QP MODELLING ASSIGNMENT

QP modelling assignment

QP modelling assignment

Introduction

The aim of a stock market index is to monitor the performance of some sectors of a financial market, such as stock and bond markets. For example, the FTSE 100 index monitors the shares of the 100 companies in the UK with the largest market capitalization. The FTSE 100 is a value-weighted index, with the weight of each share depending on the total market value of the company. It therefore follows the share pieces and can change continuously throughout a trading day.

Investors often aim to develop funds that replicate, or track, the performance of a specific index. The reason for this approach is the potential for a relatively attractive gain with minimal risk and management costs. Since out performing the market in a consistent manner is a difficult, if not an impossible task for any fund manager and associated references), an attractive investment strategy is to follow, or track a market index. Although by tracking a market index one abandons any chance to out perform the market, the chance of performing much worse than the market is also eliminated, therefore reducing overall risk (Dorsey, 2005, 53).

Key benefits include reduced risk and reduced management costs. One reason is the spread of investment through the tracking of a broad-based market index reduces the risk associated with the collapse of a specific industry or market sector. It also offers a readily available performance measure in the form of a published market index. Nevertheless, tracking market indexes might be less attractive to investors that seek high risk - high gain opportunities. Furthermore, a very accurate tracking is costly, and so by reducing management costs one also compromises tracking performance, which can lead to inferior gains compared to the original market index.

To reduce trading costs, the frequency at which the tracker fund shares are updated can be reduced. Usually, tracker funds will be updated on regular interval, with some procedure or optimization rule to decide on the new combination of shares and their relative weights.

Trading cost

The trading cost is the cost involved in buying and selling shares. This is necessary whenever the composition of shares is required to be updated. Assuming the cost of trading depends on the monetary value of the transaction required in a given tracker fund update, then this cost can be formulated as: Equation 5 where 0?=?µ?=?1 represents the part sold or bought ...