Home Country-Bias, Investment Strategy GMM - Assignment Example

Topic: Applied Portfolio management Student’s name Instructor’s name 10the June 2011 Question one a) Geometric mean maximization is the portfolio selection criterion that consists of maximization of invested capital growth and maximizing terminal wealth. b) As gambling strategy GMM criterion originated with Kelly (1956) in his analysis of a gambler’s optimal strategy of betting with private information. Kelly considered a gambler with noisy or (without certain) private information. Such a gambler made numerous bets with cumulative effects, that is, the gambler reinvested his losses and gains and each round he betted a constant proportion of his capital. The question that gave rise to GMM criterion was how much the gambler was supposed to bet is his aim was to maximize his expected terminal wealth? c) As an investment strategy GMM criterion originated with Latane (1959) who sought to determine how an individual making rational choices under uncertainty would maximize his expected terminal wealth. d) The connection between GMM criterion and the expected utility maximization arises when the underlying function of utility is logarithmic which means that the utility function must bear the property of showing decreasing risk aversion features. e) The first argument for GMM criterion is that it has the highest probability of leading to more wealth at the end of a large number of cumulative and uncertain decisions. The argument against GMM criterion was that maximizing geometric mean return is not the same as maximizing expected utility. f) One of the empirical literature on GMM criterion is that it is statistically indistinguishable from the portfolio in the market. The other empirical literature on GMM criterion is that just like SRM criterion GMM criterion does not produce highly diversified portfolio. Question two a) Hong and Stein (199) identify the following criteria for an acceptable behavioural model of asset prices. First, behavioural model of asset prices should rest on the assumption about the behaviour of the investor that are consistent or priori plausible with causal observation. Second, it should provide an explanation of the existing evidence in a unified and parsimonious way. Third, it should make a number of further predictions which can be ultimately validated and tested. b) “Boundedly rational” means that each of the two agents “newswatchers” and the “momentum traders” is only able to gather or process some segment of public information available to them. c) The “news-watchers” make their forecasts based on private observable signals about fundamentals of the future. Momentum traders condition themselves on changes in past prices. “Momentum traders” use the information on changes in prices in the past while the news-watchers use the information on future fundamentals. d) The other model assumption made by Hong and Stein (1999) is that overreaction and underreaction are unified in the sense that the existence of underreaction sows the seeds for overreaction by making it profitable for momentum traders to enter the market. e) When only “news-watchers” are active prices never overshoot their long run value which means that at nay horizon there is never any negative serial correlation in returns. f) When both agents are active, prices respond positively to new information by shooting up because the newswatchers buy more aggressively knowing that new information would bring in a new series of momentum traders. g) The phenomenon is explained by considering two different proxies for the rate of diffusion of information, that is, by considering the size of the firm and second with respect to residual coverage by analyst. Question three a) Home country-bias is the tendency where investors prefer to invest only at home or in their home country by ignoring any opportunities of investments in foreign countries. b) Efficient market hypothesis holds that financial markets are “efficient informationally” (Fama & French, 1992). In this regard, the home-country bias has the implications in efficient market hypothesis because investors feel comfortable investing in companies they have adequate information about. Hence, investors prefer financial markets with efficient information which means that investors prefer home companies which they have information about. c) “The home-country bias is a consequence of national boundaries”. This statement arises from the fact that when capital crosses monetary and political boundaries it faces fluctuations in exchange rates, regulation variation, variation in taxation and culture as well as exposure to sovereign risk. In order to avoid all such situations investors prefer investing at home where all the above situations do not arise. d) “The home-country bias results from a preference for geographic proximity”. This statement arises from the fact that investors may prefer investing in local companies of firms they have information about or having the desire to invest in firms that directly relate to the community. e) The data used by Coval and Moskowitz (1999) to test whether investors exhibit a preference for local stocks include tax considerations, liquidity as well as risk and return of investments. The model used is the Capital Asset Pricing model (CAPM). (Coval and Moskowitz, 1999). f) The empirical results from their study is that in terms of percentage managers invest in securities that are 9.32% to 11.20% closer to them than the average security in their benchmark portfolio (Coval and Moskowitz, p. 2056). Question four a) Diagram of momentum life cycle hypothesis (Lee and Swaminathan, 2000). High volume stocks High volume winners’ High volume losers Winners Losers Low volume winners Low volume losers Low volume stocks b) The diagram presents the interaction between reversals, price momentum and volume of trading one framework. The hypothesis above holds that periods of investor neglect and favouritism are experienced by stocks (Lee and Swaminathan, p.2064).On the left half of the cycle is found the stock with positive momentum of earning. On the right half of the cycle is the stock with negative momentum of earning. Positive news makes the growth stock to move up the cycle. c) According to Lee and Swaminathan (2000) intermediate horizon under reaction is the period here prices overact initially and to fundamental news and move further away before reverting ultimately to fundamentals (Lee and Swaminathan, p. 2062). Long-horizon over-reaction. At intermediate horizon, momentum profits are higher among high volume stocks (p.2063). Long-horizon over-reaction refers to the trend where more momentum traders enter into the market initial under –reaction experienced in the presence of newswatchers alone turns into overreaction. d) One of the implications the MLC hypothesis have for EMH is that trading volume may provide information useful in locating a given stock in its momentum life-cyle. The type of EMH affected is the investor’s disagreement about the intrinsic value of a stock. e) In order to exploit MLC I would trade as a high volume winner at late stage because I would enjoy favourable prices presently anticipating for stock price reversals in the future. Question five a) Book value to market value ratio of a stock is the indicator of the orientation of a portfolio towards value or growth. b) BV/MV ratio can be used to discriminate between value stocks and growth stocks through exploring the stocks with a high BV/MV ratio. Such stocks are more prone to financial distress and they are riskier than glamour stocks. Growth stocks have a high BV/MV ratio and hence riskier investments while the value stocks have a low BV/MV ratio and thus less risky. c) Value premium is the artefact of data snooping (Fama and French, 1996.p. 85).According to the authors value premium poses a tougher challenge and in this respect two features of value investing distinguish it from other plausible anomalies. The value premium, however, can be tied to ingrained patterns of the behaviour of the investors or the incentives of professional investment managers. d) Chan and Lakonishok (2004) falsify this hypothesis by providing some evidence of the existence of extrapolative biases in the pricing of value and glamour stocks (Chan and Lakonishok, p. 77). The common presumption was that BV/MV is a measure of a company’s future growth opportunities relative to its accounting value. Accordingly, the authors held that low BV/MV suggests that investors expect high future growth prospects compared with the value of assets in place (Chan and Lakonishok, p. 77-78). If these expectations are correct a negative association should exists between BV/MV and growth realized in the future. (Chan and Lakonishok, p.78) Hence, the authors falsified the hypothesis by ranking stocks by growth as a way of achieving high returns using he BV/MV ratio. Question six a) Solnik (1974) found out that the risk of a portfolio unprotected against exchange risk is larger than for a covered portfolio and thus international diversification is less desirable because it is unprotected against exchange risks as compared to industry diversification (Solnik, p. 52) b) Some of the risk associated with international diversification includes institutional, political and psychological risks (p. 48). Fluctuations in prices represent only part of a total risk of a foreign investment (p. 48). Fluctuations in prices are brought largely by exchange risks particularly in the cotemporary days when instability characterises international money (p. 49). The other risk associated with international diversification is the fear that some countries might unexpectedly impose exchange controls freezing any form of capital invested which might lead to huge losses to foreign investors (p.50). c) The model developed by Cavaglia, Brightman and Aked (2000) for determining the relative importance of country and industry factors in driving security returns is the factor model which focuses on the country and industry characteristics of asset returns (Cavaglia, Brightman and Aked, 2000, p. 45). The model comprised of excess return on security at any given time, the global factor return common to all securities determined at time t, factor return on industry (sector) and factor return on country (Cavaglia, Brightman and Aked, p. 44). All these components of the model were added together to determine the relative importance of country and industry factors in driving security returns. d) The empirical findings from the study carried out by Cavaglia, Brightman and Aked, 2000) revealed that an alternative way of examining the gains from diversifying by industry and by country considers exploiting the factor structure of equity returns (p. 42). The model estimated by the authors indicated that both the volatility and the return of securities vary by country and by industry (p. 43). Portfolios that aim to maximize the Sharpe ratio was thus found to reflect the return-to-risk trade-offs of alternative strategies (p.44). The other finding from the study was that the time series of factor returns can be used to measure the opportunities for outperforming the word index with systematic industry or country tilts (p. 45). The authors observed that factor-model estimates can also be used to draw inferences about the relative merit of international diversification by industry and by country (p. 46). References Kelly, John (1956). “A New Interpretation of Information Rate.” Bell System Technical Journal,35, 917-926. Latane, Henry (1959). “Criteria for Choice among Risky Ventures.” Journal of Political Economy, 67, 144-155. Hong, H., and Stein, J. (1997). A unified theory of underreaction, momentum trading and overreaction in asset markets, NBER Working paper #6324. Fama E, French K. (1992). The Cross-Section of Expected Stock Returns. Journal of Finance 47:427-465. Coval, J. & Moskowitz, T. (1998). The geography of investment: informed trading and asset prices, CRSP working paper. Chicago: University of Chicago. Lee, M., & Swaminathan, J. (1999). What is the intrinsic value of the Dow? Journal of Finance 54, 1693–1741. Chan, K. and Lakonishok, J. (2004). Value and growth investing: Review and update. Financial analysis journal, 71-84. Solnik, H. (1974). Why not diversify internationally rather than domestically? Financial analyst journal, vol. 30. 48-52. Cavaglia, J., Brightman, C and Aked, M. (2000). The Increasing Importance of Industry Factors, Financial analyst journal, vol. 56, p. 41-54. Read More