The Four Asset Classes

What are The four asset classes? Explain.

 

1. The four asset classes are:Shares: These instruments represent ownership in the company. Exchange of shares (Buying or selling) takes place on the stock exchange(Colonial First State Investments Limited, 2016). These are volatile assets with medium to high risk characteristics. Also, the average returns are also high. As you can see the returns are negative for certain years so they are to be dealt with carefully and proper study of the stock based on fundamentals and technical.
   1. Bonds: These are the least risky assets and the returns are also low. But these are more risky than the government bonds. These provides regular fixed payments (Coupon bonds) or a lump sum amount at maturity (zero-coupon bonds).
   2. Cash: The investment in instruments like bank bills and similar other securities is referred to as cash. These are highly liquid assets which are less risky than shares. They provide low risk income which is quite stable and is similar to regular interest payments.(Colonial First State Investments Limited, 2016)
   3. International Shares: These are the listed shares of the companies of other countries. As the performance of these shares is dependent on the performance of these companies in their respective economies, hence these are less affect by the Australian economy. International shares expands the ambit in terms of geographies and companies where the investment can be made. However, the performance is highly affected by the changes in the currency exchange rate and hence are highly volatile(Colonial First State Investments Limited, 2016).

Table 1:

Year	Australian Shares % return (ex dividends)	Australian Bonds % return	Cash Rate % average return	International Shares % return
1990	-20.1%	12.1%	14.8%	-18.7%
1991	22.2%	9.4%	10.3%	16.0%
1992	-6.0%	8.9%	6.5%	-7.1%
1993	39.1%	6.7%	5.1%	20.4%
1994	-9.2%	10.0%	5.4%	3.4%
1995	16.5%	8.2%	7.5%	18.7%
1996	7.2%	7.4%	7.0%	11.7%
1997	7.9%	6.1%	5.4%	14.2%
1998	7.7%	5.0%	5.0%	22.8%
1999	13.5%	7.0%	4.8%	23.6%
2000	2.9%	5.5%	6.0%	-14.1%
2001	2.6%	6.0%	4.9%	-17.8%
2002	-9.6%	5.2%	4.6%	-21.1%
2003	8.7%	5.6%	4.8%	30.8%
2004	22.8%	5.3%	5.3%	12.8%
2005	15.7%	5.2%	5.5%	7.6%
2006	19.8%	5.9%	5.8%	18.0%
2007	17.9%	6.3%	6.4%	7.1%
2008	-45.8%	4.0%	6.6%	-42.1%
2009	34.1%	5.7%	3.2%	27.0%
2010	2.2%	5.5%	4.4%	9.6%

 Arithematic mean, geometric mean and standard deviation are as under

Arithmetic Mean (AM)   Australian Shares 7.1% Australian Bonds 6.7% Cash Rate 6.2% International Shares 5.8%

Geometric Mean (GM)   Australian Shares 7.7% Australian Bonds 7.0% Cash Rate 6.0% International Shares -17.8%

Standard deviation (σ)   Australian Shares 18.7% Australian Bonds 2.0% Cash Rate 2.4% International Shares 19.0%

As it can be seen from the AM, GM and standard deviation, Australian bonds are least risk and with minimum return, while Australian shares are most risky and with highest return. Geometric mean has been calculated using the GEOMEAN function in excel. Standard deviation has been calculated using STDEV function in excel.

Correlation matrix	Australian Shares	Australian Bonds	Cash Rate	International Shares
Australian Shares	1.00	(0.09)	(0.31)	0.81
Australian Bonds	(0.09)	1.00	0.74	(0.02)
Cash Rate	(0.31)	0.74	1.00	(0.30)
International Shares	0.81	(0.02)	(0.30)	1.00

 

Covariance matrix	Australian Shares	Australian Bonds	Cash Rate	International Shares
Australian Shares	0.033469	(0.000335)	(0.001340)	0.027664
Australian Bonds	(0.000335)	0.000373	0.000342	(0.000058)
Cash Rate	(0.001340)	0.000342	0.000568	(0.001317)
International Shares	0.027664	(0.000058)	(0.001317)	0.034428

Correlation and Covariance matrix has been computed using the CORREL and COVAR functions in excel.

For constructing the efficient frontier with three assets it has been assumed that short sales are not allowed. Solver has been used to determine the weights of the three assets in the portfolio. The standard deviation has been minimized for certain return value such that the sum of the weights is 100%.

		Efficient frontier with three assets
	S. No.	portfolio return	W1(australian shares)	W2(australian bonds)	W3(Cash Rate)	variance of portfolio	Portfolio standard deviation (σ)	Return
		Minimum Variance portfolio	2.68%	75.04%	22.28%	0.03%	1.864%	6.60%
	1	6.61%	2.65%	76.58%	20.78%	0.03%	1.864%	6.61%
	2	6.62%	2.60%	78.45%	18.95%	0.03%	1.864%	6.62%
	3	6.63%	2.56%	80.32%	17.12%	0.03%	1.865%	6.63%
	4	6.64%	2.52%	82.19%	15.29%	0.03%	1.867%	6.64%
	5	6.65%	2.48%	84.06%	13.46%	0.03%	1.869%	6.65%
	6	6.66%	2.44%	85.93%	11.64%	0.03%	1.871%	6.66%
	7	6.67%	2.39%	87.79%	9.81%	0.04%	1.873%	6.67%
	8	6.68%	2.35%	89.66%	7.98%	0.04%	1.876%	6.68%
	9	6.69%	2.31%	91.53%	6.16%	0.04%	1.880%	6.69%
	10	6.70%	2.27%	93.40%	4.33%	0.04%	1.884%	6.70%

 Let 5 be the efficient portfolio

Return of portfolio		6.65%
Standard of portfolio		1.869%
Risk free rate		6.40%
weight of risky portfolio	combination return		Standard deviation
0	6.40%		0.000%
0.1	6.43%		0.187%
0.2	6.45%		0.374%
0.3	6.48%		0.561%
0.4	6.50%		0.747%
0.5	6.53%		0.934%
0.6	6.55%		1.121%
0.7	6.58%		1.308%
0.8	6.60%		1.495%
0.9	6.63%		1.682%
1	6.65%		1.869%

 Efficient frontier with four assets

Efficient frontier with four assets
portfolio return	W1 (australian shares)	W2 (australian bonds)	W3 (Cash Rate)	W4 (international Shares)	variance of portfolio	Portfolio standard deviation (σ)	Return
Minimum Variance portfolio	3.093%	76.156%	21.286%	-0.535%	0.035%	1.863%	6.614%
6.49%	2.349%	56.081%	40.645%	0.925%	0.036%	1.886%	6.490%
6.50%	2.409%	57.704%	39.080%	0.807%	0.035%	1.882%	6.500%
6.51%	2.469%	59.326%	37.516%	0.689%	0.035%	1.879%	6.510%
6.52%	2.529%	60.949%	35.951%	0.571%	0.035%	1.876%	6.520%
6.53%	2.590%	62.571%	34.387%	0.453%	0.035%	1.874%	6.530%
6.54%	2.650%	64.193%	32.822%	0.335%	0.035%	1.871%	6.540%
6.56%	2.770%	67.438%	29.693%	0.099%	0.035%	1.867%	6.560%
6.57%	2.830%	69.060%	28.129%	-0.019%	0.035%	1.866%	6.570%
6.58%	2.890%	70.683%	26.564%	-0.137%	0.035%	1.865%	6.580%
6.59%	2.951%	72.305%	25.000%	-0.255%	0.035%	1.864%	6.590%
6.60%	3.011%	73.927%	23.435%	-0.373%	0.035%	1.863%	6.600%
6.61%	3.071%	75.550%	21.871%	-0.491%	0.035%	1.863%	6.610%
6.62%	3.131%	77.172%	20.306%	-0.609%	0.035%	1.863%	6.620%
6.63%	3.191%	78.794%	18.742%	-0.727%	0.035%	1.863%	6.630%
6.64%	3.252%	80.416%	17.178%	-0.846%	0.035%	1.864%	6.640%
6.65%	3.312%	82.038%	15.613%	-0.964%	0.035%	1.865%	6.650%
6.66%	3.372%	83.661%	14.049%	-1.082%	0.035%	1.866%	6.660%
6.67%	3.432%	85.283%	12.484%	-1.200%	0.035%	1.868%	6.670%
6.68%	3.492%	86.906%	10.920%	-1.318%	0.035%	1.870%	6.680%
6.69%	3.552%	88.528%	9.355%	-1.436%	0.035%	1.872%	6.690%
6.70%	3.613%	90.150%	7.791%	-1.554%	0.035%	1.874%	6.700%

Effect of fiscal and monetary policy on the economy

Fiscal policy are the measures taken by the government to affect the supply of goods and services. Monetary policy are the measures taken to affect the money supply and interest rates. Monetary policy changes are generally taken by the central bank. These measures can be contractual and expansionary. For example if the government wants to increase the GDP, it will increase the spending in goods and services which increases demand. Increased demand causes companies to increase supply which improves employment (Grimsley, 2016). Increased employment increase the per capita income and also private consumption. In terms of fiscal policy, if the central bank reduces the interest rates the money supply increases which increase private consumption and the demand goes up. As the demand goes up and with limited supply in the short run, the prices go up and the inflation increases. In the long run, the firms are able to increase the supply of goods and services (Dornbusch, Fischer, & Startz, 2011). Aggregate demand AD is given by AD = C + G + I + NX. Where C is private consumption, G is government expenditure, I in investment and NX is net of exports and imports. As expansionary fiscal policy is followed, government expenditure increase and thus AD increases. As expansionary monetary policy is followed, money supply increases in the market thus increasing the private consumption and thereby increasing the aggregate demand (Investopedia, 2016).

Stock price (S0)	39
Exercise price (X)	35
Interest rate ( r )	5.30%
time to expiration (T)	0.5
Standard deviation (σ)	30%

	(ln(S0/X)+(r+σ^2/2)T)/(σ√T)	=0.741112
d2=	d1-σ√T	= 0.52898
N(d1)=	0.760737504		N(-d1)=		0.229338
N(d2)=	0.70152708		N(-d2)=		0.298473

 

Call option Price, C=	N(d1)S0 - X(e^(-rT))N(d2)
	5.76
Put option price, P=	-N(-d1)*S0 + X(e^(rT)N(-d2)
	1.23

	Contract size			100
	Initial margin			10%	= $11979
	Maintenance margin			5%	= $5989.5
Day		Trade Price($)	Futures Price (US dollar per ounce)		Daily gain($)		Cumulative gain($)	Margin account balance($)	Margin call($)
8-Feb-2016		1197.90						11979
9-Feb-2016			1198.70		80.00		80.00	12059.00
10-Feb-2016			1194.70		-400.00		-320.00	11659.00
11-Feb-2016			1247.90		5320.00		5000.00	16979.00
12-Feb-2016			1239.10		-880.00		4120.00	16099.00
15-Feb-2016			1239.10		0.00		4120.00	16099.00
16-Feb-2016			1207.90		-3120.00		1000.00	12979.00
17-Feb-2016			1211.10		320.00		1320.00	13299.00
18-Feb-2016			1226.10		1500.00		2820.00	14799.00
19-Feb-2016			1230.40		430.00		3250.00	15229.00
22-Feb-2016		1209.50			-779.50		2470.50	17699.50

 Basis risk is the risk that the price of the future contract does not move in line with the underlying and thus the price changes are not exactly in opposite direction. It may arise:

1. If the asset to be hedged is not exactly same as the futures contract’s underlying asset
2. There is uncertainty on the part of the hedger on the date of buying or selling the asset
3. Futures contracts may be closed before the delivery date(C.Hull, 2012)

It is defined as:

Basis risk = spot price of the asset – futures price of the contract

Difference between Options and future

The main difference lies in the obligation of execution. In options, the parties does not have the obligation to buy (or sell) the underlying assets where as in case of futures the parties are obliged to buy (or sell) the underlying assets (Difference between options and futures - Option Trading FAQ, 2016).

A futures contract can be entered into without any upfront cost while in case of options there is upfront premium that is to be paid.

The size of underlying is generally very large in case of futures as compared to options (C.Hull, 2012).

Portfolio performance data
	Fund	Portfolio	Market
Average return	x	12%	8%
Beta	β	1.15	1
Standard deviation	σ	33%	25%
tracking error	σ( e)	14%	0

 

Sharpe ratio(portfolio)=	(Rp-Rf)/σp	0.19697
Sharpe ratio(Market)=	(Rm-Rf)/σm	0.1
Treynor measure=	(Rp-Rf)/βp	0.056522
Jensen's Alpha=	Rp-(Rf + βp(Rm-Rf))	0.03625
Information ratio=	(Rp-Rm)/σ( e)	0.285714
M2 measure=	Rf + (Rp-Rf)*(σm/σp)	0.073939

As the Sharpe ratio of the portfolio is more than the market, it is outperforming the market.

References

C.Hull, J. (2012). Options, Futures, And Other derivatives. New York: Prentice Hall.

Colonial First State Investments Limited. (2016, June 10). Investment asset classes: Cash, fixed interest, property and shares :: Colonial First State. Retrieved from Colonial First State: https://www3.colonialfirststate.com.au

Difference between options and futures - Option Trading FAQ. (2016, 06 07). Retrieved from The Options Guides: www.theoptionsguide.com

Dornbusch, R., Fischer, S., & Startz, R. (2011). Macroeconomics. New York: McGraw-Hill.

Grimsley, S. (2016, June 10). How Fiscal Policy and Monetary Policy Affect the Economy. Retrieved from Study.com: https://www.study.com

Investopedia. (2016, June 10). How do fiscal and monetary policies affect aggregate demand? Retrieved from Investopedia: https://www.investopedia.com