AQM Coursework

March 2010 Lendyl Hosein Jekaterina Svircenkova Douglas Lin

Task 1 Question 1 To model the spot freight rates we chose Ras Tanura / Rotterdam VLCC 280,000t route. The data we collected for our sample goes back 20 years starting from February 1990. We used EViews to estimate the following models: ARMA, seasonal regression, time trend regression, single exponential smoothing and Holt with trend time series modeling methods. As the data exhibited non-stationary properties we chose to model differenced variable with ARMA and seasonal models. ARMA(2,2) The correlogram suggested using 2-month autoregressive and 2-month moving average terms. We adjusted our model for heteroscedasticity using White correction method, non-normality of variables, however, could not be remedied.
Dependent Variable: D(RATES) Method: Least Squares Sample (adjusted): 1990M05 2010M01 Included observations: 237 after adjustments Convergence achieved after 13 iterations White Heteroskedasticity-Consistent Standard Errors & Covariance MA Backcast: 1990M03 1990M04 Variable C AR(2) MA(2) R-squared Adjusted R-squared Coefficient 0.030502 0.630559 -0.885785 0.097105 0.089388
Std. Error 0.398114 0.121125 0.092836 t-Statistic 0.076615 5.205871 -9.541419 Prob. 0.9390 0.0000 0.0000

Seasonal regression model Dummy variables were constructed for all season periods (months) excluding 1 st month to avoid collinearity. The coefficients for a number of dummies were insignificant, however leaving all of them in the model ensured the highest explanatory power of the model.
Dependent Variable: D(RATES) Method: Least Squares Date: 03/30/10 Time: 13:25 Sample (adjusted): 1990M03 2010M01 Included observations: 239 after adjustments Variable C S2 S3 S4 S5 S6 S7 Coefficient Std. Error -9.245000 8.726579 6.847500 2.540500 13.19400 11.44150 10.54950 4.025632 5.767526 5.693104 5.693104 5.693104 5.693104 5.693104 t-Statistic -2.296534 1.513054 1.202771 0.446242 2.317541 2.009712 1.853031 Prob. 0.0226 0.1317 0.2303 0.6558 0.0214 0.0456 0.0652

S8 S9 S10 S11 S12

5.491000 11.85350 12.54100 17.91900 10.35000

5.693104 5.693104 5.693104 5.693104 5.693104

0.964500 2.082080 2.202841 3.147492 1.817989

0.3358 0.0385 0.0286 0.0019 0.0704 0.045188 18.20850

R-squared 0.067607 Mean dependent var Adjusted R-squared 0.022425 S.D. dependent var

Breusch-Godrfey serial Correlation LM test showed 2nd order serial correlation. White test did not show any heteroscedasticity thus model is considered to produce reliable standard errors. Time trend regression We constructed time trend series and regressed the freight rates on time, squared time and cubed time. From the residuals graph we concluded that model well captured the behavior of the dependent variable.
Dependent Variable: RATES Method: Least Squares Sample (adjusted): 1990M02 2010M01 Included observations: 240 after adjustments White Heteroskedasticity-Consistent Standard Errors & Covariance Variable C @TREND @TREND^2 @TREND^3 R-squared Adjusted R-squared Coefficient 69.64537 -1.186289 0.015133 -4.44E-05 0.279673 0.270516 Std. Error 3.504879 0.161173 0.001886 5.73E-06 t-Statistic 19.87098 -7.360351 8.025248 -7.745040 Prob. 0.0000 0.0000 0.0000 0.0000 64.42304 29.71760

Mean dependent var S.D. dependent var

Model exhibited 1st order correlation spotted by Breusch-Godfrey LM test and correlogram. The model was tested and adjusted for heteroscedasticity by White correction method. For single exponential and Holt with trend series modeling methods we took raw rates and generated our forecasts by increasing time frame for every period.

Single exponential smoothing

Date: 03/30/10 Time: 11:08 Sample: 1990M02 2007M01 Included observations: 204 Method: Single Exponential Original Series: RATES Forecast Series: Y2007M02 Parameters: Alpha Sum of Squared Residuals Root Mean Squared Error End of Period Levels: Mean 0.9160 54317.77 16.31758 52.99420

Holt with trend

Date: 03/30/10 Time: 11:32 Sample: 1990M02 2007M01 Included observations: 204 Method: Holt-Winters No Seasonal Original Series: RATES Forecast Series: Y2007M02 Parameters: Alpha Beta Sum of Squared Residuals Root Mean Squared Error End of Period Levels: Mean Trend 0.9200 0.0000 54317.21 16.31750 52.97412 0.080882

Question 2 The 1-step forecasts were obtained from EVIews by static forecasting technique. Excel was used to produce 2-step and 3-step forecasts given by the estimation formulae from models and smoothing methods forecasts were obtained from EVIews.
1-step 65.04 63.28 42.69 61.33 61.26 2-step 62.39 60.88 41.08 61.33 61.25 3-step 63.18 54.18 39.43 61.33 61.24

ARMA(2,2) Seasonal Time trend Single smoothing Holt with trend

Question 3 The models evaluation period was from February 2007 to January 2010. We evaluated our models by comparing their RMSE and Theils U. From the results models performance we saw that the most accurate forecasts were produced by ARMA(2,2) model.
1-step 2-step 3-step 1-step 2-step 3-step RMSE 24.0976 27.6584 26.2406 25.2735 34.7539 39.5371 34.8170 34.9504 35.4074 26.4719 36.1436 41.0808 Theil's U 0.1610 0.1822 0.1728 0.1689 0.2298 0.2592 0.2491 0.2499 0.2537 0.1763 0.2384 0.2690

R(2,2)

Seasonal model

Regression 1-step on time 2-step trend 3-step 1-step Single exponential 2-step smoothing 3-step

1-step Holt with 2-step trend 3-step

26.4143 35.8638 40.5164

0.1791 0.2411 0.2698

Question 4 The model produced the following forecasts for the next 11 months. The forecast shows slight downward trend with very little fluctuation.
2010/02 2010/03 2010/04 2010/05 2010/06 2010/07 2010/08 2010/09 2010/10 2010/11 2010/12 65.04 62.39 63.18 61.53 62.04 61.00 61.34 60.69 60.92 60.52 60.67
160 140 120 100 80 60 40 20 0 2008-01 2008-03 2008-05 2008-07 2008-09 2008-11 2009-01 2009-03 2009-05 2009-07 2009-09 2009-11 2010-01 2010/03 2010/05 2010/07 2010/09 2010/11
Actual freight rates Forecasted freight rates

Task 2 Question 1 Firstly, the daily prices of 15 different stocks over the last year were collected from FTSE100 index. The Log difference of the prices was taken and the mean daily return of individual stock was obtained by taking the average sum of all Log returns. Equal weights of 1/15 were multiplied to the individual returns to obtain an expected daily return of 0.10%. This is then annualised by applying the equation (1+dailyreturn^365)-1, which gives an annual expected return of 46.44% for the equally weighted portfolio. In order to calculate the expected risk, a covariance matrix is first obtained. Weights (1/15) are then multiplied to the covariance matrix and the product is then multiplied to the transpose of weights to obtain the expected daily variance of 0.000271. Expected daily risk (Standard Deviation) is calculated by taking the root of variance giving 0.0165(1.65%). Question 2 The correlation between the 15 stocks are calculated individually using the =CORREL excel function. The figures are then presented in a Correlation Matrix. Question 3 In order to calculate the one week 1% VaR of the portfolio, daily standard deviation(SD) of the 15 stocks are scale up by multiplying them with square root of 5 (the number of trading days in a week), this gives the weekly SD. The individual VaR is then calculated by multiplying 2.326, the Z-score at 1% with the weekly SD, the weight and the value of the portfolio. Giving the equation 2.326*weekly SD of stock*1/15*1000000.

The one week 1% VaR is calculated by the equation SQRT(V*C*Vt). Where V is the weekly VaR of individual stock, C is the correlation matrix and Vt is the transpose of the weekly VaR of individual stock. Applying the equation a weekly 1% VaR of 31,760.97 is obtained. Question 4 The optimum weights were solved using excel solver add-in. The Variance of each optimum portfolio (5%, 10% and 15%) was selected as the target cell. The 3 different required annual returns of 5%, 10% and 15% were converted down to daily returns giving the following:

5%
Daily Returns Required

10%

15% 0.000554765

0.0001936 0.000378287

The solver was instructed to solve for minimum variance by changing the weight of investment on the 15 stocks. The other constraints include, non-negativity for all investments, total weights of investments must equal to 1 (100%) and return must be more than or equal to the 3 required expected returns (e.g. Return >=0.0001936). The weights for the different scenarios are presented in the table below: Firms AVIVA BHP BILLITON BP BT GROUP CENTRICA GLAXOSMITHKLINE HSBC HDG MARKS & SPENCER GROUP RIO TINTO ROLLS-ROYCE GROUP SAGE GROUP SAINSBURY (J) TESCO VODAFONE GROUP XSTRATA 5% 0.00% 0.00% 11.11% 3.73% 14.03% 36.26% 0.00% 0.00% 0.00% 0.00% 6.55% 17.60% 7.85% 2.87% 0.00% 10% 0.00% 0.00% 11.52% 0.56% 14.29% 29.53% 0.00% 3.23% 0.00% 0.00% 13.63% 12.09% 12.62% 2.53% 0.00% 15% 0.00% 0.00% 9.96% 0.00% 14.66% 24.92% 0.00% 6.71% 0.00% 3.35% 17.99% 7.12% 15.27% 0.00% 0.00% Min Variance 0.00% 0.00% 11.54% 0.07% 14.38% 28.62% 0.00% 4.11% 0.00% 0.00% 14.52% 11.16% 13.29% 2.30% 0.00% Sharpe Ratio 0.00% 0.00% 0.00% 0.00% 13.25% 5.16% 0.00% 11.69% 8.66% 12.49% 28.84% 0.00% 19.91% 0.00% 0.00%

Question 5 The optimum risk-return portfolio is obtained using the same solver add-in. However, the Sharpe Ratio (Expected return/Variance) is targeted instead of a specific annual return and instructed to solve for maximum. This will allow solver to solve for the weights which gives the highest expected return to risk ratio. Thus giving the optimum portfolio, the weights of investment in this portfolio is presented in the table above.

Question 6 The minimum variance (risk) portfolio is obtained using the same methods utilised in Question 4, targeting the variance cell and instructing solver to minimise variance. However, in this case no profit constraint was entered. The weights of investments obtained are multiplied with the weekly SD, 1% Z-Score and value of portfolio, i.e. Weight*Weekly SD*2.326*1000000. Applying the formula to all 15 weights will reveal the 1% VaR of the individual stocks in the minimum variance portfolio. Applying the formula SQRT(V*C*Vt), where V is the 1% VaR of the individual stocks, C is the correlation matrix and Vt is the transpose of V, will yield the one week 1% VaR of the minimum variance portfolio. Question 7 The 5% expected tail loss is calculated based on the weighted average VaR. This is done by firstly splitting the tail into 10 sections. Secondly, multiplying each Z-score to the weekly SD and weight of individual stocks (e.g. 1.645*Weekly SD*Weight). This gives row vector of the individual VaR which can be manipulated into the portfolio VaR by applying the formula SQRT(V*C*Vt), where V is the individual weekly VaR, C is the correlation Matrix and Vt is the transpose of V. After obtaining all the various VaR from the different Z-score, a weight of Alpha/total Alpha is assigned to each VaR. The weight VaR is obtained through the sum of VaR*(Alpha/0.275), giving a one week 5% ETL of 41,762.03.

1- 0.95 0.955 0.96 0.965 0.97 0.975 0.98 0.985 0.99 0.995

Z-score 1.645 1.695 1.751 1.812 1.881 1.96 2.054 2.17 2.326 2.576 Average VaR

VaR 37,248.93 38,381.12 39,649.17 41,030.44 42,592.85 44,381.71 46,510.22 49,136.89 52,669.31 58,330.24

Alpha 0.05 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005

Alpha/0.275 0.181818182 0.163636364 0.145454545 0.127272727 0.109090909 0.090909091 0.072727273 0.054545455 0.036363636 0.018181818

Weighted VaR 6,772.53 6,280.55 5,767.15 5,222.06 4,646.49 4,034.70 3,382.56 2,680.19 1,915.25 1,060.55 41,762.03

44,993.09 0.275

Question 8 The methods employed above cover many different scenarios and examine the different outcomes of the same 15 stocks. Applying different constraints to achieve results which can be use to cater to possible outcome. Base on technical analysis of risk, volatility and returns, it enables preparation for possible losses and volatility. It also builds an image of expected returns of the different portfolio allowing for better management of risk and volatility when investing in the 15 stocks.

Task 3 Question 1 A simulation of 52 weeks production of the manufacturer is created. Opening stock of week 1 equals to 60 while opening stocks after week 1 equals to the closing stock of the previous week. E.g. Week 2 opening = Week 1 closing stock. Unit produced is based on constraints provided (>30 produce 140, 80> produce 100, otherwise produce same as previous week). Holding costs are $300/unit and $30,000 cost of changing production. Unit sold each week is based on given information of mean 120 and SD of 15. The following formula is used in excel to replicate the distribution function: =RiskOutput()+MIN((NORMINV(RAND(),mean,SD)),TotalStock) By putting total stock as constraint in the formula, excel will prevent sales from exceeding total stock ensuring a reasonable simulation. Cost of changing production are implemented using IF analysis, adding an additional $30,000 to cost when ever production constraint is triggered. Total cost is a function of (Holding cost *Closing stock)+Cost of changing production. From the simulation, a total cost of $1,158,311.24 and an average cost of $27,210.52 are obtained. The following graph is the 52 Weeks product inventory showing changes in stock levels:

Stocks
120 100 80 60 40 20 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 Stocks

Question 2 This part involves a simulation of 10,000 trials to estimate the average 52week cost which was based on a similar spreadsheet to the previous one but this time the upper limit values of inventory was ranging from 50 to 100 in increments of 5. This means that for each production policy of u=50,55,60,65,70,75,80,85,90,95 and 100, a simulation with 10,000 iterations each would have to be run. In order to do this, the @Risk function which allows sensitivity analysis to be performed on certain input variables, RISKSIMTABLE was used. For this a new table of input data had to be inserted to the spreadsheet which included the 11 upper limit production levels. The function used was [=RiskSimTable(50,55,60,65,70,75,80,85,90,95,100)]. The output cell as set to Total costs and the 11 simulations were run with 10,000 iterations ach.

Question 3 As per this question, the sample mean and standard deviation of the 52 week cost under each policy is required. It is apparent from the following graph that the minimum mean cost and SD would be possibly at the upper production level l=75. (The excel sheet from which these data have been derived from is illustrated in Appendix 3D)
Average Cost per week 90.0% 5.0% 34.19

5.0% 6 5

9.64

Values x 10^-5

4 3 2 1 0 10 15 20 25 30 35 40

Average Cost per week (Sim#1)

Values in Thousands ($)

Minimum Maximum Mean Std Dev Values

$ 983,168.47 $ 1572,399.22 $ 1274,355.19 $ 83,267.94 10000.00

From the previous simulation using a 90% confidence interval it was estimated that the best inventory level is 90. The inventory will be within the range of $1,139,551 and $1,389,555. Upper Inventory Level 50 55 60 65 70 75 80 85 90 95 100 5% C.I
$ $ $ $ $ $ $ $ $ $ $ 1139,757 1140,239 1135,585 1139,447 1138,314 1140,206 1139,011 1138,280 1139,551 1138,545 1139,816

45

95% C.I
$ $ $ $ $ $ $ $ $ $ $ 1386,262 1387,737 1387,683 1387,723 1387,893 1386,702 1388,143 1388,003 1389,555 1386,417 1386,386

The graph below shows the average cost against inventory level. It justifies the decision that an inventory level of 90 gives the lowest average cost. The highest costs are associated with inventory level of 100, 85 and 55 units.

Cost vs Inventory
100 95 90 85 80 75 70 65 60 55 $1266,000 $1266,500 $1267,000 $1267,500 $1268,000

Question 4 The flexibility of the production policies of 100, 140 and previous week could be increased to different levels to achieve a better optimized level of inventory and cost. To optimize inventory the manufacturer can also look at changing the upper and lower production limits. However, by doing these the manufacturer runs a higher risk of incurring higher costs of changing production. Additionally, the inventory levels could be reduced but this increases the possibility of lost sales due to variability of demand.

Appendix Task 1 Refer to EViews and Excel file Task 1 Task 2 Refer to Excel file Task 2 Task 3 Refer to Excel file Task 3