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June 2011
Abstract
As global markets are flooded by fiat currencies since the discontinuation of Bretton Woods by Nixon in 1971, we seek to identify the optimal alternative portfolio by applying financial theory, primarily CAPM and statistical measurements. The alternative portfolio constructed consists of precious metals, foreign exchange rates, commodities and stock indices measured with prices on a monthly basis. During the time period 1971-2011 precious metals and oil displayed high returns and risk levels while foreign exchange rates provided very little return but low risk. The designed optimal risky portfolio outperformed all other assets on a risk-return basis with a return of almost two percent per month on average with a volatility level of ten percent. In addition this portfolio provided the investor with a significant alpha return on average 1,2% every month. Thus any arbitrary risk-willing rational U.S. investor would choose to passively invest in the optimal risky portfolio between 1971 and 2011. Furthermore we identified strong linear relationships in the foreign exchange rates.
Keywords: CAPM, Quantitative Analysis, Market Portfolio, Bretton Woods, Gold, Silver, Bear Market, Bull Market, Fiat Money, Foreign Exchange Rates, Correlation and Alternative Historical Investments. JEL Classification: G10 & G11. 2
Acknowledgments
Lars-Gran Larsson: For steering us in the right direction and for his excellent support. Joakim Lennartsson, Librarian at the Economics Library, Gothenburg: For pinpointing essential databases, saving a lot of time. Dr. Jianhua Zhang, University of Gothenburg: For help during labs in Portfolio Investments. Federal Reserve Bank of St. Louis: For providing excellent, easy to use data. Federal Reserve Board of Governors: For providing excellent, easy to use data. Dow Jones: For providing excellent, easy to use data. Thomson Reuters: For providing us with easy to access data.
Table of Contents
Post Bretton Woods study of an alternative efficient portfolio using CAPM. ........................................ 2 Abstract ................................................................................................................................................... 2 Acknowledgments ................................................................................................................................... 3 Introduction............................................................................................................................................. 5 Background.......................................................................................................................................... 5 Aim of thesis ........................................................................................................................................ 6 Limitations and demarcations of study ............................................................................................... 6 Methodology ........................................................................................................................................... 6 Literature Review .................................................................................................................................... 7 Capital Asset Pricing Model (CAPM).................................................................................................... 7 Assumptions of CAPM ..................................................................................................................... 7 Criticisms and limitations to CAPM ................................................................................................. 7 Expected return ................................................................................................................................... 8 Risk level & Beta-value ........................................................................................................................ 8 Financial ratios .................................................................................................................................... 9 Jensens alpha.................................................................................................................................. 9 Variance & Covariance Matrix (VCM) & Correlation Matrix ............................................................... 9 Minimum Variance Portfolio (MVP) .................................................................................................... 9 Optimal Risky Portfolio (ORP).............................................................................................................. 9 Capital market line (CML) .................................................................................................................. 10 Data ....................................................................................................................................................... 11 Stock indices ...................................................................................................................................... 11 Dow Jones Industrial Average ....................................................................................................... 11 S&P 500 COMPOSITE - PRICE INDEX (U$) ...................................................................................... 11
Commodities ..................................................................................................................................... 12 Gold Bullion LBM (U$ per Troy ounce) .......................................................................................... 12 Silver Fix LBM (U$ per Troy ounce) ............................................................................................... 12 Oil Spot Price: West Texas Intermediate (U$ per barrel) .............................................................. 12 Wheat U.S. Cash price at principal markets (U$ per bushel) ........................................................ 12 Foreign exchange rates ..................................................................................................................... 13 Foreign exchange rate JPY/USD .................................................................................................... 13 Foreign exchange rate CHF/USD ................................................................................................... 13 Foreign exchange rate GBP/USD ................................................................................................... 13 Interest rates ..................................................................................................................................... 14 3 Month U.S. Treasury (risk free rate) ........................................................................................... 14 Results ................................................................................................................................................... 14 Return and risk .................................................................................................................................. 14 Historical returns ........................................................................................................................... 15 VCM & Correlation Matrix ................................................................................................................. 17 Portfolios ........................................................................................................................................... 17 Financial ratios .................................................................................................................................. 18 Summary and conclusions ..................................................................................................................... 20 Summary ........................................................................................................................................... 20 Conclusions........................................................................................................................................ 20 Suggestions for further studies ......................................................................................................... 21 Bibliography........................................................................................................................................... 22 Literature: .......................................................................................................................................... 22 Web & Data Sources:......................................................................................................................... 22 Tables .................................................................................................................................................... 23
Introduction
As global markets are flooding in paper currencies without real backing, so called fiat currencies, since the end of Bretton Woods by Nixon in 1971 we seek the optimal historical alternative portfolio by applying financial theory and statistical modeling. The alternative portfolio constructed consists of precious metals, foreign exchange rates, commodities and stock indices.
Background
From the beginning of time the main fuel for the global economy has been trade. In order for trade to occur exchanges of goods and/or services must take place. Historically an advanced trading environment without bartering requires a monetary medium to enable price discovery and liquefy the market. Thus facilitating trade of goods and services requires a monetary medium that grants its holder future value, i.e. purchasing power when traded for e.g. a good. Evidently the currency must be limited if not scarce and universally tradable with perpetual demand if it should be able to store purchasing power over time. Presently the financial world is in disarray with governments and large institutions receiving tremendous amounts of credit and bailouts with huge deficits as a result. The current monetary regime began after the Nixon shock in 1971 when the U.S. discontinued the redeemability of an American dollar into gold, thus formally ending the dollars scarcity as the Bretton Woods treaty ended. As money supply increased over time through quantitative easing, credit growth and deficit spending, financial markets developed and prices adjusted thus potentially weakening the currencys confidence - the ability to store value. Historically, gold and other precious metals have been safe storages of value. Though they offer no interest in return their inherent scarcity and high demand in combination with global confidence provides stable purchasing power over time.
Since 1971 the money supply, measured by M2 Money stock, as depicted above increased over 1800%, thus indicating an enormous increase in the supply of U.S. Dollars in circulation. This measure 5
includes a broader set of financial assets held principally by households. (M2 | Federal Reserve Bank of St. Louis, 2011) In modern times an Investor has vast amounts of investment opportunities available and it has never been easier to invest in different securities, e.g. stocks, indices, bonds, commodities and foreign exchange rates. Therefore the purpose of this thesis is to evaluate portfolio allocations from the discontinuation of Bretton Woods in order to maximize return and optimize risk exposure for an arbitrary rational risk-willing U.S. investor.
Aim of thesis
The objective is to evaluate portfolio allocations between 1971 and 2011 in order to maximize return and optimize risk exposure for an arbitrary rational risk-willing U.S. investor with hindsight, given the plethora of investment opportunities available to investors today.
Methodology
Being financial students at the Economics department at the School of Business, Economics and law grants us theoretical insights and understanding of portfolio theory and its practical applications. Courses, such as econometrics and portfolio investments have been undertaken adding further knowledge and a deeper interest of finance. Skills acquired include financial analysis using e.g. CAPM, calculating and analyzing various financial/statistical key performance indicators. Thru financial quantitative analysis on the empirical data acquired for all of the selected investments, ranging from indices to precious metals and global currencies. The objective is to reveal the historically optimal risky portfolio. Applying financial theory, primarily the CAPM model, and statistical methods will enable the calculation of the optimal risky portfolio. Accordingly performed by solving for the maximal return in relation to risk exposure, as found in the modern portfolio theory. In addition the minimum variance portfolio, i.e. the portfolio with maximized diversification effect, will also be solved for in order to find the efficient frontier of the portfolio and thus enabling valuations with the benchmark market via the capital market line. All calculations will be performed by using spreadsheet programming in Microsoft Excel with the analysis toolpak kit and the solver add-in for statistical calculation respectively for finding the optimal portfolio weightings. Ultimately this analysis will result in an optimal risky portfolio, revealing how an U.S. investor should 6
have passively invested since the U.S. discontinued the monetary system Bretton Woods in order for the rational risk-willing investor to maximize return in terms of risk.
Literature Review
The analysis will be based upon the CAPM model. This model was developed by Sharpe, Lintner and Mossin in several articles published in 1964, building on Markowitz foundation of modern portfolio theory from 1952. (Bodie, 2008)
Assumptions of CAPM
Perfect competition exists, i.e. investors are price-takers, none of the individual investments affect security prices All investments are held for identical time periods There are no transaction costs or taxes Investors are able to borrow and lend at the risk-free rate Identical information and expectations for all investors, e.g. same probability and variance Investors are risk-averse Assets are infinitely divisible Investors are mean variance optimizers
Criticisms and limitations to CAPM Due to the several assumptions behind CAPM it has naturally been challenged and criticized for not being a model holding up to the scrutiny of the real world, as the assumptions are almost impossible for the real market to fulfill. E.g. it does not account for interest rate risk, counter-party risk, transactional costs or inflationary effects. Consequently CAPM has been vigorously tested by researches since its inception and inconsistent results have been acquired. Using data from 1930 - 1960 evidence was found that suggested that the average return of a portfolio was positively linked to its beta. On the contrary, Farma and French found no relationship between average return and beta while analyzing a dataset over the period 1963-1990. (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2009) Ultimately the CAPM model can provide a good benchmark if investors hold highly diversified portfolios with mostly passive investments assuming that correlations between assets remain fixed.
Therefore the selected time period is of utmost importance in order to create a reliable model.
Expected return
In order to properly evaluate an asset the actual return has to be calculated. It is calculated by taking the difference in price 2 consecutive periods and put it in relation to the former period, thus resulting in the nominal return. Forecasting the expected return for an arbitrary period is calculated by the average return of all return datasets for each asset. (Bodie, 2008)
Beta depicts the relationship of the asset or portfolio with the market as a whole. It measures the variance that cannot be removed by diversification, i.e. the systemic risk. (Hillier, Ross, Westerfield, Jaffe, & Jordan, 2009)
Financial ratios
A key feature in measuring risk-return ratios is by measuring how much an extra unit of excess return will cost in terms of added risk for that very asset. Two major ratios are used; The Sharpe ratio measures risk by the standard deviation of the asset, the Treynor ratio uses the systematic risk, the assets beta as the risk factor. (Bodie, 2008) A larger ratio is preferable in both cases.
Jensens alpha Alpha is a measured value of the excess return for a portfolio given risk exposure, asset correlation and the risk free rate. Created by M. Jensen (1968) it is the main indicator of investor performance compared to market.
composite portfolio enables the construction of a portfolio efficient frontier, i.e. a linear relationship between risk and return (see figure 1). (Bodie, 2008)
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Data
The data used in this study is collected from various sources depending on the nature of the commodity. Included are four major commodities, gold, silver, oil and wheat, all whose price is denominated in U.S. dollars. As well as three of the worlds most widely traded exchange rates, the Japanese Yen, the Swiss Franc and the British Pound, all directly paired with the U.S. dollar. Also included are the assumed risk free asset, the 3-month U.S. Treasury bill and the Dow Jones Industrial Average. The selected benchmark is the S&P 500 due to its specification and linkage to high market cap equities, the largest 500 companies - thus creating a suitable proxy for the overall market. Selected data consists of monthly observations stretching 40 years from January 1971 to January 2011, with oil as an exception as oil data ranges from the end of December 1970 to the end of December 2010, which is assumed to be equal the following period (end of Dec 70 ~ beginning Jan 71). 1971 being a suitable start off point due to the U.S. suspension and later discontinuation of the Bretton Woods system where they no longer could guarantee the redeemability of a dollar into gold, i.e. the dollar became a fiat currency. (IMF, 2011)
Stock indices
Dow Jones Industrial Average The Dow Jones I. A. is one of the oldest market indices in U.S. starting as a 12-stock industrial average and currently grown to a 30-stock average consisting mostly of manufacturers of industrial and consumer goods but also companies in the entertainment and financial industry as well as companies in the information technology business. At the present time it is not calculated as a standard average but as a price-weighted average that also takes the effects of stock splits into consideration. It is the highest quoted index in all media. (CME Group Index Services, LLC, 2011) Data, monthly end prices due to limitations assumed to be same as following months start price, for the period 1970-12-31 - 2010-12-31 was acquired from CME Group. (*CME Group Index Services, LLC, 2011) S&P 500 COMPOSITE - PRICE INDEX (U$) The S&P 500 has its focus on large cap companies traded on NYSE or NASDAQ. Since 1957 it has provided a free-float capitalization-weighted index containing 500 leading U.S. companies in principal industries. It reflects approximately 75% of the U.S. equities market and is a leading barometer in the market due to its wide range of companies and sectors, not only including value stocks but also growth stocks. Due to the characteristics of the index it is the benchmark. (Standard & Poor's, 2011) Data, monthly start prices for the period 1971-01-01 - 2011-01-01 was acquired from Reuters through DataStream. (Thomson Reuters , 2011)
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Commodities
Gold Bullion LBM (U$ per Troy ounce) Gold has historically been regarded as a monetary medium and also as a safe haven for investors when times have been unstable due to economic or political uncertainty. It is a frequently traded precious metal and is sometimes almost thought of as a currency because of how it behaves in the market, i.e. as a safe storage of purchasing power. Since 1919 markets have used The London Gold Fixing as a pricing medium to price gold products and derivatives. The price is set two times a day by the five members of the London Gold Market Fixing LTD and is determined by speculation thru supply and demand in the market. (The London Gold Market Fixing Ltd, 2011) Data, monthly start prices for the period 1971-01-01 - 2011-01-01 was acquired from Reuters through DataStream. (Thomson Reuters , 2011) Silver Fix LBM (U$ per Troy ounce) As gold, silver is and has been a major tradable precious metal for investors for a very long time. It usually tracks the changes in gold price with high correlation. However, inherently it is more volatile than gold, mostly because of lower liquidity in the market. Due to lack of physical demand for the commodity, large investors and speculators are able to influence the price. The price of silver is determined almost in the same way as gold. The difference is that only three members of The London Silver Market Fixing LTD set the price, and only once every day. (The London Silver Market Fixing Ltd, 2005) Data, monthly start prices for the period 1971-01-01 - 2011-01-01 was acquired from Reuters through DataStream. (Thomson Reuters , 2011) Oil Spot Price: West Texas Intermediate (U$ per barrel) Oil has been drilled and used for centuries but it was not until the oil boom in the late 19th century that it earned the status it has today. Because of its easy transportability and high energy density it quickly became one of the most important energy sources man has come across. It is often referred to as the black gold. The three main crude oil benchmarks are West Texas Intermediate (WTI), refined in the Midwest and Gulf Coast regions, it is predominantly used in the U.S. and is the commodity underlying the oils futures price on the New York Mercantile Exchange. Brent blend found in the North Sea and mainly used in Europe and the Dubai crude extracted from Dubai. (BBC, 2007) Data, monthly start prices for the period 1971-01-01 - 2011-01-01 was acquired from the Federal Reserve Bank of St. Louis. (WTI | Federal Reserve Bank of St. Louis, 2011) Wheat U.S. Cash price at principal markets (U$ per bushel) Wheat has become one of the most important crops largely because it is easy to grow on a large scale and it is easy to store for long periods of time. The large demand for wheat has mainly come from demand of flour globally, due to increased population, but lately the main drivers of wheat prices are the increase in use of bio fuels and the increase of meat consumption in the developing world, as it requires a lot of grain to produce 1 kilogram of meat. Wheat in the commodities market is classified in many different classes, based on the quality of the grain.
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Data, monthly start prices for the period 1971-01-01 - 2011-01-01 was acquired from U.S. Department of Agriculture. In order to create a fair price, a wheat basket was constructed to provide an average price independent from quality and location in the U.S. This basket was created with equal weighting from these types of wheat: (USDA, 2011)
No. 1 hard red winter (ordinary protein), Kansas City, MO No. 1 hard red winter (13% protein), Kansas City, MO No. 2 soft red winter, Chicago, IL No. 2 soft red winter, St. Louis, MO No. 2 soft red winter, Toledo, OH No. 1 soft white, Portland, OR
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Interest rates
3 Month U.S. Treasury (risk free rate) U.S. three-month Treasury bill priced at secondary market rate on yearly discount basis in percent. In order to calculate monthly returns rates have been divided by twelve, providing a monthly return. Further divided by a 100 in order to obtain nominal return in its decimal form. (UST 3M | Board of Governors of the Federal Reserve System, 2011)
Results
Below is a presentation of relevant information and statistics extrapolated from the selected data from 1971 to 2011.
Highest returning assets are oil and silver while a dollar investment in Pound Sterling yields very little.
Regarding returns, as depicted in Figure 2 above it is clear that all selected assets display a positive average return on a monthly basis. Precious metals and oil are top performers with an approximate average return of one percent every month. Worst performer is a dollar based investment in Pound Sterling, which barely is positive and all dollar investments in foreign exchange return less than the benchmark risk free rate. Concerning risk, as measured and displayed by standard deviation in Figure 3, it can be seen that both oil and silver exhibits relatively high levels of risk. Lowest risk is achieved through dollar investments in foreign exchange rates. The risk free benchmark is close to zero, thus making that assumption plausible. Visually combining risk and return it seems that gold offers highest return per unit of risk.
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Historical returns Further analysis was performed in order to graph and outline returns over a historical perspective which has been divided into decennial data groups. As this is a mere overview we will not put any changes into a historical event perspective, as we are only interest in prices and returns.
Figure 5: Nominal returns 1971-1981, observed returns range (-50% +150%) Nota Bene: Return axis is elongated by one unit.
Figure 4 reveals an extraordinary volatility in oil and silver returns during the period 1971-1981. In addition wheat returns fluctuate heavily between 1972 and 1975. Few but very large chocks in returns over the period 1971-81.
During 1981-1991 silver returns display large bidirectional movements. Additional and similar movements can be seen in oil returns, which also are very volatile. Around 1987 a large drop (~20%) occurs on the Dow asset. During 1981-91 more frequent chocks in returns but intensities are lower than previous period. 15
Frequent moves in oil and silver similar to previous periods. Gold displays a steady trend until 1999 when returns soared to 20%. During 1991-01 more frequent chocks in return but intensities are lower than previous periods.
As previously silver and oil returns are very volatile but in addition several chocks hit wheat returns between 2002 and 2011. Also noted are two chocks to the Dow and the S&P 500 in 2001 and 2008.
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Largest variance along the diagonal above is observed for Silver and Oil, matching the visual representation in figure 3. Small covariances overall, highest are gold and silver (0,004).
CORREL. Gold Silver Dow Oil JPY CHF GBP Wheat S&P UST Gold 1,00 0,69 -0,05 0,07 0,17 0,28 -0,21 0,04 -0,01 -0,07 Silver 1,00 0,08 0,07 0,06 0,10 -0,10 0,13 0,11 -0,09 Dow Oil JPY CHF GBP Wheat S&P UST
1,00 -0,02
1,00
Confirming findings in table 2 the correlation between gold and silver reveals a strong positive linear relationship (+0,69). The Swiss Franc displays highly negative correlation with the British Pound Sterling (-0,64) but a positive correlation to the Japanese Yen (+0,58). Further findings include very strong correlation between S&P 500 and the Dow Jones (+0,90).
Portfolios
Further statistical analysis in combination with the results, included above, provides the foundation on which an efficient portfolio frontier can be calculated, by finding the optimal risky portfolio (ORP) and the minimum variance portfolio (MVP).
ORP Asset Weights E(r) Gold 1,10 1,9% Silver 0,01 Std. dev. Dow 1,07 10,0% Oil 0,45 Sharpe R. JPY -0,03 14,4% CHF -0,80
GBP -1,00
Wheat 0,20
Through solving for the maximal Sharpe ratio the optimal risky portfolio is constructed given the portfolio constraints. The resulting portfolio shorts all foreign currencies and invests heavily into gold and the Dow Jones index. Smaller positions in oil and wheat are taken as well as a very tiny position
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in silver. The ORP displays a very high return (1,9%), high risk (10,0%) with a positive Sharpe ratio (+14,4%) thus rewarding an investor for the amount of risk taken w.r.t. risk free return.
MVP Asset Weights E(r) Gold 0,01 0,3% Silver 0,00 Std. dev. Dow 0,08 Oil 0,02 1,0% Sharpe R. JPY 0,09 -16,7% CHF GBP 0,32 0,45
Wheat 0,02
By solving for the minimal standard deviation, i.e. risk, the minimum variance portfolio is constructed given the portfolio constraints. The resulting portfolio goes long in all foreign currencies, primarily in British Pound Sterling and Swiss Franc. Also the portfolio takes very small long positions in precious metals, oil, and wheat. The long position in the Dow Jones is approximately as large as the one in the Japanese Yen. The MVP displays a very small return (0,3%)and low risk (1,0%) with a negative Sharpe ratio (-16,7%). Thus not rewarding an investor for the amount of risk taken w.r.t. risk free return.
Figure 9: Efficient Portfolio Frontier & Capital Market Line (S&P 500)
Plotting the efficient portfolio frontier (EPF) demands the MVP, ORP to be constructed and other portfolios along this non-linear frontier. Consequently a comparison can be made to the capital market line (CML) which is based upon the risk-free rate (Y-intercept) and adding the market excess return (rm - rf) in relation to units of risk, i.e. standard deviation. Thus a visual analysis easily reveals that the constructed optimal risky portfolio outperforms the benchmarked index in terms of return per unit risk. However this is not true for MVP making it unattractive to any rational investor.
Financial ratios
Gold Avg. return Variance Stddev 0,9% 0,4% Silver 1,1% 1,0% Dow 0,6% 0,2% Oil 1,1% 0,9% JPY 0,3% 0,1% CHF 0,4% 0,1% GBP 0,1% 0,1% Wheat 0,5% 0,4% S&P 0,7% 0,2% UST 0,5% 0,0% (ORP) 1,9% 1,0% (MVP) 0,3% 0,0% 1,0% 0,04
6,2% 9,9% 4,5% 9,6% 2,7% 2,9% 2,5% 6,3% 4,5% 0,3% 10,0% Beta -0,01 0,23 0,90 0,06 -0,03 -0,08 -0,02 0,01 1,00 0,00 1,06 Table 6: Average return, Variance, Standard deviation and beta for all assets, benchmark, risk-free and portfolios
Calculating the average returns for both portfolio the visual analysis made in figure 8 is confirmed, the optimal risky portfolio has a, on average, monthly return of 1,9% with a risk level at 10% standard deviation and has a beta value slight above one (1.06) indicating a strong positive relationship to the 18
benchmarked index. The MVP shows low return but the lowest risk level and a beta value of 0,04 indicating very little linkage to the benchmarked index.
Gold Sharpe Ratio 7,8% Treynor Ratio -59,0% E( r ) CAPM 0,9% Silver 6,3% 2,7% Dow 4,3% 0,2% Oil 6,2% 9,3% JPY -4,3% 4,1% CHF -3,6% 1,3% GBP -13,9% 13,8% Wheat 0,9% 6,2% S&P 4,3% 0,2% 0,8% 0,0% UST 0,0% 0,0% 0,5% 0,0% (ORP) (MVP)
1,1% 0,8% 1,1% 0,3% 0,3% 0,1% 0,5% Jens. Alpha 0,5% 0,6% 0,0% 0,6% -0,1% -0,1% -0,3% 0,1% Table 7: Performance indicators for all assets, benchmark, risk-free and portfolios
From table 6 further calculations are made in order to deepen the evaluation of each asset and portfolio, resulting in the financial ratios depicted in table 7. Excess return in terms of risk is dominated by the ORP, followed by precious metals and oil. MVP and GBP underperform heavily and indicate negative risk-return relations (<-10%). Comparing the assets and portfolios on a Treynor basis, i.e. excess return in terms of beta value (benchmarked market relationship) depicts that gold has a tiny negative beta value and as such is hardly influenced by the markets, thus making the Treynor ratio somewhat inconclusive (-59%). Likewise is the situation for British Pound Sterling, which has a negative excess return and a tiny negative beta, thus also resulting in an inconclusive Treynor ratio (+13,8%). Regarding alpha profits, measured by Jensens alpha on average every month, findings are that the ORP provides a vast 1,2% alpha profits, followed by oil and silver at 0,6 %. Fourth in order comes gold with a profit of 0,5%. Worst performers are GBP at -0,3% and MVP at a slightly higher -0,2%. Wheat however provides a tiny 0,1% alpha return. None of the foreign exchange rates provide alpha profits, neither does UST nor Dow Jones. Finally, in figure 9 and 10, is a graphic representation of average returns and risk levels for all assets and both portfolios constructed within this study.
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Conclusions
The constructed optimal risky portfolio outperformed all other assets on a risk-return relationship basis with a return of almost two percent per month on average with a volatility of ten percent. Similarly it provides the highest alpha value of all securities. However, the minimum variance portfolio with the highest diversification underperformed below the set capital market line, thus making it an irrational investment choice. Therefore, any arbitrary risk-willing rational U.S. investor would choose to invest in the optimal risky portfolio, granted hindsight. Precious metals and oil all provided an investor with a high monthly return but with high risk. Especially silver displayed high volatility over time. Most probably this is associated to leveraged speculation in the precious metals market, with very little physical liquidity and very few contracts being delivered. Also these monthly returns could be related to weakening of the purchasing power of the dollar due to e.g. increases in money supply or perhaps a loss of confidence. Wheat displayed a mediocre return but exhibited as high risk as precious metals thus making this asset an irrational investment choice. An investor could however benefit from the diversification effect of investing in wheat as it has very little correlation to other assets in the portfolio set.
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Foreign exchange rates offer very small but stable returns with quite low risk levels. The Dollar has thus likely lost much purchasing power over time in the international market, when accounting for 40 years of compounding positive returns of foreign exchange rates. This could also depend on a larger money supply in the U.S. Especially the Swiss Franc has appreciated against the U.S. Dollar, gaining on average almost a half percent each month since 1971, for a total averaged return of 549% as of January 2011. The high positive correlation between the exchange rates for the Swiss Franc and the Japanese Yen could perhaps be a result from exploits of arbitrage possibilities in the interest rate and foreign exchange markets. Also, as the British Pound Sterling is not gaining as much, perhaps due to similar market conditions in the U.K. and the U.S. regarding money supply, deficits etc. Consequently, the returns could be a sign of weakening of the dollar. Furthermore when Swiss Francs and Japanese Yen appreciate against the U.S. Dollar the correlations reveal that British Pound Sterling depreciates. Also, not surprisingly, we found very high positive correlation between the benchmark S&P 500 index and the Dow Jones Industrial average, as both are major stock indices in the same market. However, reflecting over historical returns, they seem to vary in intensity and frequency over time. Hence it is questionable if the returns truly are mean variance efficient.
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Bibliography
Literature:
Bodie, Z. K. (2008). Investments (8th edition). New York: McGraw-Hill. Hillier, D., Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2009). Corporate Finance. Berkshire: McGraw-Hill.
Factsheet_SP_500.pdf&blobheadername2=ContentDisposition&blobheadervalue1=application%2Fpdf&blobkey=id&b The London Gold Market Fixing Ltd. (2011, May 11). History. Retrieved May 11, 2011, from Gold Fixing: http://www.goldfixing.com/GF1.html The London Silver Market Fixing Ltd. (2005). Silver Fixing. Retrieved May 11, 2011, from Silver Fixing | Introduction: http://www.silverfixing.com/intro.htm Thomson Reuters . (2011, April 20). University Library - Datastream Software. Gothenburg, Sweden. USDA. (2011, April 19). ERS/USDA Data - Wheat Data. Retrieved April 20, 2011, from USDA Economic Research Service: http://www.ers.usda.gov/data/wheat/ UST 3M | Board of Governors of the Federal Reserve System. (2011). FRB: H.15 Release--Selected Interest rates--Historical Data. Retrieved May 11, 2011, from Board of Governors of the Federal Reserve System - Economic Research & Data: http://www.federalreserve.gov/releases/H15/data.htm WTI | Federal Reserve Bank of St. Louis. (2011). Download data for Spot Oil Price: West Texas Intermediate (OILPRICE). Retrieved April 20, 2011, from Economic Research | Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/OILPRICE/downloaddata?cid=98
Tables
Tables with calculations and data are available online at: Thesis Calculations and Data Microsoft Excel Spreadsheet (http://actarius.se/storage/THESIS_PBW_VR_RN.xlsx)
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