1. Calculating Required Rate of Return (Expected Return) with CAPM ; 2. Calculating Required Rate of Return (Expected Return) with Fama And French model 3. Comparing FF model with CAPM Marks = 8 Due Date = February 20, 2012
Note: A. The following assignment must be done in the alreadyformed groups
B. The due date is
Feburuary 20, 2012 . Try to submit the assignment on due date otherwise 0.5 mark will be deducted per day.
C. Each group has been assigned a unique set of companies, called universe, for this assignment. You are required to use data only of the specific universe for the specific year.
D. Submit the assignment to this email: ims.assign@gmail.com
E. Assignments similar in contents, format, and explanation, will not get any mark
DATA: Index point and Tbill rates are here MS Excel files from d2000.xls to d2008.xls at the bottom of data sources page contain key financial data of all KSE listed firms from the year 2000 to 2008. Requirements:
 Calculating Required Rate of Return (Expected Return) with CAPM
 Calculate required rate of return (RRR) on the stock of your assigned companies by using Fama and French (FF) model
 Compare CAPM with FF model and decide which model can better predict the required rate of return on your selected security. In other words, based on your analysis tell which model is more realistic.
Steps to Follow:
A. Calculating Expected return with Fama and French
To calculate expected return with Fama and French Model, we
need to calculate betas and values of three independent variables through the
following equation:
To operationalize the above equation, follow these steps:
A.
Obtain end of month share prices of the two
companies assigned to your group for a period of 12 months for your assigned
year
B.
Calculate Ri = (P1Po)/Po, for both companies
individually C.
Take interestfree rate in your assigned year
and divided that rate by 12 to make it a monthly rate D.
Deduct the monthly interest free rate (Rf) from
the Ri and you will obtain RiRf
A.
Obtain end of month index points for KSE 100
index for a period of 12 months for your assigned year B.
Calculate Rm = (Index1Indexo)/Indexo C.
Take interestfree rate (Tbill rates) of your
assigned year and divide that rate by 12 to make it a monthly rate D.
Deduct the monthly interest free rates (Rf) from
the Rm values and you will obtain RmRf A.
Obtain total assets figure of your UNIVERSE
companies for you assigned year B.
write the total assets figures in column next to
the companies names C.
Sort the UNIVERSE companies from large
to small by using the A Z function
on the assets figures D.
Select the top 5 companies and name this group
of 5 companies as BIG E.
Select the bottom 5 companies and name this
group as SMALL companies F.
Obtain monthly (endofmonth) closing share
prices for 12 months for the BIG companies G.
Calculate monthly returns for each company in
the BIG group H.
Calculate average return for the BIG in each
month by averaging the returns of the 5 companies I.
Repeat the same process for SMALL group to
calculate average monthly return J.
Subtract the average returns of BIG from the
average returns of SMALL in each of the 12 months. These monthly differences
are your SMB
1.
Calculate Book value per share for your UNIVERSE
companies for your assigned year 2.
Book per share = Total Equity / No. Shares outstanding 3.
Obtain Market value per share for you Universe
Companies in the given year 4.
Market value per share = Share price at the end
of the given year 5.
Calculate B/M ratio = Book value / Share price 6.
Place the B/M ratio values in columns next to
the UNIVERSE companies 7.
Sort the UNIVERSE companies from HIGH
to LOW B/M ratio by using the A Z function of MSExcel on the B/M ratio 8.
Select the top 5 companies and name this group
of 5 companies as HIGH 9.
Select the bottom 5 companies and name this
group as LOW companies 10.
Obtain monthly (endofmonth) closing share
prices for 12 months for the HIGH companies 11.
Calculate monthly returns for each company in
the HIGH group 12.
Calculate average return for the HIGH in each
month by averaging the returns of the 5 companies 13.
Repeat the same process for LOW group to
calculate average monthly return 14.
Subtract the average returns of LOW from the
average returns of HIGH in each of the 12 months. These monthly differences are
your HML
1.
Go to Tools Menu and check whether Data Analysis
is installed, if not, follow instructions at the bottom of this page for
installation 2.
Copy the (RiRf),( RmRf), SMB, and HML values
to a 4 columns adjacent to each other 3.
Remember to give the above headings at the top
of relevant column 4.
If you have MSExcel 2003, go to Tools Menu >
Data Analysis > Regression > Input Y Range > Select RiRf column,
(including the first cell wherein you have given the heading of RiRf > Come
back to regression window [ If you CANNOT SEE the Data Analysis in tools, then perhaps it is not installed yet, for installation, go to Tools menu>>Add ins>>select Data Analysis Toolpack>> the installation will ask for Office CD, so insert Office CD in CD room] 5.
Click on Input X Range > Select all the three
independent variables with their headings i.e. RmRf, SMB and HML by dragging
the mouse on all the three variables from start to bottom of data range>
come back to regression window 6.
Click the “Labels” checkbox and leave other options as without touching
them 7.
Click Ok and you find regression output in a new
sheet
Suppose
we have the following output from the regression analysis SUMMARY OUTPUT 










 Regression
Statistics 



 Multiple R  0.858827001 



 R Square  0.737583818 



 Adjusted R Square  0.63917775 



 Standard Error  0.060728886 



 Observations  12 









 ANOVA 




  df  SS  MS  F  Significance
F  Regression  3  0.082928037  0.027643  7.495308  0.010369059  Residual  8  0.029503981  0.003688 

 Total  11  0.112432018    





  Coefficients  Standard
Error  t
Stat  Pvalue  Lower
95%  Intercept  0.035  0.0202  1.741549  0.119762  0.01143538  SMB  0.012  0.0311  3.30466  0.010784  0.174728046  HML  0.084  0.0364  2.327802  0.048327  0.000795263  (RmRf)  0.494  0.31861  1.5516  0.159358  1.22909265 
The above output shows that SMB has beta of .012, HML has beta of .084
and RMRf has beta of .494.
As you know the equation used for calculating expected return in in Fama
and French is as under:
(RmRf)* This is the annual risk premium on market portfolio. Simply add
up all the monthly RmRf value and you will get the annual RmRf (SMB)** This is the annual size premium which you can obtain by adding
up all the SMB values in all of the 12 months (HML)*** This is B/M ratio premium and cab be obtained by adding up the
HML values of all of the twelve months
Once you calculate the expected return, compare it with actual
return, if actual return is greater than expected return, then security is
undervalued or vice versa.
B. Calculating Expected return with CAPM The Beta formula under CAPM is given by:
As you have already calculated the (RiRf) and (RmRf) variable in Fama and French model, simply apply regression to only
these two variables in the following way:
A. (RiRf) is your dependent variable and (RmRf) is your independent variable B. Use regression technique to find the coefficient of (RmRf), this coefficient is your beta C. After finding beta, use the CAPM equation to find out the required rate of return on your stock D. Compare this required rate of return with actual rate of return of the stock to find out whether the stock is overvalued, undervalued or fairly valued

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