Choose any three stocks from the S&P/ASX 20 Constituents (Links to an external site.) that you like. Make sure that the three stocks you chose are in different industries. Assume that the risk-free rate is 3% per year. Consider the following:
Go to Yahoo Finance (Links to an external site.) and download their daily historical adjusted closing prices from November 2020 to October 2021. Make sure that you use the adjusted close price (click here for an example), as it incorporates dividends and stock split. Based on the daily adjusted closing prices, calculate the daily average returns, standard deviations, and correlations among these three stocks during the same period. Annualize the daily returns and standard deviations and consider them along with the correlations as your parameters to be used in your efficient diversification below. (8 marks)
Based on the following 21 combinations of portfolio weights, calculate each of the 21 combination portfolios’ returns, standard deviations, and Sharpe ratios. This is known as the opportunity set. Based on your findings, identify the minimum variance portfolio and the tangent portfolio. Be as exact as you can. (12 marks)
Combination Weight in Stock A Weight in Stock B Weight in Stock C
1 1 0 0
2 0.8 0.2 0
3 0.6 0.4 0
4 0.4 0.6 0
5 0.2 0.8 0
6 0.8 0 0.2
7 0.6 0 0.4
8 0.4 0 0.6
9 0.2 0 0.8
10 0 0 1
11 0 1 0
12 0 0.8 0.2
13 0 0.6 0.4
14 0 0.4 0.6
15 0 0.2 0.8
16 0.2 0.6 0.2
17 0.2 0.4 0.4
18 0.2 0.2 0.6
19 0.4 0.2 0.4
20 0.2 0.4 0.2
21 0.6 0.2 0.2
After identifying the tangent portfolio, plot the capital allocation line (CAL). Briefly explain the implication of your CAL, using numbers and values created from your findings above. (6 marks)
Would you consider your CAL the best achievable risk-reward combination? Suggest a number of industries/asset classes that you think would further enhance your risk-return tradeoffs. Be specific to the context and refer to the firms you chose above. Explain what would happen to your opportunity set and CAL if you are able to identify industries/asset classes that can improve the risk-return tradeoff. (4 marks)
