DDM's IRR with the Bloomberg required return. Is the stock undervalued or overvalued? What other comparison from the Bloomberg DDM can you make to determine that? (120min)
- Present your stock picks. Which of the stocks populating the DJIA should be included in the asset allocations which you computed in Unit 2? Which stocks should be excluded? Once you have your asset allocation and stock selection, construct your portfolio. What is the weight of each stock in it? (40min)