Financial Analysis Exercise #2, #3 and #4

Overview

Financial analysis exercise #2, #3 and #4 will all build on the frame work of exercise #2. During these three projects you will layout the strategy, selection and hedging of $10,000,000 stock/bond/option portfolio.

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In exercise #2, you will develop an investment strategy to outperform the S&P 500 by selecting sector(s) and industries that will outperform the overall market in the next 12 months. This will be based on economic forecast and likely scenarios proved as well as research into the historic performance of the sectors and industries.

In exercise #3, using the sector and industry strategy developed in exercise #2, you will select specific firms in the industries that will make up your portfolio. The portfolio must consist of 50% stocks and 50% bonds. The selection process must be supported by historic performance and fundamental valuation techniques to identify firms that will outperform the market because they are undervalued or because their earnings will improve.

In exercise #4, you will develop an options strategy for your portfolio to enhance profitability and to hedge risk in the portfolio.

Financial Analysis Exercise #2 (100 Points)

Background   

The S&P 500 is a market index that also defines firms into sectors, industries that contain specific firms. A link is provided below with the standard sector/industry breakdown used by the S&P.

https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/sectors_in_market.jhtml

The S&P 500 identifies ten different sectors and industries within each sector:

Consumer Discretionary       (12 Industries)

Consumer Staples                (6 Industries)

Energy                                 (2 Industries)

Financials                            (8 Industries)

Health Care                          (6 Industries)

Industrials                            (14 Industries)

Information Technology        (8 Industries)

Materials                             (5 Industries)

Telecommunication Service (2 Industries)

Utilities                                 (5 Industries)

If you go to the link above, it will allow you to see each industry within the sectors. Sector analysis is fundamental to managing an investment portfolio that provides returns that are superior to market returns. This requires an understanding of the current economic conditions, forecasts about the future, and consensus forecasts about future earnings prospects within sectors/industries and specific firms.

Requirements

Exercise #2 is due by the end of Module 4. In this exercise, you will need to select 1 to 3 sectors and then 1 industry within each sector to that you think will outperform the S&P 500 over the next year.

In order to meet all the requirements for the financial analysis exercise #2, you are required to complete the following tasks:

Identify sectors and industry:

The exercise #2 requires you to identify 1 to 3 sectors and 1 industry within each sector that will be used complete this exercise. The sectors selected should be on the basis of their past behavior that was pro cyclical, counter cyclical or a neutral sector sector/industry. The best place to start would be to scan the firms in each industry and look for familiar names from your own consumer experience or other sources. Then, roll back up to the industry and sector.

Perform fully analysis:

The first part of the analysis is to perform a SWOT analysis on each sector/industry selected. Identifying its strengths, weakness, opportunities and threats. Look at the sector, such as utilities, they are neutral. People always need to electricity, water and gas. They are all highly regulated industries. A SWOT analysis might indicate that their strength is stability and neutrality but it would also be a threat to future growth and earnings potential. Opportunities could be to expand their base or acquire other firms, which could also be threat. Keep it simple but be thoughtful and provide perspective and insight.

Analyze past performance:

This will require you to research on past performances during recessions and periods of growth, which will help you determine whether they are pro, counter, or neutral sector cyclically. This type of information should be readily available from numerous reliable internet sources, which includes: S&P, investment firms, but no Wikipedia or other nonacademically acceptable sources. Graphs should be readily available from these sources but any graphs should be sighted as to the source.

Present research on future economic scenarios:

Another source of information would be consensus forecasts of the sector and industry performance. Many investment firms publish their predictions of earnings by firm, industry and sector. Do not rely on a single source but bring together the broad view of as many sources as possible.  

Demonstrate why these particular sector(s)/industries will outperform the overall market: The last part of this particular project is to demonstrate why these particular

sector(s)/industries will outperform the overall market. This requires understanding some of the key drivers in the industry such as consumer spending, consumer spending on durable products. This further requires using a combination of the historic data and interpolation about those relationships and how they will impact the industry in the future.

For example, for this section if Consumer Discretionary sector were chosen and the industry Hotels, Restaurants and Leisure, there are likely parts of that industry that are counter cyclical such as McDonalds in the restaurant industry. They typically perform

better in low growth or recessionary times while Chili’s and other sit down restaurants generally see a slowdown.     

Financial Analysis Exercise #3 (100 Points) Background Financial Analysis Exercise #3 will build on exercise #2 and the sector/industry analysis. This exercise #3 is due by the end of Module 6.

In this exercise, it will require selection of 3 firms with each sector/industry analyzed to invest $10,000,000 of a special portfolio into both stocks and bonds evenly. The objective of the portfolio is to produce superior returns to those of the S&P 500 over the next 12 months. Therefore, given the economic environment, the sector sensitivity and performance expected, 3 firms will need to be selected per industry that will outperform their sector.

Requirements In order to meet all the requirements for the financial analysis exercise #3, you are required to complete the following tasks: • Select stocks and bonds to purchase based on sector and industry analysis • Use 3 methods to calculate relative value of stocks: dividend discount, Gordon model and P/E or other approved method. • Obtain the consensus earnings forecast for the firms • Explain how this will affect the expected future price • Obtain a consensus interest rate forecast • How will this effect bond prices? • How will this affect the roll down the yield curve?

Financial Analysis Project 4 (100 Points)

Background   

Financial Analysis Exercise #4

will build on exercise #2.

In this exercise, you will develop different strategies to hedge and enhance your portfolio returns. In addition, you will select, value and analyze the different options and determine how they will perform in three different markets characterized by different volatility.

Requirements

In order to meet all the requirements for the financial analysis exercise #4, you are required to complete the following tasks:

Develop a strategy to use options or futures to hedge the market value and enhance the profitability of the portfolio. Identify strategies that will work best in each of the following markets:

o  Flat market – low volatility

o  Rising market – moderate volatility

o       Rising/Falling market – high volatility

Value the selected options for the strategies with the CBOE calculator found in Module 8.

Identify options that are in liquidity markets and describe the characteristics of the market and the broker’s trade book.

Identify the implied volatility of each option.

Identify the Greeks for these options.

How will the Greeks affect your decision to purchase these options in the different markets identified above?

Additional     Instructions  

The first step is to develop a strategies using options or futures. The hedge strategies could include, selling calls, buy puts, bull spreads, collars or whatever strategy you choose from those available. Explain the strategy and how it will work, for example selling calls. Explain what you hope to accomplish with the strategy and how it will work in the three different markets listed below. The strategy be developed for both stocks and bonds and with options or futures could be used. Discuss strategies that would work best in each of these different markets and explain why it would work.

Next, discuss the option the value of the options in the market and those calculated with the CBOE calculator. Calculate the implied volatility of each option in your strategy. In particular, discuss the Greeks and how they help understand the changes in the options value as result of those 5 different factors. Discuss how volatility in particular would affect the value of the options/futures selected. Also, look discuss the open interest in the options/futures and whether that would affect your decision to trade that option. Discuss the effect of open interest and trading volume. Discuss the broker’s trade execution book and what affect this could have on filling your option/future orders.

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