Financial Markets Report Question And Answers

Question 1

US Treasury Yield

Normal (Upward Sloping) Yield Curve

The yield rates, which demonstrate the link between yields and multiple maturities, are represented on the y-axis, while the x-axis shows the time to reach maturity (in years). Plot each Treasury security's time to expiration (in years) on the x-axis: 0.25, 0.5, 1, 3, 5, 10, 20 and 30 years. Plot the two corresponding yield rates (5.55%, 5.47%, 5.33%, 4.64%, 4.53%, 4.58%, 4.91%, and 4.75%) on the y-axis (ycharts.com, 2023).

Table 1: US Treasury Yield

The immediate future interest rates are much lower than longer-term rates in a typical yield curve. Usually, this is the case whenever market sentiment anticipates steady economic growth (Urbano, Aparicio & Audretsch, 2019). Moreover, it implies that in exchange for assuming the risk of investing over a longer period, investors want bigger yields.

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Forward Interest Rate Implications

The form of a typical yield curve indicates that the investment community anticipates higher rates of interest in the future, which may be a sign of anticipated inflation and economic expansion. In order to protect their assets from future rate hikes, investors may be more inclined to lock in investments for a longer period when rates for short-term investments are substantially lower than long-term rates. As per the narration of Creamers, Fleckenstein & Gandhi (2021), Based on the rates given, the U.S. Treasury yield curve seems to be equipped with a typical, upward-sloping form. The fact that the rates for short-term loans are higher than those for long-term loans suggests that the financial sector anticipates a gradually expanding economy and a spike in interest rates. This form suggests that although the market expects the interest rate to rise in the not-too-distant future, such rises should only be somewhat significant. 

Figure 1: US Treasury Yield Curve

The degree of anticipated future rate changes is also indicated by the curve's steepness. Greater predicted fluctuations in rates in the future are indicated by a steeper curve and the futures interest rates may be estimated using the yield curve as a guide. For example, the point at which it intersects the curves one year from now will be expected to be greater than the present one-year rate, for instance, if the one-year rate is estimated in the one-year future (Chaudron 2018). This implies that rate increases are anticipated for the upcoming year. The yield on a U.S. Treasury bond having a very short duration of just three months is represented by the 3-month Treasury rate. Subsequently is frequently considered as a standard for US short-term interest rates. Given the high rate, there is a clear market for short-term government obligations. In unfavourable economic times, investors are probably looking for safety and money, which contributes to raising short-term rates. 

Question 2

a) Mean Returns and Return Standard Deviations

Based on the rates given, the United States government bond yield curve seems to be equipped with a typical, upward-sloping form. As cited by Fagereng et al. (2020), the fact that the rates for short-term loans are higher than those for long-term loans indicates that the financial sector anticipates a gradually expanding economy and a spike in interest rates. This form suggests that although the market expects the interest rate to rise in the not-too-distant future, such rises should only be somewhat significant.

Table 2: Mean Return and STDEV Returns

Investment 3 is the most desirable alternative in terms of coming back, but it is still not positive, since it has the least positive average return. Investment 3 is the riskiest in terms of risk or volatility (as determined by standard variance), followed by Investments 2 and Investment 1. When all else remains the same, investors often favour assets with lower risk and volatility. 

b) Covariance’s and Correlations between Each of the Three Pairs of Returns

Table 3: Covariance

Table 4: Correlations

FTSE 100 and JD SPORTS FASHION have an exceptionally high connection of -0.0127654, or almost zero. This implies that there is little to no correlation between the achievement of JD SPORTS FASHION and the FTSE 100. The coefficients of correlation between the three set of returns—FTSE 100, JD SPORTS FASHION, and RECKITT BENCKISER GROUP—appear to be represented in this table. The degree to which earnings on JD SPORTS FASHION fluctuate concerning themselves is indicated by the covariance value of 58.481771. For instance, if the one-year rate is anticipated in the one-year future, the point at which it intersects the curves twelve months from now will be predicted to be bigger than the current one-year rate. The self-dependency of earnings for the brand JD Sports Fashion is measured by this covariance. Once more, further context would be needed to determine the exact type and scope of the association (positive or adverse).

c) Compute and Plot the Portfolio Frontier of Two Stocks (RB and JD)

Figure 2: Return of JD SPORTS

Figure 3: Return of RECKITT BENCKISER GROUP

Plot the standard deviations and the returns of the portfolio on a graph, with the mean returned (reward) on the axis and the variance of the standard deviation (risk) on the axis. When integrating these two stocks into portfolios, the portfolio frontier's shape will provide details on the trade-off involving risk and return. Additionally, it usually shows a curve with an upward trend that demonstrates the various risk-return profiles that may be obtained by altering how the two products are allocated (Eckert & Gatzert, 2018). The smoother the curve, the more dispersed the assets are in the sense of low or negative relationships (low covariance), enabling investors to mix and match assets to obtain superior risk-return trade-offs. The curve could, however, be less smooth if the assets have a high degree of association (high covariance). 

d) Portfolio Investment 

In this instance, have given a monthly risk-free rate of 0.1%, and to illustrate the investment portfolio frontier, enclose to calculate the returns on the portfolio and standard deviations depending on the RB and JD weightings. Additionally, should compare the Sharpe ratios for every point on the portfolio frontier to determine which portfolio has the highest Sharpe ratio. Between the various alternatives, the set of options with the greatest Sharpe ratio indicates the best risk-adjusted return.

e) Market Beta of Two Stocks 

Table 5: Market Beta of Two companies

With a beta of 58.48, JD SPORTS FASHION is quite vulnerable to changes in the market, particularly concerning the benchmarks are using. The standard of excellence is typically thought to possess a beta of 1.0. With a beta of 58.48, JD SPORTS FASHION has traditionally moved around 58.48 times greater than the benchmark on average. This implies that the company's shares are very erratic and are prone to significant price swings in reaction to shifts in the overall market subsequently is regarded as a high-beta stock, which denotes a high degree of risk and possible large profits.

f) Computation and Interpretation of the Expected Returns and CAPM 

Table 6: Calculation of CAPM

The rate of return that is deemed "risk-free" or the return on an asset zero of risk is known as the risk-free rate (Rf). Although the risk-free rate has not been defined specifically in this instance, individuals have previously suggested a rate that is risk-free of 0.1% per month in question. JD SPORTS FASHION is projected return by dividing the asset's beta, estimated market return, and risk-free rate. Additionally, it yields an estimated return of 149.66% in this instance. This indicates that investors would anticipate receiving a yearly profit of 149.66% on this stock taking into account the unique beta of JD SPORTS FASHION, the expected risk-free rate, and the overall stock market return.

Question 3

The Chicago Mercantile Exchange (CME) offers Bitcoin contract futures, which are derivatives of financial markets that let traders and shareholders profit from fluctuations in the cryptocurrency's price despite actually holding the coin in their hands. 

Contract Specifications

Usually, each Bitcoin futures agreement symbolizes a certain amount of Bitcoin, like 5 or 1. The contracts have set expiration dates and come in a variety of time frames, including quarterly and monthly. 

Price quotation

A Bitcoin futures contract's price is expressed in US dollars per Bitcoin (John, O'Hara & Saleh, 2022). For instance, if acquire one contract at the current $50,000 per Bitcoin futures price, are essentially wagering that the market value of Bitcoin will exceed $50,000 when the contract expires.

 Leverage

With the financial advantage provided by Bitcoin futures, traders may manage a greater stake in the cryptocurrency with very little cash. For example, one could manage $50,000 worth of Bitcoin with only $10,000 if one purchases a Bitcoin contract for futures with a 5:1 leverage.

1. Speculation on Bitcoin Price

One can take a long (buy) investment in Bitcoin futures if they think the price will increase. For instance, if a Bitcoin contract for futures is purchased for $50,000 per Bitcoin and the market value of Bitcoin increases to $60,000 by the time the contract's term expires, the investor will benefit by $10,000 for each Bitcoin.

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2. Hedging a Long Spot Bitcoin Exposure

Bitcoin futures to diversify position if currently hold Bitcoin and are looking to guard against a possible price drop. Individuals should open a short (sell) position in Bitcoin futures to do this. A short position in futures could compensate for the loss of spot Bitcoin ownership should the price of Bitcoin decline.

3. Deriving No-Arbitrage Prices for Bitcoin Futures

According to the non-arbitrage principle, there ought to exist no risk-free profit possibilities at the price of a Bitcoin futures product van der (Merwe, 2021). The current price of the digital currency Bitcoin, the risk-free interest rate, the number of days before expiry, and the cost of carry that is, the cost of funding the purchase of Bitcoin are the factors that go into determining no-arbitrage values.

Reference list 

Chaudron, R. F. (2018). Bank's interest rate risk and profitability in a prolonged environment of low interest rates. Journal of Banking & Finance, 89, 94-104. Retrieved from: https://www.clausiuspress.com/conferences/LNEMSS/FMESS%202022/Y1159.pdf

Cremers, M., Fleckenstein, M., & Gandhi, P. (2021). Treasury yield implied volatility and real activity. Journal of Financial Economics, 140(2), 412-435. Retrieved from: https://pdfs.semanticscholar.org/bcc3/4e1942343f3b7a7a9e7959bd66b6904d5c8c.pdf

Eckert, J., & Gatzert, N. (2018). Risk-and value-based management for non-life insurers under solvency constraints. European Journal of Operational Research, 266(2), 761-774. Retrieved from: https://papers.ssrn.com/Sol3/Delivery.cfm/SSRN_ID3378246_code2842526.pdf?abstractid=3378246

Fagereng, A., Guiso, L., Malacrino, D., & Pistaferri, L. (2020). Heterogeneity and persistence in returns to wealth. Econometrica, 88(1), 115-170. Retrieved from: https://www.researchgate.net/profile/Pedro-Chaim/publication/328278692_Volatility_and_Return_Jumps_in_Bitcoin/links/5bc3c72e458515a7a9e79dc1/Volatility-and-Return-Jumps-in-Bitcoin.pdf

John, K., O'Hara, M., & Saleh, F. (2022). Bitcoin and beyond. Annual Review of Financial Economics, 14, 95-115. Retrieved from: https://www.annualreviews.org/doi/pdf/10.1146/annurev-financial-111620-011240

Urbano, D., Aparicio, S., & Audretsch, D. (2019). Twenty-five years of research on institutions, entrepreneurship, and economic growth: what has been learned?. Small business economics, 53, 21-49. Retrieved from: https://sebastian-aparicio.com/onewebmedia/SBE-Accepted-Manuscript-2018-03-20.pdf

van der Merwe, A. (2021). Cryptocurrencies and Other Digital Asset Investments. The Palgrave Handbook of FinTech and Blockchain, 445-471. Retrieved from: https://arxiv.org/pdf/2112.07386

ycharts.com, 2023. Yield maturity. Retrieved from: https://ycharts.com/indicators/1_year_treasury_rate#:~:text=Basic%20Info-,1%20Year%20Treasury%20Rate%20is%20at%205.33%25%2C%20compared%20to%205.29,long%20term%20average%20of%202.92%25 [Retrieved on: 05^th November, 2023]