Analysis of Earnings Momentum Strategies with Financial Calculation

This assignment solution focuses on financial calculations related to earnings momentum strategies. It involves analyzing monthly returns for a set of stocks and evaluating the performance of different investment portfolios based on earnings surprises. The solution includes computations of average returns, Capital Asset Pricing Model (CAPM) alpha, and Fama-French three-factor model alpha for various portfolios categorized by good and bad news stocks. The analysis assesses the profitability of these strategies, considering factors like stock beta, size effect (SMB), and value effect (HML). The findings indicate that portfolios based on positive news tend to outperform those based on negative news, and shorting strategies involving bad news stocks may not yield favorable results. The solution also suggests additional factors, such as profitability and investment, that could enhance the analysis.

FINANCIAL CALCULATION
Contents
Question 1.............................................................................................................................................2
Answer 1................................................................................................................................................2
Question 2.............................................................................................................................................2
Answer 2................................................................................................................................................2
Question 3.............................................................................................................................................3
Answer 3................................................................................................................................................3
Question 4.............................................................................................................................................3
Answer 4................................................................................................................................................3
1

Question 1
Answer 1
In the given question, the computation of monthly average return has been undertaken for three
portfolios with the following characteristics:
(a) 30 Stocks of Good Category- Portfolio -1;
(b) 30 Stocks of Bad Category- Portfolio-2;
(c) 30 Stocks long of Good Category and 30 Stocks short of Bad Category- Portfolio-3.
On the basis of above categorisation, the average return of the portfolios have been computed which
stands at 2.13% for Portfolio-1 , 0.99% for Portfolio-2 and .38% for Portfolio 3. The detailed
computation has been annexed in the excel.
For part-2 of the question regarding computation of Capital Asset Pricing Model Alpha and 3 factor
Fama and French Model, computation of Beta of stock has been made by computing covariance of
stock and market and dividing the same form variance of the market. Further, the beta of SMB has
been computed on the basis of Covariance of Portfolio and Small minus big Index divided by Small
minus big Standard deviation square. Similarly, Beta of HML is computed on the basis of Covariance
of Portfolio and High Minus low Index divided by High Minus low Standard deviation square.
On the basis of above, the Capital Asset Pricing Model Alpha has been computed at 0.34% for
Portfolio -1 , -1.63% for Portfolio-2 and 0.79% for Portfolio-3.
On the basis of above, the Fama and French Alpha has been computed at 0.64% for Portfolio -1 , -
28.78% for Portfolio-2 and -0.19% for Portfolio-3.
On the basis of average return earned, the strategy is profitable for Portfolio-1 as the stock return only
beat the market in Portfolio-1. Thus, only portfolio-1 worked out well.
Yes, the strategy is profitable based on CAPM Alphafor Portfolio -1 and Portfolio -3 as the return
from the portfolio is greater than the return expected on the basis of Capital Asset Pricing Model.
Yes, the strategy is profitable based on Fama and French 3 Factor Model for Portfolio – 1 and 2 only
while it did not work out for third portfolio.
Question 2
Answer 2
In the given question, the computation of 3 factors has been undertaken for three portfolios with the
following characteristics:
(a) 30 Stocks of Good Category- Portfolio -1;
(b) 30 Stocks of Bad Category- Portfolio-2;
(c) 30 Stocks long of Good Category and 30 Stocks short of Bad Category- Portfolio-3.
Under the said model, the three factors are Beta of stock, Small Minus Big and High Minus Low. The
computation of the Beta Factors have been presented here-in-below:
Computation of Beta of stock has been made by computing covariance of stock and market and
dividing the same form variance of the market. Further, the beta of SMB has been computed on the
basis of Covariance of Portfolio and Small minus big Index divided by Small minus big Standard
deviation square. Similarly, Beta of HML is computed on the basis of Covariance of Portfolio and
High Minus low Index divided by High Minus low Standard deviation square.
2

On the basis of above Beta of stock has been computed at 1.12 for Portfolio-1, 1.64 for Portfolio-2
and -.26 for Portfolio-3.
On the basis of above Beta of SMB has been computed at 1.03 for Portfolio-1, 1.69 for Portfolio-2
and -.06 for Portfolio-3.
On the basis of above Beta of HML has been computed at -.18 for Portfolio-1, 0.40 for Portfolio-2
and -.29 for Portfolio-3.
All the above measure the sensitivity of change.
Question 3
Answer 3
Good news contribute very highly to the portfolio and defeat the benchmark index while bad news
portfolio contribution does not beat the benchmark index and investing in them gave poor returns to
the overall portfolio. Further, shorting the bad news portfolio under Portfolio-3, further worsened the
portfolio giving even poor returns compared to portfolio-2. Thus, only good news portfolio helped to
contribute to the total earning. However, for maintain earning momentum maintenance shorting of
bad stocks did not work out well for the company as a result of the same the profit of the company fell
and the result was not so impressive.
Question 4
Answer 4
The profitability of this strategy is driven by goods news as it is a major contributor to the overall
profit while shorting the bad news stock did not work out well for the company as the average return
of the bad stock was positive which led to fall in the profits of the strategy. The other factors that
could have been added shall include the following:
(a) Profitability Factor;
(b) Investment Factor.
3