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Chapter-1
Theoretical part of the report
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Dynamic Asset Allocation
Executive summary
One of the most debated questions in recent financial research is whether asset returns or equity is
predictable. This question is of significant importance for portfolio choice. If asset returns are
independently and identically distributed over time, then the optimal asset allocation is constant
over time. However, if asset returns are predictable, then the optimal asset allocation depends on
the investment horizon and the predictive variables. Economists disagree with the predictability of
asset returns. The empirical models of predictability can yield useful out-of-sample forecasts if
one restricts parameters in economically justified ways.
Dynamic asset allocation is one of the most active portfolio management strategies which involve
frequent/constant and quick adjustments of investments inline with the performance of
investments over time and with the market trends. Unlike two other popular portfolio
management strategies, strategic and tactical asset allocations strategies, dynamic asset allocation
does not involve keeping a fixed investment ratio. Dynamic investors diversify their investments
by investing in equities, mutual funds, index funds, currencies, derivatives and fixed income
securities. They buy instruments which are rising (or are predicted to rise) and they sell
instruments which are falling (or are predicted to fall).
A major investment decision for individual and institutional investors alike is to choose between
different asset classes, i.e., equity investments and interest-bearing investments. The asset
allocation decision determines the ultimate risk and return of a portfolio. The asset allocation
problem is frequently addressed either through a static analysis, based on Markowitz’ mean-
variance model, or dynamically. The dynamic asset allocation shows how the optimal asset
allocation depends on the investment horizon, wealth, and the investor’s risk preference and how
it therefore changes over time depending on cash flow and the returns achieved.
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Dynamic Asset Allocation
In this strategy, the manager replicates an option through a process of continually revising, in a
prescribed manner, the proportions of a portfolio consisting of the underlying the asset and the
risk less asset. Besides the complex nature of the underlying option pricing theory, the dynamic
strategy calls for buying more stock when the market is going up and selling off some stock as the
market goes down.
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Dynamic Asset Allocation
Insured Portfolio
The financial product known as portfolio insurance was born the night of September 11, 1976.
Hayne Leland had recently returned from France, and had been lamenting the weakness of the
dollar. Portfolio insurance is a dynamic trading strategy designed to protect a portfolio from
market declines while preserving the opportunity to participate in market advances. An early
criticism of portfolio insurance was that it reduced return as well as reducing risk. But users are
discovering that portfolio insurance can be used aggressively rather than simply to reduce risks.
Long run returns can actually be raised, with downside risks controlled, when insurance programs
are applied to more aggressive active assets. Pension, endowment, and educational funds can
actually enhance their expected returns by increasing their commitment to equities and other
high‐return sectors, while fulfilling their fiduciary responsibilities by insuring this more
aggressive portfolio. Compared with current static allocation techniques, annual expected returns
can be raised by as much as 200 basis points per year.
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Dynamic Asset Allocation
Chapter- 2
Industry Analysis
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Dynamic Asset Allocation
Before going to invest in any company’s stock it is essential to make industry analysis because it
helps the investors to isolate investment opportunities that have favorable return risk
characteristics. To pinpoint the benefits and limitations of an industry analysis three things are
important:
1. Is there a difference between the returns for alternative industries during specific time
periods?
2. The stability and consistency of the performance of the industry during a time period?
3. The potentiality of future good and sound performance.
An investor who is convinced that the economy and market are attractive for investing should
proceed to consider those industries that promise the most opportunities in the coming years. The
significance of industry analysis can be established by considering the performance of various
industries. After considering the above requirements and the relative industry risk I took 4
different industries to make dynamic asset allocation. I have decided to invest in Banking and
Financial Sector, Engineering Sector, Pharmaceuticals Sector, and Cement Sector.
These industries are selected as Banking industry is the growing sector and the capital adequacy,
profitability and most importantly the price trends are increasing. In perspective of the chosen
investment horizon of the year 2007 Engineering industry was experiencing profitability and price
hike. Pharmaceuticals industry is also a growing segment. Finally according to market
capitalization and the increasing demand of construction sector the cement industry is chosen.
Bank 53%
Pharmaceuticals 7%
Investment 5%
Eng 4%
Cement 4%
Insurance 3%
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Dynamic Asset Allocation
Market Capitalization at DSE
As on December 30, 2007 market capitalization marked at 135.85% rise over the previous year to
close at Tk. 742195.87 million from Tk. 315446 million. The percent market capitalization is
15.88% of Bangladesh’s total GDP.
Bank 59%
Textile 3%
Insurance 3%
Sector wise DSE evaluation shows the weighted average P/E ratio of Bank sector rose to 24.97 in
2007 from 15.49 of 2006.
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Dynamic Asset Allocation
Industry-Wise Standard Error of Average Price
BANKS 0.18
Cement 0.31
ENGINEERING 0.32
Insurance 0.55
INVESTMENT 0.61
It can be revealed from the graph Bank, Engineering, and Pharmaceuticals and Cement Industry
shown lowest possible standard error comparison with other industry in the market. So choosing
for industry among all of them I think it’ will be right portfolio for investment.
1400
1200
Amount (TK)
1000 BANKS
800 Engineering
600 Pharmaceuticals
400 Cement
200
0
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Month
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Dynamic Asset Allocation
Chapter- 3
Security Selection & Company Analysis
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Dynamic Asset Allocation
Company Analysis
When a portfolio manager is assigned to construct a portfolio that suits particular investor’s risk-
return class he or she must evaluate the securities taken to construct the portfolio in terms of
necessary parameters. Here to construct a portfolio before evaluating Dynamic Asset Allocation
Strategy I have selected the stock securities of 5 companies. These companies are not chosen
randomly rather based on some quantitative and judgmental analysis. The parameters that are
taken into account to select the companies are given below:
1. Stock category: In the process of selecting the companies first of all I have considered the
category of the companies. I only took ‘A’ categorized companies to construct my portfolio.
Investors who prefer periodic income would like to invest in securities that generate income
in the form of dividend. Average investors are of this class. So I selected ‘A’ categorized
companies that pay dividend.
2. Dividend: I have also ensured that the securities that are chosen to construct the portfolio
provide cash or stock and also that must be in regular basis. My argument is that dividend is a
good signal to the investor about the performance of the companies. Companies that provide
regular dividend considered as profitable entity and are preferred in the policy statement.
3. Earnings per share: Investors may not like to receive cash dividend from source otherwise
than from a positive earnings. If companies to maintain their regularity of dividend borrow
fund or issue debt runs the possibility of bankruptcy and that will mostly hurt the
shareholders’ interest. So companies historically generating positive earnings are considered.
4. P/E ratio: P/E is always a good determinant of the securities. Companies with greater price
earning multiple are chosen for the portfolio.
5. Return on equity: firm that doesn’t provide a handsome return on equity is not a good
component of the portfolio. If an investor can earn a greater return from otherwise investment
won’t go for portfolio construction.
6. Industry position: Companies in the portfolio are chosen also in terms of industry position.
Companies that occupy a better position in their industry are taken. Companies that alone
have a greater market share than their competitors are in the portfolio.
7. Profitability: profitability must be considered when securities of companies are used to
construct portfolio. Profitable companies have greater possibility to be considered as valuable
for a portfolio. That’s why only profitable stock is considered.
8. Industry profitability: 5 industries are chosen. They are profitable and have greater
possibility to be expanded. Traditional profitable and new growth industry companies are in
the portfolio.
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Dynamic Asset Allocation
9. Standard Error Estimate: I have chosen the company which has lower level of standard
error in historical price in comparison with others.
10. Beta: Another very important factor
Company Name Beta
determining the company selection is beta
Al-Arafah Islami Bank -1.65
coefficient. The companies have been selected Islamic Finance &
in such a way that the portfolio beta becomes Investment 0.06
Renwick Jajneswar 0.22
zero. It will ensure the return in any movement
Square Pharma 0.88
of the market index. The portfolio beta Heidelberg Cement Bd. 0.50
condition has been given aside: Portfoilio Beta 0.00
11. Risk-Return Combination: To observe the risk and return pattern of the selected securities
price data was collected.
The concerned time period Security Risk-Return Combination
portfolio risk-return
2.50%
combination. In security
Average Return
2.00%
risk-return combination it is
observed that, Islamic 1.50%
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Dynamic Asset Allocation
12. Correlation Matrix: Correlation among the securities chosen is a better estimate of the
portfolio combination efficiency. The correlation matrix among the securities is as follows:
Al-
Arafah Islamic Heidelberg
Correlation Islami Finance & Renwick Square Cement
Matrix Bank Investment Jajneswar Pharma Bd.
Al-Arafah
1
Islami Bank
Islamic
Finance & -0.5613 1
Investment
Renwick
-0.6721 0.7433 1
Jajneswar
Square
-0.5923 0.366 0.4065 1
Pharma
Heidelberg
-0.8306 0.5816 0.686 0.7877 1
Cement Bd.
The above table shows that Al-Arafah Islami Bank has negative correlation with all other
securities in the portfolio. Moreover, Square Pharma has very lower level of correlation with other
securities. So, it can be said that the portfolio construction is moderately efficient.
Assumptions
By portfolio insurance we mean all the policies which aim to protect portfolio, usually share
portfolios, against losses. But, to make things easier, the protection of a generic capital invested in
a single kind of share is considered. The results can be easily extended to the general case. In
practice, if a portfolio manager has to ensure an ample there will certainly be some complications
in the implementation, but all of the indications obtained for the portfolio are based upon some
pre specified considerations. Before constructing the dynamic portfolio several matters were taken
into consideration.
Based upon the assumption the portfolio is constructed to insure the initial investment value
against price falling risk. The assumptions are:
Total amount of investment is BDT 5, 00,000.00
T bill rate is considered as 91-day rate for the respective quarters.
Price data and dividend data are collected mainly for the year 2008, as I have considered
investment horizon to be in the year 2008.
Continuous compounded risk free rate is assumed.
The amount of Tk. 100,000 will be distributed among the 5 securities equally.
Initial distribution of total fund is considered to be 50: 50 in securities and T-bills.
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Dynamic Asset Allocation
The above assumptions are considered for the dynamic portfolio construction. Before going
directly to the dynamic portfolio construction 100% equity, 50% Equity 50% risk free assets
investment is made for comparison and calculation purpose.
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Dynamic Asset Allocation
Chapter- 4
Static Asset Allocation Interpretation
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Dynamic Asset Allocation
From the above table it is observed that the initial invested amount of tk. 500,000.00 increased to
tk. 890,195.25. It gives a positive return to the portfolio. In the appendix the lower and higher
value of each quarter is calculated using the higher and lower prices of the respective share’s for
that quarter. Though the portfolio is giving us a sound profit but it is risky to invest the entire
amount in the risky portfolio. Higher risk aversion investor will want to be secured even after
sacrificing some portion of return.
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Dynamic Asset Allocation
will fully protect the investor from price fluctuation. But both of these portfolios give lower return
than the 100% risky portfolio. In this strategy the proportion of investment is fixed at the initial
stage only. It is not maintained for the rest of the quarters.
Portfolio Value
1,000,000.00
900,000.00
800,000.00
700,000.00
Total Value (50%
600,000.00
Equity)
500,000.00
400,000.00 Total Value (100%
Equity)
300,000.00
200,000.00
100,000.00
0.00
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
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Dynamic Asset Allocation
Chapter-5
Dynamic Asset Allocation Interpretation
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Dynamic Asset Allocation
In this strategy, the manager replicates an option through continuously revising the proportions of
a portfolio consisting of the underlying risky asset (stock/bond) and the risk less asset
(bond/T‐bill) to insure portfolio’s value. This strategy requires buying more stock when the
market is going up and selling off some stock as the market is goes down. The proportions
allocated to the underlying risky asset and the risk less asset change every period, so this strategy
requires a significant amount of trading. The number of units of the underlying risky asset that
must be held long at any given moment will be given by the call option’s ‘Delta’, the reciprocal of
how many calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the
number of units of the underlying portfolio to hold.
In case of constructing my dynamic portfolio the amount of risk less asset to hold is determined
by subtracting the value of the units held in the underlying asset from the total value of the
insured portfolio. The delta tells us the number of stocks required to make a portfolio insured. It is
the optimal number of risky assets that ensure the highest amount of return with the given
insurance. In case of the Dynamic Portfolio Construction I have calculated Delta by following the
above procedure.
Delta = Insured Equity Value (High- low) /100% Equity High Value- 100% Equity Low Value
Delta is the ratio of the variation of the insured value to the variation of the equity portfolio value
available to invest in stock. The delta tells us the number of units of the underlying portfolio to
hold. The amount of the risk less asset to hold is determined by subtracting the value of the held
units of the underlying portfolio from the total value of the insured portfolio. In case of the
Dynamic Portfolio Construction I have calculated Delta by following the above procedure
The initial delta was .50 which requires that the total tk. 500,000.00 will be invested equally in
equity and risk free security. Initially the insured value of the portfolio was Tk. 500,000.00.
Initial 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Delta .50 0.6519 0.1376 0.5728 0.8183
Buy (Sell) Share 61255.98 (280,618.44) 97,797.96 87,975.56
Buy (Sell) T-Bill (61255.98) 280,618.44 (97,797.96) (87,975.56)
From the table we can observe that the delta value has been changed with the course of time. The
value increased in the 1st quarter and then decreased in 2nd quarter drastically. But after that the
delta value increased gradually in 3rd and 4th quarter. To adjust the delta value the buy/sell
decisions of equity and T-Bill have been taken in every quarter. There were buy decisions of
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Dynamic Asset Allocation
nd
equity in all the quarters except in 2 quarter. In case of T-Bill, there were sell decisions in every
quarter except in 2nd quarter.
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
New Equity 464,601.61 265,091.59 322,529.73 446,304.46
New T-Bill 193,558.54 477,904.54 389,444.09 309,166.99
Insured Portfolio 658,160.15 742,996.13 711,973.82 755,471.45
From the above table we can observe that the equity and T-Bill amount have been changed in
every quarter to adjust the delta value in every quarter. Consequently, the insured portfolio has
also been changed in line with the change in equity and T-Bill amount. In 1st quarter the equity
amount is higher than the T-Bill amount. It is also noticed that the insured portfolio has increased
to TK. 658,160.15 from TK. 500,000.00. In 2nd and 3rd quarters, equity amounts were lower than
the T-Bill amounts. Insured portfolio increased in 2nd quarter though decreased in 3rd quarter. In
4th quarter, equity amount became higher than the T-Bill amount again and the insured portfolio
became the historical highest.
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Dynamic Asset Allocation
Chapter-6
Static vs. Dynamic Asset Allocation
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Dynamic Asset Allocation
From the comparison of the two different asset allocation strategies it is observed that dynamic
asset allocation strategy provides the base for insured portfolio. Where static allocation of asset
requires the rigid proportion of assets, dynamic asset allocation strategy requires the adjustment of
the proportion of asset with the change of equity price. If price increases, dynamic asset allocation
strategy requires increasing the equity proportion and vice versa. The portfolio value is different
in static and dynamic asset allocation in every quarter. The graph comparing the static and
dynamic asset allocation strategy is given below:
780,000.00
760,000.00
740,000.00
Amount (BDT)
720,000.00
700,000.00
680,000.00
660,000.00
640,000.00
620,000.00
600,000.00
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Dynamic Static
From the above graph we can observe that, dynamic asset allocation strategy provides better
results than static asset allocation strategy. The insured portfolio value is similar in both the cases
for 1st quarter. However, after that quarter dynamic asset allocation strategy outperformed static
asset allocation strategy in all the quarters. This is the evidence of supremacy of the dynamic asset
allocation strategy.
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Dynamic Asset Allocation
Chapter-7
Findings & Conclusion and Appendix
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Dynamic Asset Allocation
Findings & Conclusion
The basic dynamic trading approach involves replicating the insured portfolio’s price action with
an ever-changing combination of positions in the underlying portfolio and the risk less asset. The
proportions allocated to the underlying portfolio and the risk less asset change every period. The
dynamic insurance strategy requires a significant amount of trading. By dynamic asset allocation
it can be shown that how the same replication is accomplished (approximately) with either a stock
portfolio and short futures positions or the risk less futures.
Where static allocation of asset requires the rigid proportion of assets, dynamic asset allocation
strategy requires the adjustment of the proportion of asset with the change of equity price. If price
increases, dynamic asset allocation strategy requires increasing the equity proportion and vice
versa. The portfolio value is different in static and dynamic asset allocation in every quarter.
After preparing the dynamic asset allocation of selected five securities, a bunch of findings have
been sought out. Theses are as follows:
1. Industry Selection is the primitive task in portfolio investment.
2. Security selection is the most vital part of the portfolio investment.
3. Where static allocation of asset requires the rigid proportion of assets, dynamic asset
allocation strategy requires the adjustment of the proportion of asset with the change of
equity price.
4. If price increases, dynamic asset allocation strategy requires increasing the equity
proportion and vice versa.
5. The result may differ in static allocation and dynamic allocation.
6. Dynamic asset allocation provides insured portfolio unlike static asset allocation.
Finally, it can be said that, dynamic asset allocation strategy is the better model of portfolio
investment in comparison with the static asset allocation strategy. This method provides the basis
for adjustment in asset proportion in the portfolio in terms of the changes in prices of the
underlying securities. This is a continuous process of changing the portfolio combination and
structure which provides better insurance of the portfolio value indicating the supremacy above all
other methods of portfolio construction.
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Dynamic Asset Allocation
Appendix
1. Price Data:
TRADE LOW HIGH CLOSING
COMPANY NAME DATE PRICE PRICE PRICE
AL-ARAFAH ISLAMI BANK LTD. 30-12-2007 410.25 445.00 440.25
AL-ARAFAH ISLAMI BANK LTD. 31-03-2008 360.00 408.00 374.50
AL-ARAFAH ISLAMI BANK LTD. 30-06-2008 480.00 520.00 489.75
AL-ARAFAH ISLAMI BANK LTD. 25-09-2008 377.00 440.00 433.50
AL-ARAFAH ISLAMI BANK LTD. 30-12-2008 410.00 460.00 444.25
ISLAMIC FINANCE & INVESTMENT LTD. 30-12-2007 190.00 215.00 209.00
ISLAMIC FINANCE & INVESTMENT LTD. 30-03-2008 196.00 216.50 212.50
ISLAMIC FINANCE & INVESTMENT LTD. 30-06-2008 350.00 380.00 372.75
ISLAMIC FINANCE & INVESTMENT LTD. 25-09-2008 330.00 337.00 332.50
ISLAMIC FINANCE & INVESTMENT LTD. 30-12-2008 307.00 354.50 337.50
RENWICK JAJNESWAR &
COMPANY(BANGLADESH) LTD. 30-12-2007 185.50 188.00 186.50
RENWICK JAJNESWAR &
COMPANY(BANGLADESH) LTD. 31-03-2008 652.00 708.00 698.75
RENWICK JAJNESWAR &
COMPANY(BANGLADESH) LTD. 30-06-2008 427.00 428.00 427.25
RENWICK JAJNESWAR &
COMPANY(BANGLADESH) LTD. 25-09-2008 395.00 409.00 398.00
RENWICK JAJNESWAR &
COMPANY(BANGLADESH) LTD. 30-12-2008 656.00 720.00 680.50
SQUARE PHARMACEUTICALS LIMITED 30-12-2007 3,533.25 3,690.00 3,682.00
SQUARE PHARMACEUTICALS LIMITED 31-03-2008 4,070.00 4,150.00 4,110.25
SQUARE PHARMACEUTICALS LIMITED 30-06-2008 5,389.00 5,512.00 5,458.75
SQUARE PHARMACEUTICALS LIMITED 25-09-2008 2,800.25 2,860.00 2,841.00
SQUARE PHARMACEUTICALS LIMITED 30-12-2008 3,126.00 3,232.00 3,151.25
HEIDELBERGCEMENT BANGLADESH LIMITED. 30-12-2007 1,120.00 1,228.00 1,204.75
HEIDELBERGCEMENT BANGLADESH LIMITED. 30-03-2008 1,300.00 1,421.00 1,405.25
HEIDELBERGCEMENT BANGLADESH LIMITED. 30-06-2008 1,347.00 1,435.00 1,406.75
HEIDELBERGCEMENT BANGLADESH LIMITED. 25-09-2008 1,160.00 1,270.00 1,234.00
HEIDELBERGCEMENT BANGLADESH LIMITED. 30-12-2008 1,101.00 1,227.00 1,214.00
2. Dividend Data:
Dividend History
Company Name
Announcement Cash Stock
Date Dividend Dividend
AL-ARAFAH ISLAMI BANK LTD. 16.03.2008 na 20%B
ISLAMIC FINANCE & INVESTMENT LTD. 30.04.2008 15% na
RENWICK JAJNESWAR & COMPANY LTD. Na na na
SQUARE PHARMACEUTICALS LIMITED 21.07.2008 40% 35%B
HEIDELBERGCEMENT BANGLADESH LIMITED. 29.04.2008 25% na
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Dynamic Asset Allocation
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Dynamic Asset Allocation
st
7. 50 percent Equity (1 Quarter)
Initial Lower Higher Closing
Company Name Value Value Value Value
AL-ARAFAH ISLAMI BANK
50,000.00 40,885.86 46,337.31 51,039.18
ISLAMIC FINANCE &
INVESTMENT 50,000.00 46,889.95 51,794.26 50,837.32
RENWICK JAJNESWAR
50,000.00 174,798.93 189,812.33 187,332.44
SQUARE PHARMA
50,000.00 55,268.88 56,355.24 55,815.45
HEIDELBERG CEMENT
50,000.00 53,953.10 58,974.89 58,321.23
Total
250,000.00 371,796.72 403,274.03 403,345.62
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Dynamic Asset Allocation
11. Static Portfolio
Initial 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
91 Days T-Bill Rate 7.63% 7.68% 7.74% 7.83%
Continuous
1.019768
Compounding Rate 1.019258 1.019386 1.019538
Amount to be
343,703.30
invested in T-Bill 250,000.00 254,814.52 335,459.46 368,047.82
Amount to be
374,450.54
invested in Equity 250,000.00 403,345.62 386,529.65 306,033.65
718,153.84
Total Value 500,000.00 658,160.15 721,989.10 674,081.47
Equity 250,000.00
T-Bill 250,000.00
Delta 0.5000
New portfolio
Equity 250,000.00
T-Bill 250,000.00
Total 500,000.00
T-Bill 254,814.52
Delta 0.6519
New portfolio
Equity 464,601.61
T-Bill 193,558.54
Total 658,160.15
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Dynamic Asset Allocation
nd
14. Dynamic Allocation: 2 Quarter
2nd Quarter
T-Bill 197,286.11
New portfolio
Equity 265,091.59
T-Bill 477,904.54
Total 742,996.13
T-Bill 487,242.05
New portfolio
Equity 322,529.73
T-Bill 389,444.09
Total 711,973.82
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Dynamic Asset Allocation
th
16. Dynamic Allocation: 4 Quarter
4th Quarter
T-Bill 397,142.56
New portfolio
Equity 446,304.46
T-Bill 309,166.99
Total 755,471.45
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